Friday, February 06, 2009

This Economy Brought to You by the Wrong Metrics

How did we get in the global economic shape we’re in?

You and I bought stocks and mutual funds (and you might have bought hedge funds). We expected above-average returns from those investment managers.

The investment managers make money by selling more shares in their funds. To do that, they needed to show higher-than-average returns. They had only a secondary interest in the long-term health of the companies they were buying (despite statements to the contrary in their prospectus). The really just needed to show strong returns NOW to compete with other funds. That made their focus short-term even if they wouldn’t admit it.

Since CEOs need demand for their company stock to keep the price high (and keep the board happy), they obliged these fund investors by pushing to meet short-term earnings growth to increase the rationale for a higher P/E multiple. As a result, their decision process became somewhat perverted towards hitting every quarterly target they promised to Wall St. and the fund managers.

This perversion drove managers working for the CEOs onto a slippery slope of buying and selling things that had substantially higher risk profiles than they were used to, and many hidden risks that have only recently come to light. Altruistically in most cases, but not all.

The CEO was OK with this as A) it was driving earnings growth; and B) they were “trusting” their expert managers and consultants (who were also paid handsomely for making recommendations to participate in such behaviors).

The fund managers were OK keeping a blind eye to this, as long as the returns for their fund were above average.

You and I were happy as long as our investment portfolios were rising in value.

In short, we all got too focused on the WRONG metric of short-term growth in stock prices. It’s the same thing that happened in the dot-bomb era, only with a different rationale. Only this time, we managed to ensnare millions of homeowners in the process, destabilizing their confidence in spending. This, in turn, destabilized the climate for corporate investments, and increased layoffs. Thus the viscous cycle we’re in now.

I raise this as an example of how seriously wrong things can go if we’re not focused on the right metrics.

The answer isn’t higher levels of government oversight and regulation. It’s higher levels of transparency in companies reporting what they’re doing to hit earnings targets, combined with a closer monitoring of their productivity in generating organic growth. And it’s paying more attention to the leading indicator metrics of consumer behavior – security, liquidity, and confidence.

Just like many of our businesses, it often takes a knock upside the head for us to realize that we slowly lost focus on the right metrics.

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