Mortgage

Ralph planned to continue working hard to build the company’s credibility with Wall Street analysts and investors. It would be essential for EG to track analyst views on its performance and prospects on a regular basis. Ralph wanted to do this for two reasons. First, he would be able to ensure that the market had sufficient information to evaluate the company at all times. Second, Ralph knew that the market was smart. He could learn a lot about the direction of his industry and competitors from the way investors evaluated his shares and those of other companies. He did not believe that he could, nor would he try, to fool the market about EG. He was convinced that it was sound strategy to treat investors and the investing community with the same care that the company showed its customers and employees. Had previous management taken the time to understand what the market was saying about EG, the company might have avoided the difficult position in which it found itself.
In addition to tracking the analysts’ opinions and meeting with them regularly, Ralph thought EG should be more active and clearer in communicating with investors. Henceforth, communications with the market at securities analyst meetings and in press releases would focus on what EG was doing to build value for shareholders. He even thought it might be a good idea to have a section in the annual report entitled “Perspective on the Value of Your Company” that would discuss the company’s strategy for creating value.
He thought that EG could go as far as publishing estimates of the value of the company, as long as the assumptions were spelled out clearly. Ralph knew that this communications strategy would be a break with the practices of many companies and with EG’s recent past. However, Ralph did not really think investors got much benefit from the mechanical—and usually vague—explanations of changes in year-to-year performance typically found in annual reports. Likewise, the glossy photographs and glowing language in the front sections of many annual reports did little to give investors a clear sense of where a company was going and what the status of their investment was.

Injecting a value-creation focus into EG’s planning and performance review process would make a big difference. Ralph also knew he needed to make changes in the way the company looked at major spending proposals.
To evaluate capital spending, EG had been using discounted cash flow analysis for at least five years, as had most other companies. This was fine, but Ralph saw two problems. First, capital spending was not linked tightly enough to the strategic and operating plans for the businesses. Because of this, capital spending proposals were out of context and difficult to evaluate. Second, EG had been using a corporatewide hurdle rate to assess capital investment proposals. From the restructuring review of EG, Ralph knew that each of the EG businesses involved a different degree of risk, so the hurdle rates for assessing capital investments should be different, too. To make matters worse, the hurdle rate was too high, having been set in an attempt to smoke out unrealistic operating projections. The result was an ineffective capital spending process. Ralph figured that many investments that earned about the cost of capital were being passed up because they did not meet EG’s extremely high hurdle rate. On the other hand, major capital investments were not evaluated as closely as they should be since the whole process had degenerated into a numbers game about assumptions. Ralph intended to tie capital spending closely to strategic and operating plans to ensure that its evaluation was realistic and fact-based. He would also ensure that the finance staff developed appropriate hurdle rates that would differ by division to reflect the relevant opportunity cost of capital.
Ralph knew that one of EG’s biggest problems had been the evaluation of acquisitions. He knew they had paid too much for the Woodco acquisitions in the 1980s. In the restructuring review, he had seen the impact of paying too much on the company’s share price. Fortunately, as CEO he would have direct control over the decision to pursue acquisitions. He would insist that when proposing an acquisition, the relevant operating manager and CFO do a thorough valuation analysis based on cash flow returns for the transaction. He would not make the mistake his predecessor had of believing that just because he could make the accounting earnings and dilution figures look good in the first year or two of an acquisition, it made sense from a value standpoint.
To Ralph it was really quite simple. Either the cash flow value to EG’s shareholders of an acquisition would be higher than the price EG would have to pay, or Ralph would not make the acquisition. And he believed that value could be assessed much more systematically than in the past.
First, EG management would evaluate the target’s business on an ”as is” basis, just as the team had done for EG. Next, management would use the restructuring hexagon approach to identify improvements that could be made to the value of the company on a stand-alone basis. The management of the target company might or might not be capable of making these improvements on its own. Third, EG management would evaluate the potential for synergies with other EG businesses on a systematic basis. These synergies would be evaluated in concrete terms for their impact on value. Finally, EG management would think about the strategic options the acquisition would create. These would be difficult to evaluate and value, but could nevertheless be important. For example, an acquisition might give EG an option on a new technology in one of its businesses, or access to a new market, both of which could have substantial value under the right conditions.
Armed with this information, Ralph would be much better able to evaluate the logic of any acquisition, certainly much clearer than EG management had ever been. He would know how much EG could afford to pay. Equally important, he would know more specifically what to do with the business after it had been acquired. Before entering negotiations, Ralph would also have his team assess the value of the target to other potential acquirers; in this way he could be sure that he would not enter into a fruitless bidding contest or end up buying the company at a price higher than he needed to. He certainly did not want to fall into the trap of giving all the potential value of the candidate to the selling shareholders. After all, why should EG do all the work and the sellers receive all the rewards? Acquisition proposals would be subjected to a new test. EG management would no longer presume that the best way to pursue a new business idea was by acquisition. Ralph would ensure that management considered entering a business in other ways, such as through a joint venture. Such approaches might be alternatives to the ”big bang” acquisitions that seem like easy solutions at the time, but afterward cause endless problems for the company’s stock market performance.

Ralph believed that one of the most powerful levers he could use in building a value-creation focus throughout EG was the compensation system. At present, the package contained relatively little performance-based incentive for top managers. They did receive a bonus, but it was a relatively modest proportion of total compensation. They also received stock options, but few viewed these as significant in terms of their ability to build capital for doing a good job. It was clear to Ralph that the top-management incentives did not focus on value creation. Bonus payouts were geared toward achievement of earnings-per-share targets, which as he knew did not always correlate well with creating value. In addition, the compensation of business-unit managers was tied more closely to the performance of EG as a whole than it was to the fortunes of their particular business unit.
Ralph figured that several schemes were capable of meeting his objectives. He asked his human resources executives to consider phantom stock for each of the divisions; a deferred compensation program structured around the economic profit targets that the businesses were adopting, and using the attainment of goals on particular value drivers as a basis for compensation awards.

Ralph knew that his managers needed clear targets and performance measures to track their progress. While the stock price performance was the ultimate measure, he needed something more concrete and directly manageable by his managers,particularly his business unit managers. He also knew that traditional accounting measures like net income ignored the opportunity cost of the capital tied up to generate earnings. Return on invested capital (ROIC), on the other hand, ignored value-creating growth. So he turned to a measure that incorporated both growth and return on invested capital, called economic profit (EP). EP is the spread between the return on capital and its opportunity cost times the quantity of invested capital:Ralph chose this measure because he knew that the discounted value of future economic profit (plus the current amount of invested capital) would equal the discounted cash flow (DCF) value (see Chapters 3 and 4 for a more complete  description). In other words, EG could maximize DCF value by maximizing economic profit. Ralph asked that all strategic plans and budgets include economic profit targets for each of the business units.
Knowing that lower level managers also needed targets and performance measures that they could directly influence, he asked his business unit managers to translate economic profit targets into specific operational performance measures for their operating managers. For example, the manufacturing manager might be measured by cost per unit, quality, and meeting delivery schedules. Sales might be measured by sales growth, price discounts of list prices, and selling costs as a percent of revenues.
This integrated system of target setting and performance measurement required a new mindset for Ralph’s accounting group, which was accustomed to dealing with accounting results. The accounting group resisted but Ralph convinced it of the benefits of integrating financial results with operating measures and with moving toward more economically relevant financial measures.

Ralph was convinced that one of the main reasons EG had gotten into trouble was a lack of focus on value creation in developing corporate-level and business-unit plans. Likewise, evaluations of the performance of the businesses had only a vague focus on value. Ralph firmly believed that it was the responsibility of all senior managers to focus on value creation. Ralph would ensure that company plans included a thorough analysis of the value of each of the businesses under alternative scenarios. He would also make sure that EG used the restructuring hexagon approach on an annual basis to identify any restructuring opportunities within EG’s portfolio.
This new focus on value would also require some changes in the way EG thought about its corporate strategy. For the next year or so, EG had to focus on restructuring. In the longer term, Ralph would need to develop a plan for sustaining EG’s advantage in the market for corporate control. To do this, he would need to better understand the company’s skills and assets and in which businesses they would be most valuable. Most important, he would have to ensure that the value of these skills could be identified in terms of higher margins, growth rates, and the like before building action plans around them. Too often, Ralph was convinced, EG had done a perfunctory analysis of its capabilities and entered businesses without a clear idea of how and why EG would be a better owner and able to create value for its shareholders. As a first step, later in the year Ralph would establish a task force to compile an inventory and do an analysis of EG’s skills and assets compared with its competition, as well as ideas for new businesses EG might enter.
At the business level, EG’s new focus on value would require some changes too. The restructuring review had pointed out a number of specific strategic and operating actions that the various business managers would need to take. Beyond this, management in the business units would need to think differently about their operations. They would need to focus on what was driving the value of their businesses—whether it was volume growth, margins, or capital utilization. Everyone was accustomed to focusing on growth in earnings, but what would matter in the future would be growth in value and economic returns on investment. Sometimes this would mean foregoing growth in the business that would have been accepted in years gone by. At other times, managers would have to get more comfortable with the idea of reporting lower earnings when investment in research and development or advertising with a longer term payoff made economic sense. Ralph knew that these changes would be difficult for his management group, because it had not been encouraged to think this way in the past. To help bring about change, he decided to share with the management group the results of the corporate restructuring analysis and to develop a series of training seminars for senior division management about shareholder value.

Ralph also urged his CFO to look hard at EG’s financial structure and come up with an aggressive plan to take advantage of the tax advantages of debt financing. EG had had a policy of maintaining an AA rating from Standard & Poor’s and liked to think of itself as a strong investment-grade company. Ralph knew that many companies had taken on much higher debt levels and performed well. The performance of many had been spectacular, as managers thought harder about how to generate additional cash flow and looked more critically at investment requirements and so-called fixed expenses.
EG had sizable and stable free cash flows that could support much higher debt. The Consumerco business, which generated the bulk of the cash, was recession resistant. Ralph also knew that he did not need much reserve financial capacity given the relative maturity of EG’s core business and its limited need for capital. He also believed that EG would be able to get access to funding for a major expansion or acquisition, if it made economic sense. Otherwise, it was probably a poor investment in the first place.
By the CFO’s calculations, EG could indeed carry a lot more debt than it did, depending on the interest coverage Ralph wished to maintain. As the financial performance of the EG businesses improved, EG would be able to carry an even higher debt load comfortably. Ralph figured that at a minimum, EG could raise $500 million in new debt in the next six months and use the proceeds to repurchase shares or pay a special dividend. This debt would provide a more tax-efficient capital structure for EG, which would be worth about $200 million in present value to EG’s shareholders, assuming a combined federal and state marginal tax rate of about 40 percent.

Ralph Demsky was familiar with EG’s worrisome corporate situation and had been a vocal advocate of a sharper focus on shareholder value for EG for several years. Ralph was convinced that great opportunities existed for EG to boost its value. Upon retirement of the previous chairman and CEO, the board had tapped Ralph to lead EG because of his controversial ideas and his strong operating track record leading Consumerco.
Ralph knew he needed to act fast. His plan was first to uncover and act on any immediate restructuring opportunities within EG. Then for the longer term, he would put in place management systems and approaches to ensure EG did not pass up rich opportunities.

It is debatable whether or not momentum traders are trend-followers. There is no debate when it comes to flow-based currency speculators. The very act of using order flow information for the purpose of trading in the currency markets requires that the user is following the trend suggested by that flow data. Currency speculators who focus on flow, use that information to anticipate the continuation or end of a trend. Clearly, with flow products, both the quality and the relevance of the flow data are crucial elements in deciding whether or not to use such products as one’s primary information source for trading. There is no point in using a flow product where the order flow is neither reflective of the currency market as a whole nor has any impact on it. Flow-based currency speculators can certainly earn excess returns, but as with other trading approaches discipline is needed. Unlike in the case of the momentum trader where the model creates the signal irrespective of all other factors and therefore the trader’s only job is to execute according to that signal, there is still a significant degree of discretion and interpretation in flow-based currency speculation. For instance, temporary seasonal factors can distort flow. If the flows model were passive, this would mean that a trading signal would be triggered irrespective of this important consideration. That said, the aspect of discretion automatically increases the possibility of misinterpretation and making mistakes. As with most types of trading or currency speculation, experience counts.

Momentum funds have a different trading approach as regards currency speculation. Rather than focusing on apparent disparities between the economics and the price, they use so-called momentum models to trigger buy or sell signals in currency pairs irrespective of the economics. Granted, one could argue that since economics affects the price of the currency, so it also affects their models and therefore their trading approach. However, it is fair to say that economics is not their primary focus. Their aim is to be disciplined to the extent that they rigorously follow the trading signals of their momentum models. As one might expect, the nature of these models varies. For instance, one such momentum model relies on technical analysis indicators to provide short-term moving averages. When a 5-day moving average crosses up through the 15-day moving average they buy and when the opposite happens they sell. Granted, this is a vast oversimplification and there are many significantly more sophisticated momentum models than this. That said, the principle is surely the correct one. Momentum models, however complex and whatever indicators they rely on, focus on changes in market prices as their key determinant for providing signals rather than economic fundamentals. Therefore, it is probably a reasonable generalization to say that they are more short term in their trading approach than macro-based currency speculators might be, depending of course on how long the momentum signal lasts.

This approach is for the most part identified with the so-called “macro hedge funds”. Broadly speaking, “macro” or macroeconomic-based currency speculators look for market pricing inconsistencies between the prevailing economic fundamentals and the long-term currency valuation, with the current market pricing. Their raison d’etre and their incentive is that current market pricing is “wrong” relative to those fundamentals and valuation, and they can earn excess returns by trading against that market pricing.
Here again, the line between the currency speculator and the “fundamental” market participant is blurred. After all, where is the difference in terms of incentive and action between the asset manager who invests in a country’s equity or fixed income markets and the macro-based currency speculator who invests in a currency because they think it is undervalued relative to fundamentals and valuation?
It is widely assumed that currency speculators only trade against currencies rather than in their favour, but this is very far from the case. Indeed, during the Asian crisis itself, a number of macro hedge funds bought Asian currencies such as the Indonesian rupiah on the view that they had overshot their fundamental value — unwisely and prematurely as it turned out. It has frequently been easier to make excess returns by trading against currencies rather than in their favour during the 1990s, not for any malign reason but simply because it was discovered that semi-pegged exchange rate regimes were incompatible with free and open capital markets. Keeping on the Asian example, to focus on currency speculation for or against Asian currencies is to ignore the fact that the Asian boom became a speculative bubble that was in any case waiting to burst, a bubble which the authorities were seemingly unwilling or unable to stop. Macro currency speculators are a stabilizing force against economic imbalance, an arbiter of government economic policies. The disruption that currency markets might experience is not caused by their activity. Whether they were capable of doing so in the past due to much greater leverage, that is certainly not the case now. They can merely accelerate the process, but they cannot cause it. The real cause is the government policy in the first place, which triggered the economic imbalance.