What struck me is how differently both sides view the crisis. The Germans with whom we met typically view the crisis as a consequence of bad behavior on the part of both private and public actors in the periphery. The Spaniards with whom we met, who do not deny that bad behavior amongst private and public actors played a role, nevertheless view the crisis as one aided and abetted by the countries in the core.

Given the divergent views on the causes of the crisis, both sides, not surprisingly, disagree on how to resolve what ails the Euro zone.

The core is pushing the austerity agenda – e.g., compelling peripheral countries to cut government expenditures and reduce labor costs – to accomplish an internal devaluation to improve competitiveness. Unfortunately, austerity is very painful medicine, and has serious unemployment and social stability consequences.

Peripheral countries, by contrast, are asking for the ECB, and the countries in the core, to do more – e.g., intervene to stabilize sovereign borrowing costs, explicitly allow for greater levels of inflation, engage in stimulus, and/or lessen demands for austerity - as a means of helping the periphery make difficult structural adjustments (i.e., to cushion the blow).

Personally, I think those in the periphery have a point. I don’t think austerity has been working so well – resulting in a deeper, and more protracted, recession. The ECB seems wedded to austerity as an answer, even in the face of evidence to the contrary (though they do seem increasingly open to engaging in quantitative easing – OMT – if necessary). The powers that be in the core, however, have very little appetite for allowing inflation to increase (as memories of the Weimar Republic loom large).

So unfortunately, and especially for the constituents at the core, the issue is not just economic, but political. And as long as those in the core keep pushing austerity as the answer and remain unwilling to come to the aid of their brethren (and part of the problem is that they don’t see them as brethren) in the periphery, the prospects for the Euro remain bleak. How much pain can countries like Spain, Italy, and Greece endure before there they decide that enough is enough and walk away from the Euro experiment? We might not on the precipice at the moment, but without a meaningful compromise, such an outcome might be inevitable.

Nevertheless, as the unbridled optimist that I am, I am hopeful that when push comes to shove, the ECB will intervene and the core countries will do more – ultimately recognizing that they bear tremendous costs should countries like Italy and Spain abandon the Euro. I am also hopeful that once the federal elections pass in Germany (in September), that the current rhetoric in favor of austerity will shift to one that emphasizes European unity and solidarity, with a commensurate commitment to do more to keep the Euro together. But let’s just hope that countries like Italy and Spain don’t reach their breaking point before that happens…

The article noted a recent conflict between activist/investor David Einhorn and Apple in which Einhorn has requested Apple distribute cash to investors. Marty Lipton criticized Einhorn’s actions and, more broadly, the practices of some activist investors. According to the New York Times:

Martin Lipton, one of the nation’s top corporate lawyers…wrote a scathing memo to his clients on his view that “shareholder democracy” has run amok…Mr. Lipton said that long-term shareholders in public companies are being undermined “by a gaggle of activist hedge funds who troll through S.E.C. filings looking for opportunities to demand a change in a company’s strategy or portfolio that will create a short-term profit without regard to the impact on the company’s long-term prospects.”

Although I don’t always agree with Marty Lipton (best known for inventing the poison pill), I think he’s onto something here.

Clearly, it can be problematic when the goals of short-term institutional investors don’t match those of the companies in which they invest, where the incentives should favor long-term outcomes.

I’ve written about these issues in the context executive compensation (see Revisiting Executive Pay: The Problem is Systemic), but given the prominence of institutional investors with short-term horizons, I think the overarching issues are worth revisiting.

In a previous article I mused:

Who are shareholders? Although seemingly a silly question, the answer has important implications…

Historically, shareholders were individual company owners (often dispersed) who held stock for long periods of time. Today, the picture is quite different. Shareholders are represented less and less by individuals and institutions holding stocks for the long-term, and more and more by individuals and institutions looking to make a quick profit – buying and selling shares with frequency. The rise of such traders who seek to profit from near-term volatility in stock prices has changed the nature of the system. These traders are inconsistent with the spirit of the view of the shareholder as a long-term owner. They are not really owners, and sometimes have little interest in the long-term survival of the firm. They often only care about micro-movements in share price in a very narrow window of time.

I think what really drives this point home is the fact that even the definition of “short-term” has gotten, for the lack of better words, shorter. In the 1960s, investors held stocks for an average of about 8 years. That number can now be counted in days (see Stock Market Investors Have Become Absurdly Impatient). Add in high frequency traders, and the average hold time can be counted in seconds (see How long does the average share holding last? Just 22 seconds).

I think we really need to ask ourselves: Given the decreasing shareholding periods, are current shareholders congruent with our vision of shareholders as long-term owners?

The short-term mentality now prevalent among a certain strata of shareholders is not only a troubling in its own right, but it can also have serious implications for companies and how they are managed on a day-to-day basis. How can the CEO and the company’s top management team focus on long term outcomes when they are forced to cope with a set of stakeholders who favor near-term performance? After all, according to theory, managers are supposed maximize profitability over an infinite time horizon.

So, how can we solve the problem of some institutions trying to game the shareholder democracy system? For me, one interesting possibility lies in differentiating between ownership classes of stock and trading classes of stock. For example, perhaps we could consider creating “ownership” classes of stock that must be held for longer periods of time and come with certain, enhanced voting privileges so as to better align the incentives of shareholder/owners with the company. We could also create “trading” classes of stock with fewer ownership and control rights that can be freely traded at will. I’ve written a bit about this idea in the blog post entitled “Different Stock Classes: Trading vs. Ownership Shares“. I’d encourage you to take a look if you have an interest in the topic.

Nevertheless, whatever the outcome, one thing is for certain –this issue hasn’t been getting nearly the attention it deserves.

In a series of insightful articles, the magazine highlighted the trend of companies rethinking their offshoring strategies and bringing work back home (see Welcome Home).

According to The Economist, the “reshoring” trend is being driven not only by increased automation in manufacturing, but also by rising labor costs.

…The pull of low-wage countries is weakening. In a survey of big American manufacturers by the Boston Consulting Group last spring, nearly two-fifths of firms said they were either planning to move or thinking about moving production facilities from China back home…Consultants at both BCG and Alix Partners reckon that by 2015 it will cost about the same for an American firm to manufacture in America as in China.

It is only natural that as labor becomes increasingly more expensive overseas, and as automation tools become increasingly cost competitive, companies will reconsider their decision to offshore work. But the calculus doesn’t end there.

Western firms are also finding that innovation is easier when manufacturing is in the same place as research…early pioneers of services offshoring are bringing work back home, having discovered that looking after customers and developing new IT tools are in fact a “core” part of business.

It’s not solely about the nominal wage differences, but the hidden costs associated with managing far-flung activities. In many cases, cost differentials don’t compensate for quality differentials or its long-term strategic consequences. As I mentioned in prior blog posts (see Small Business Reevaluate Outsourcing and Revisiting Outsourcing Again):

…managers typically overestimate the benefits of offshore outsourcing (i.e., the ability to access cheap labor) and underestimate its costs (e.g., those born out of cultural, political, economic, and regulatory differences across countries)…[offshore] outsourcing is not without strategic consequences.

Although the economics of outsourcing can seem compelling on its face, the trend toward “reshoring” seems to suggest that managers are finally starting to recognize that the benefits are not quite what they seem.

With all that in mind, I invite you to take a closer look at The Economist special report. You can also watch the accompanying (embedded) video introducing the special report. Enjoy!

The offer implies an enterprise valuation of $6.7 billion for the entire firm. However, many, including the article’s author, believe that Chrysler is worth much more (see Valuing Chrysler Too Cheaply).

Mr. Marchionne’s offer values Chrysler at just four times his own expectation of the company’s 2012 net income. General Motors, meanwhile trades above nine times expected earnings for last year, and Ford Motor’s multiple is just over 10 times.

The Fiat proposal also pegs the enterprise value of Chrysler at $6.7 billion, scarcely more than the company’s $5.5 billion of…Ebidta…Ford’s enterprise value-to-Ebidta multiple is over five times; G.M.’s is just 2.6 times, partly thanks to $20 billion of net cash. That makes Mr. Marchionne look mighty cheap.

Sergio Marchionne, Fiat’s chief executive, admits that the offer might not be in line with Chrysler’s current performance. However, I am more interested in understanding why Fiat would undervalue Chrysler. Given Fiat’s current struggles, I can’t help but wonder if the real issue is that Fiat can’t afford to buy it anymore…

Hits

Tesco’s entry into the U.S. Market – Several years ago I suggested that Tesco would face some serious headwinds in the U.S. market (see Tesco’s Venture into the U.S.). Consistent with my expectations, it now seems Tesco is considering ending its presence in the U.S. because the “journey to scale and acceptable returns will take too long relative to other opportunities” (see Supermarket Tesco says ready to exit U.S.).

Misses

Tata JLR – I was skeptical of Tata’s acquisition of JLR (see Foreign Takeover Troubles?, Tata and Jaguar/Rover Revisited, Update: Tata and Jaguar/Rover, Progress Report: Tata Motors and JLR, Buyers Remorse: Will Tata Rue the Purchase of Jaguar and Land Rover?). Although Indian firms have had a pretty bad track record acquiring companies overseas, the JLR acquisition has bucked the trend. JLR sales have, so far, exceeded expectations (see Tata Profit Up on JLR Sales). So as of today, I’ve gotten this one wrong. Of course, these things take years to play out, and I still think we need a few more JLR product cycles to reach a definitive conclusion. But as the Magic 8-Ball used to caution, I think it’s only fair to say, “Outlook not so good” for my prediction thus far.

On the Fence

Fiat Chrysler - Again, I was very skeptical about this deal (see Fiat-Chrysler Darts Forward, Fiat/Chrysler Revisited, Can Fiat Really Pull It Off, and Is Fiat Nuts?). Fiat is certainly struggling; however, Chrysler has experienced something of a revival (see Fiat Europe Struggling). I cannot say for sure whether Fiat will ultimately succeed in the U.S., and/or with its ownership interest in Chrysler, but so far, my predictions for Chrysler’s demise have been postponed, …perhaps indefinitely??

Anyhow, business predictions aside, here’s to wishing you all a happy and healthy New Year!

However, James Kwak of the Baseline Scenario points out that there might not be such a tight coupling between pay and performance when star executives move from one company to another. According to a review of the academic literature on the topic by Charles Elson and Craig Ferrere (as summarized by Kwak),

Elson and Ferrere cite multiple empirical studies finding no relationship between a CEO’s performance at one company and his performance at the next company that massively overpaid to hire him. They conclude: “the empirical evidence suggests a negative expected benefit from going outside rather than pursuing an internal succession strategy, despite the ability to access an enhanced talent pool. In the aggregate, CEOs appear to be at their most effective only when they have made significant investments in firm-specific human capital.”

The argument is that “star” CEO’s lured from one company to another – i.e., the ones that everyone believes will succeed because they have succeeded in the past – don’t create value for the hiring company. Rather, it is likely that they appropriate most of the value that they generate by commanding higher pay packages than what should have been granted them. It is also quite possible that their “inalienable” management talent is not as “inalienable” as many believe. Otherwise stated, they are not as good as their pay suggests.

Although not in the context of CEO’s, Boris Groysberg (of Harvard) has a similar study of star analysts (see Chasing Stars: The Myth of Talent and the Portability of Performance). Like the CEO study, he finds that when star analysts move from one company to another, they usually under-perform  and are overpaid for the privilege. They appropriate more value than they bring to the new company. In essence, they are likely not as good as most believe them to be, their prior performance depends upon the resources available to them at their former employer, and the teams they had in place while working for that company. In short, it’s less about individual, portable talent and more about a team of people working together.

I’ve written about executive compensation extensively in the past (see The Credit Crunch and Executive Pay, Revisiting Executive Pay, A New Approach to Executive Compensation and Are Managers Really Rational). I’ve previously pointed out other factors contributing to the complex issue of excessive compensation packages:

1. The nature of the shift over time in shareholder profiles (from a traditional long-term individual investors to more short-term institutional traders).
2. The fundamental misalignment in incentives created by the differences between the accounting view of the firm (infinite lifespan) and the tenure of the average CEO (less than 5 year lifespan), and the inability of stock options to alleviate the short-term versus long-term incentive problem (see especially my post A New Approach to Executive Compensation).
3. Poor (or at the very least disinterested) governance on the part of the board members in general (and the compensation committee specifically).
4. The role of compensation consultants in bench-marking against “peer” companies and then subsequently ratcheting up executive compensation.

We can now add to that the “chasing stars” phenomenon.

Overall then, there are various reasons why executive compensation might not reflect such a “rational” process. And unfortunately, it is shareholders who end up bearing the real costs associated with any perversion in the compensation system.

According to the Economist:

The index includes all of the firms in the S&P 500 index that provide a useable geographical breakdown of their revenues. This amounts to 135 firms. Each company’s weight in the index is supposed to reflect their China revenues…Some companies report their China revenues explicitly. Many others report only their revenues for Asia-Pacific, excluding Japan. In these cases, we assume that China’s share of those revenues matched China’s share of the region’s GDP.

In principle, I think creating such a graphic is a great idea. However, a true China dependence graphic should also include exposure to the supply side, not just the demand side. In most cases, S&P 500 companies have a greater dependence on China’s supply chain than its consumers…

You can check it out and play with it by clicking on the Global Public Debt Clock link or the picture below. It’s pretty cool!

There has been a lot written lately about the emerging country champions – such as Haier, Lenovo, and Tata Motors – expanding abroad. I’ve even documented how difficult it can be for emerging market multinationals to expand into developed markets.

What’s interesting about this article, however, is that it highlights a particular challenge –building a global brand.

…non-branded companies typically earn gross margins of 3-8% and are constantly at risk of being undercut by cheaper rivals. Branded firms enjoy fatter margins (15% or more) and more loyal customers. Yet becoming a global brand is exceedingly hard. Emerging-market firms…struggle with limited budgets and unlimited prejudice.

The article describes a recent book by Amitava Chattopadhyay, of INSEAD, and Rajeev Batra, of the University of Michigan’s Ross School of Business, that addresses these challenges. The book argues that emerging market companies can overcome branding challenges by:

1. Exploiting their two basic advantages—economies of scale and local knowledge—to expand into new markets;
2. Defining a market segment in which they have a chance of becoming world-class;
3. Innovating; and
4. “Old fashioned” brand-building

As I pointed out in Innovation in China, Part Trois, manufacturing low-margin goods isn’t sustainable for emerging market multinationals in the long run. And unfortunately, moving up the value chain from a low margin manufacturer to a globally-recognized company takes an inordinate amount of time.

In both India Buys Global and Technological Ascendancy, I commented on the challenges that emerging market multinationals face when they expand into developed markets through acquisition:

In addition to the typical motivations for foreign expansion including market access and/or access to basic resources, firms from emerging markets often expand in an effort to tap into, and assimilate, state of the art technologies available in developed markets…[But] effectively integrating advanced technological knowledge is challenging. Closing the skills gap with advanced countries is no easy task.

Moreover, companies trying to establish their brand in a developed market oftentimes must combat the developed country consumers’ preconceived notions about the quality of goods. According to the Economist article:

Emerging-market firms must struggle with limited budgets and unlimited prejudice. GfK, a consumer-research company, found that only one-third of Americans were willing even to consider buying an Indian or Chinese car.

So although I think the book authors provide some good tips and isolate the kinds of things that emerging market multinationals need to do to overcome the challenges associated with global expansion, more often than not, these things are easier said than done.

In light of the economic situation in the Eurozone, it’s no surprise that the auto industry has taken a hit. Without consumers to purchase automobiles and fuel factories, many auto companies are faced with two less-than-desirable options: slim down or close down.

Analysts say the unprofitable automakers have no choice but to start closing production lines and cutting payrolls…Huge overcapacity…has spawned a crisis similar to the one the U.S. industry barely survived just a few years ago…Underused plants are ruinous for car companies, which must continue to pay upkeep costs and make payroll even as revenue plunges. By some estimates, the European industry as a whole is operating at only about 60 percent to 65 percent of capacity. As a general rule, plants must operate at about 75 percent or 80 percent to be profitable…

The current auto industry crisis in Europe follows the ongoing sovereign crisis and recession. In many ways, Europe’s auto industry crisis parallels the broader Euro crisis, with weakness concentrated in the periphery.

…the pain falls disproportionately on Southern Europe, while Germany seems immune. Car sales actually rose slightly in Germany during the first six months of the year. They plunged more than 14 percent in France and almost 20 percent in Italy…In Portugal and Greece…car sales fell more than 40 percent through June…

The auto industry crisis in Europe is similar to patterns we observed during the 2008-2009 financial crisis, where the effects spill over to companies outside the financial industry. As the Times rightly points out, it is difficult for countries such as Greece, Spain, and Portugal to respond.

When the financial crisis caused a recession in 2009, France and other European countries spent billions of euros to bail out their car companies. But instead of using that money to ease painful downsizing of plants and payrolls, governments provided financial incentives for people to trade in older models for new ones, or subsidized worker salaries to dissuade companies from cutting jobs…But now…European governments are financially ill-equipped to respond.

And even European carmakers that are willing to take desperate measures and reduce capacity are facing pressure from their governments to not engage in such cutbacks. For example, Peugeot has been attempting to close a plant in Aulnay; however, the union and France’s new government are exerting tremendous amounts of pressure to keep the plant open. This could eventually result in Peugeot’s demise.

I’ve written about the auto industry crisis extensively (see Overcapacity Still Plagues the Auto Industry and Auto Industry’s Big Little Problem). I have emphasized the importance of meaningfully reducing capacity from the industry, especially since it largely didn’t happen during the financial crisis. Instead, governments looking to preserve jobs propped up auto-makers in both the U.S. and Europe. I also noted in my previous entries that auto companies cannot rely on demand from emerging markets, like China, to fix the overcapacity problem.

As a result, we’re stuck in the same situation yet again -there is still overcapacity and the weakest of the automobile firms still need to contract. Something’s gotta give…