Incremental Revenues - Fact or Fiction

Last week, I got a chance to look at a tool that was developed by a company called Advanced Predictive Technologies. This tool cultivates the culture of Test and Learn. Say, you are planning to put together a marketing campaign initiative, this tools gives you the flexibility to test the effectiveness of the campaign on a small sample before you roll it out to the whole population. The idea behind this is great but the users of this tool need to be extremely cautious in interpreting the results of their promotion. The reason why these kinds of tools are profligating the industry landscape is to provide some sort of a platform and a strutured framework that can systematize the process of isolating the benefits for the thousands of initiatives being rolled across a corporation.

Each of the initiative claims to add an incremental x% to the top-line revenues over and above all the initiatives that are already in effect. At times, you get a feeling the amount of incremental revenue that each of the initiatives bring to the table, if you add them up is greater than the base business itself. An interesting analogy would be the value of derivatives from a financial product is greater than the underlying financial product itself.

At some point, I would like to design a tool (if somebody has something like that already in place - please let me know) that clearly identifies what the base business value is and layer in - each of the incremental benefits from different initiatives. Eventually this representation of the base business and incremental uplifts along with the costs of implementing each of the initiatives should become part of annual reports that can allow some sophisticated investors to make appropriate investing decisions.

Business Intelligence

I came across a great blog authored by one of my friends Karthikeyan Sankaran. This is a well-written blog written from a practitioner's perspective. The link to the blog is given below.

http://www.beyeblogs.com/karthikonbi/

I am getting a feeling that some people do not have enough perspective about life. For them I suggest a movie - Goodwill Hunting. This is a great movie that gives you an idea of what perspective is all about.

On a related note, some are so bad - that they just want to put you in a spot deliberately. They do not get it because they do not have the knowledge - they have probably worked in the same field for thousands of years and they know they are coasting. These are the guys who fear the unknown and try to prevent others from reaching their potential by putting in ridiculous curbs whenver possible.

Credit crisis - Great Recession of 2008 and 2009

I have been following the financial crisis the last several months and it is fascinating. The amount of incredible failures that could happen in the last few months seems to suggest the so called market values are fleeting at best, nailing the fundamentals of efficient market theory. I still tend to believe in facets of efficient market theory but I cannot fathom a company valued at $170 per share getting reduced to $2 in a span of 12 to 18 months. Just see the list of companies that went under in the last few months - Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Wachovia, Washington Mutual and indirect failures like GM, Chrysler and many others. The root cause is blamed on the subprime borrowers, extraordinary low interest rates and an expectation that the house prices will keep on increasing. Because of low interest rates, there was a huge demand for housing, resulting in huge amounts of borrowing by the households and then by banks. Some of the investment banks had leverage ratios of 30 to 1. That is for every one dollar of asset they own, they had 30 dollars of debt. In some markets like California, Nevada, Arizona and Florida the house prices kept on increasing while the growth in incomes remained stagnant. This was an indicator used by many hedge funds to bet against the housing market. This is where credit default swaps (CDS) come in.

CDS is a fascinating instrument that allows you to make bets on specific credit events like debt downgrades, default etc. Here you pay an insurer a premium every month so that if the credit event were to happen - the insurer will make you whole by giving you back the face value of the credit instrument that you had betted on. This is a great instrument that allows you to transer the risk of owning a credit instrument to somebody else for a premium. The CDS market is an OTC market [euphemism for very little regulation] and anybody can bet on a specific credit event. For example, I can bet that AIG can default on its debt even though I have no stake in either their debt or shares. It is like a horse race where you can bet on a horse even though you do not own the horse or not invested in its success. At least in horse racing people know it was for fun. In casinos, you can bet on events like Wimbledon, French Open, Superbowl and may such events. The horse-racing and casino gambling are strictly treated as entertainment gambling events and gamblers and casino holders know about it. Casinos are strictly regulated in the sense that they should hold enough cash reserves if a casino were to lose a gambling event. As an aside, in all casinos the odds are stacked in favor of casinos and in the long run casinos will always win.

Combing back to CDS, there was very little regulation on how much reserves the insurance companies need to hold in order to make the CDS buyers whole. The last few years, there have been a lot of transactions involving buying and selling CDS and the biggest insurance company that had a lot of CDS contracts outstanding was AIG. As some of you may know, AIG is an insurance behemoth - having interests all over the world. They had a stellar credit rating [AA or AAA, if I remember right] - which means they can be given credit at a very low interest rate. Being a trustworthy insurance company, with a very good credit rating, makes you think that they know what they are doing. They entered into lots of contracts with hedge funds and other banks worth at least half a trillion dollars. AIG bet that the companies that the hedge funds are making their bets on - like the Lehmans of the world and Citibanks of the world - will not fail and they have taken sufficient precautions to protect themselves in case something happens. Their assumption was companies like Lehman which is a 150 year old institution and Citibank, the biggest and the most global bank in terms of assets would not fail and the money they get in terms of premium from the hedge funds is free money.

But things started happening very fast - first Bear Stearns faced a classic "run on the bank" in March where they were so short on cash that they were forced to merge with JP Morgan for a mere pittance. The Bear Stearns building was morth more than the price that JP Morgan paid for this purchase. Then Fannie Mae and Freddie Mac collapsed and they have to be taken over by the government and then the biggest event of all - Lehman brothers collapsed. Hedge funds and investment banks that predicted these events were naturally demanding that they be made whole which in turn made the insurers [like AIG and other hedge funds] to come up with the impossible task of coming up with huge amounts of money overnight. Also because of the Lehman brothers' event, banks did not trust one another - that they just kept hoarding on the cash reserves that they got and did not lend money to other banks and other investment activities pushing the LIBOR rates up. This resulted in other rates, like adjustable rate mortgages which are anchored of LIBOR to go up as well. Typically, if borrowing rates go up then the investment activities come down and the companies have to take actions to sustain themselves as going concerns. This involves cutting jobs, benefits, salaries, reducing capital investment decisions etc. that can have devastating effects on the economy. On some days, the US Treasury were the most sought after investments, driving down yields of the 3-month Treasury rates to negative values.

The US government realized the ripple effects of these events were so devastating that the government ended up bailing out AIG by investing almost $170B and started pumping in huge amounts of money to the tune $700B into commercial banks and investment banks. It also became a major player in buying mortgage backed securities, started guaranteeing bank debts and reduced the benchmark interest rates to near zero. These actions were taken within a span of 15-30 days. Inspite of all these, and a coordinated global effort to reduce the after-effects of the credit shocks, the unemployment rates continued to raise and in US it currently stands at 9.4%. The fourth quarter GDP contracted by more than 5-6%.

Some of the events that happened here have probably happened in the 1930s - the era of Great Depression when hundreds and thousands of banks failed and the unemployment rate reached 25%. The events that are happening now [2008, 2009] are being branded as Great Recession, since the effects have not reached the Great Depression levels. But some of the remedial effects that were put in place, like FDIC after Great Depression cushioned the effects of this crisis.