Neuberger Berman's Recent Outlook

The following is Neuberger Berman’s (NB) 2^nd quarter 2010 economic outlook.  It is very thorough and well conceived.  In these challenging economic times, it is worth a review:

Neuberger Berman’s MLG Group’s Current Outlook 

THE WORLD IS STILL UPSIDE DOWN

August 18, 2010

Over the last decade, so much has structurally changed on Planet Earth that we believe the only informative perspective from which to view the world is…“upside down.” We first introduced this concept in our third quarter 2009 client letter and, as we think about the investment landscape currently, we believe this “paradigm shift” is underappreciated by investors.

Our team spent much of the second quarter 2010 pursuing an extensive global research effort to determine if this view of the world is still relevant. As you might expect from the title of this letter, our answer is yes!  Our research travels took us to China, Singapore, Indonesia, Mongolia, Australia and Brazil. Below, we share our takeaways from this research, some investable themes we have identified and how we are navigating this volatile and challenging investment environment...

4 Gloomy Scenarios

The US Economy continues to be unhealthy.  A review of various forecasts, suggests either a painfully slow recovery or future declines should be expected. One can never trust various predictions to be accurate, but there were four experienced voices who provided sincere concern.

Here is the first:

"The Hindenburg Omen reared its ugly head late last week, signaling more doom and gloom as stocks plod along amid the dog days of summer."

“Yes Folks, Hindenburg Omen Tripped Again” - Mr. Steven Russolillo

The second:

"The Dow Jones Industrial Average will lose about half of its value over the next couple of years as it follows a Nikkei-like pattern of several sharp rallies in an overall decline, according to Charles Nenner, founder and president of Charles Nenner research."

“Dow Faces Bouncy Ride to 5,000: Strategist” - CNBC.com

The third:

Some have predicted this continued deterioration of the economic climate.  Mr. David Farr, the Chief Executive Officer of the Emerson Electric Co., referenced a number of the circumstances contributing to this poor economy in an opinion piece from 2009.

Mr. Farr's Op-Ed is referenced here:
"An Op-Ed on Federal Spending and Legislation"

And finally the fourth:

Neuberger Berman’s MLB Group's 2nd quarter 2010 Economic Outlook is very thorough and well conceived.  It contributes positively with global investment opportunities as well as a potential Achilles' heel to the recovery. 

In these challenging economic times, it is worth a reading and can be accessed here:
"The World Is Still Upside Down"

Where Is China Heading?

Mark Leonard's book “What Does China Think?” presents a number of China's modern beliefs and challenges.  Mr. Leonard discusses China's current struggles and the new priorities the Chinese State has determined are essential to address contemporary problems.

It is interesting, for the first time in China’s history, the State's 11th five-year plan does not list economic growth as the top focus. The plan includes mantras, such as: “put people first”…“respecting the natural environment”… and introduces a model which resembles some Scandinavian attempts in Social Welfare to address existing concerns.

The Book suggests China’s most pressing problems are:

1. The rise in protests,
2. The gap between rich and poor,
3. The near bankruptcy of the rural economy,
4. The lack of domestic consumption,
5. The pervasive corruption of the political elite,
6. The environment.

Official records cite 87,000 protest demonstrations in 2005, which is a ten times the amount of such displays since 1993.  It is most likely, the actual number of organized public protestations is much higher.

Mr. Leonard maintains the theory, modern China hopes to develop into an “Asymmetric Superpower”.  This conception believes the USA has an unhealthy obsession with military production, and this is the United States' greatest weakness, blinding policy-makers to the wider picture of military strategy.  Mr. Leonard's offering suggests the current Leadership of China, must include the use of economic, legal, and political tools as well, which is referenced: “non-military warfare”.  This modern version of China's “Economic Warfare” includes investing billions of dollars in “Special Economic Zones” within foreign Nations.

However, today China invests billions to improve it's military might, as Chinese Leaders correctly believe economic power without a strong Military, in context to the rest of the World, will reduce China as an overall power.  They prefer to obtain a Military Force which will become equal to the United States.

“China is attractive to other nations because of its economic power but this attractiveness will not last. It will need to change its political system to become a ‘Hyper-Power’ equal to the USA”.

But for China to achieve this status, the State will need to eliminate its incongruous and obsessive policy on a number of issues, it has mistakenly elevated to threats to its survival: Taiwanese and Tibetan freedom, the relationship with the Dalai Lama, the rise of Falun Gong, and various radical Muslim Enclaves.

Why William Clay Ford, Jr. Failed

In October 2006, the Ford Motor Company replaced William Clay Ford, Jr. as its Chief Executive Officer.

Why did Mr. Ford fail?

His own words, reported by Micheline Maynard of the New York Times on July 16, 2006, titled "Is Ford Running On Empty" revealed the answer.

"I bowed to managers on what I knew were product development mistakes”. “I can’t delegate to anybody…dealing with unyielding managers that stymie and condescend to me.” “… would have performed better if not faced with people obstacles”. - William Clay Ford, Jr.

Mr. Ford cited as one of his victories his environmentally friendly new River Rouge assembly plant. He believed this to be a victory because “…I did it over the objections of company executives.”

He brought in a new Chief of Staff and Gatekeeper, who is his best friend and brother-in-law, whose prior experience was as manager of the Henry Ford Museum. “He helps me decide which meetings and projects deserve my attention.”

One of his priorities was examining “…everything from how we’re going to treat each other in meetings to the trappings of our job.”

All of the priorities he listed in the article were essentially 'trivial many' when he had vital priorities that need attention. His “River Rouge” victory was quite minor with the intractable problems Ford is facing. Crowing about it publicly was a polarizing mistake. His new Chief of Staff, his brother in-law, further undermined him.

He made the fundamental CEO error, not persuading his managers to change their position on vital priorities. If he couldn’t persuade them, he should have made the correct strategic decision. He was not leading the company. He was not in command.

One example of Ford’s bloated overhead is its executive dining room replete with waitresses, multi-course menu, and silver finger bowls. Mr. Ford would have been more successful if he had executed an operational restructuring that significantly reduced salaried headcount in 2006 – not phased in over 3 years.

Better yet, he would have been well served to adopt Toyota’s performance target of 10% improvements in salaried productivity every year. If he adopted these principals, Mr. Ford, Jr. might then have been in a position to encourage unions to voluntarily modify contracts, base wage rates, pensions, and retiree medical care.

Leadership is learned. Taking command is learned. Mr. Ford held the CEO position for five years. He did not learn.

His lack of leadership and lack of prioritized focus, as demonstrated by his poor relationship with his managers, turned into poor performance at Ford. Only increasing Ford's low quality ratings, unimpressive new models, lack of worldwide integration in sourcing - product development, and the negative financial performance.

Alan Mulally, Ford’s new CEO, would be well served if he followed the practice of Neville Isdell when he was first named CEO of Coca-Cola. He was asked what are his plans for the company. Mr. Isdell's memorable response: "I plan to spend the first 120 days visiting employees and managers around Coke finding out what the state of the business really is."

Certainly the correct approach.

It is just that simple to get a company focused. Establish a rough-cut strategy, lead and motivate the team.

India – What Hinders Its Development?

Some thoughts on the interesting book “In Spite of the Gods – The Strange Rise of Modern India” by Edward Luce, the Financial Times' Washington Bureau Chief. He worked and lived in India for years.

While his conclusion is that India will become an economic super power, its many negatives will delay its development.

Some of the negatives:

Its massively ineffective and corrupt "quasi-socialist" political system.

Labor laws are too restrictive, cannot fire or lay off any employees, even if they are criminals, which supports the case for outsourcing only and not investing in 100% owned operations.

Literacy in China is 90%, in India it is 65% - female literacy is 48%. Focus in India is on university education, not elementary school education which China has focused on to build a viable work force. By comparison, the USA's literacy rate was 90% during its industrial and economic ascendancy in the 1800s.

India lacks investment in infrastructure, just starting to build roads and highways.

Bulk of population lives in small villages, not an urbanized country most developing countries tend toward. Of 1 billion population, 750 million live in small villages.

People are not motivated to seek a better life, caste system is an obstacle, lack of ambition somewhat stifled by elite strata which are still very British oriented.

Corruption is pervasive and extensive. Bribes are commonplace.

A telling difference between China and India is that China has accepted capitalism. Surprisingly for China's controlling government, its economy is based on market-driven industrialization. India has not accepted capitalism with its over-regulated private sector which is a draw back to growth and development.

An interesting fact:
India's police have "encounter specialists" which are policemen who kill criminals the police decide are guilty - prior to a trial. India has a 27 million criminal and civil case backlog. Police kill criminals because evidence gets lost, witnesses die, low-paid judges are easy to bribe and it takes too long for cases to come to trial.

2nd Follow-up to the Analysis of the Financial Crisis

Mr. Komal Sri-Kumar analyzed the Financial Crisis on October 31. It is his fourth webcast since October 3. Mr. Sri-Kumar is TCW Group’s Chief Global Strategist.

It is a meaningful, worthwhile analysis.

A summary of Mr. Sri-Kumar's views and forecasts:

1. The 4th quarter of 2008 will be the worst quarter with a 4% drop in GDP.

2. Is relatively optimistic in expecting the USA recession to end in the middle of 2009 because: “…the economy and stock market went down very fast…for the same reason the upturn will be equally rapid”.

The significant decline in consumer sentiment suggests a deep consumer recession. Does not see a depression risk. Expects unemployment to hit 8% or higher.

3. Federal Reserve should not have cut the interest rate by 50 basis points. It gave little stimulus to the economy. It was not the reason for the stock market increase. The stock market surged because the TED risk spreads have come down. The principal negative issue is the “liquidity trap” in that lenders are not willing to lend.

He suggests that direct to consumer stimulus is more important than interest rate reductions.

Does not see an inflation risk – including copper and oil. But he advises that the Federal Reserve will need to increase the interest rate in six months to avoid inflation.

Federal Reserve has ignored older people who largely rely on interest income for living expenses. An important factor to the economy.

4. As this webcast was prior to the Presidential election, he commented on both candidates and said the new President will not have much flexibility. Senator McCain cannot reduce taxes because of the sizeable budget deficit. President-elect Obama will not be able to increase taxes – particularly dividend and capital gains tax rates – because of the negative impact on economic growth.

5. Forecasts a $1 trillion budget deficit in 2009 which at 7% of GDP he views as manageable.

6. Continues to be bullish on equities. Is negative on Europe’s prospects. Expects equities to yield 9%-10% over the next 3 to 5 years. Forecasted 3% GDP growth and 2% inflation. Considers leverage dead.

7. Surge in the dollar has ended.

8. “What worries him most?” Policy maker errors. Not the economy. Not consumers. In September 2007 he predicted a recession. Federal Reserve and Treasury policy makers ignored the signs. “…will need to depend too much on policy makers”.

Click on this link for access Mr. Sri-Kumar’s October 31, 2008 webcast, approximate duration 60 minutes, expires January 31, 2009:

On October 15, 2008 a panel of economists at New York University gave a decidedly bleaker analysis of the financial crisis compared to the analyses Mr. Sri-Kumar has given.

Click on this link for a summary and access to NYU’s October 15 webcast:

Bankruptcy - The Fate of General Motors, Ford and Chrysler?

General Motors, Ford and Chrysler may have to enter into Bankruptcy to reduce their hourly cost of labor. Running out of cash may be the trigger that puts one or all of them into bankruptcy, but it will be a blessing in disguise.

One of their most significant problems is that their hourly labor costs are reportedly $20 to $30 per hour higher than their Japanese competitors. Some of the differential will be reduced with the UAW’s assumption of retiree health care with VEBA -- Voluntary Employee Beneficiary Association – beginning in 2010. This could reduce employee health insurance costs by one-third but will only produce a relatively small reduction in hourly labor costs. This won’t be enough - including consideration of the two-tier wage structure.

Most of the Japanese competitors have non-union hourly labor in their USA manufacturing operations. As such, their labor costs will not significantly increase over time. In fact, they will probably decrease because of higher capital investments with more effective productivity improvements.

By comparison, GM, Ford and Chrysler are at a distinct disadvantage. They are strapped for cash which severely limits their ability to invest capital for operating improvements. Recent plant closings and operational restructuring have reduced their overall costs by billions of dollars, as well as their hourly headcounts by the thousands. However, the overall impact is somewhat misleading. The hourly cost for direct labor employees has not been reduced. While the number of automobiles manufactured by the Big Three have declined in dramatic fashion, the actual cost of each automobile continues to be higher than its Japanese competition.

Will they be able to negotiate “voluntary” hourly labor cost reductions with the UAW?

One negative example from my turnaround experiences:

I was CEO of a legally insolvent, severely distressed manufacturing company. We asked the local union members to accept minor “voluntary” changes in the union labor contract. Specifically, we needed a delay in the contracted 3% increase in the base wage rate and an increase in the co-pay percentage for health insurance. These proposals were rejected by the local union leaders, although we had the International’s support for the changes. The local labor leaders proved indifferent to the company’s condition and were hostile to essential requests needed for the restructuring required to help save the company.

Admittedly this distressed company was not the size of GM, Ford or Chrysler. However experience suggests the UAW will not “voluntarily” agree to the significant reductions needed in hourly labor costs. (Which may require cuts as large as $10 per hour or more). Thus, the Big Three will be forced to attempt to terminate the labor agreement in Bankruptcy Court. If they fail to do so, they will continue to decline. And their future will offer even more desperate operating and financial conditions.

Kinko’s – Was It Damaged?

Claudia H. Deutsch of the NY Times reported on Clayton, Dubilier & Rice’s management of Kinko’s on May 5th 2007 with an article titled "Paper Jam At FedEx Kinko's". One quote referring to the culture change: “Some say Clayton, Dubilier massacred Kinko’s, and that FedEx can never repair the damage.”

On March 8, 2008 the New York Times reported again on the issue, “...the unit has underperformed since FedEx bought the business for $2.4 billion.”

In my experience as CEO, a culture change was necessary in every turnaround I have managed. The turnarounds were largely penal colonies staffed with brow beaten and frightened officers and managers. The uncoordinated top-down, silo management process was used. Analysis made it clear that mistakes mounted and financial deterioration occurred a matter of months following the start of a punishing culture.

Improving the cultures was accomplished via cross-functional communication meetings with candid discussions at all organization levels. Once an improved culture was accomplished and a self-confident team was developed, profits followed shortly thereafter – usually in just a few months.

One lesson I learned seeing the consequences of the angry, confrontational style used by Emerson Electric Co.'s CEO was not to bully and yell at employees. As CEO I want strong, assertive but civil officers and managers to build a solid performing company. A CEO can whisper and get results.

Emerson Electric conducted anonymous employee opinion surveys annually on each of its divisions. Ironically, if a division president was confrontational with employees and maintained a punishing culture, Chuck Knight would remove him.

As Peter Drucker and Jim Collins advise, use metrics to make people accountable for tangible results. Fire the non-performers. Only deal in brutal facts in an open culture in which everything can be discussed. A tyrant style can sometimes get immediate profit improvement, but it usually results in the company becoming uncoordinated followed by unexpected mistakes and short-term profit decline. It can make the sale of the company problematic if potential buyers realize the management is weak.

A Helpful History Book For CEOs

I came across an impressive book, which would be very helpful to any CEO. It is an interesting historical effort and was referenced in a footnote of a best selling business book “Good to Great”. It proved to be a better book on management in my opinion, than the popular business publication.

Barbara Tuchman wrote “The March of Folly”. In the work, she reviews four historical debacles. The reasons for these past failures, was primarily due to “wooden-headedness and cognitive dissonance”.

Ms. Tuchman's essential definitions:

“Wooden-Headedness”: the source of self deception, assessing a situation in terms of preconceived fixed notions while ignoring or rejecting any contrary signs – acting according to wish while not allowing oneself to be deflected by the facts, the refusal to benefit from experience.

“Cognitive Dissonance”: reject objective evidence and rigidly hold on to strongly held beliefs regardless of rationality of disproof.

“Folly”: the obstinate attachment to a disserviceable goal.

This book gives meaningful perspectives on:

• How to manage,
• Why open and cross-functional communication is important,
• Hubris,
• The true meaning and benefits of “hard-work, homework, hands-on”.

The most interesting of the debacles is the British handling of the American Colonies prior to the Revolutionary War. Not one member of the British Parliament, their staff and the King’s staff had ever been in the Colonies. They did not send anyone to evaluate it.

The British Generals who had been in the Colonies were essentially opposed to a land war, but there was no “cross functional” type communication and their advice was not heard.

The King and the Parliament believed America was small, populated with criminals and other worthless people. In fact it had a population of 2.5 million, was an economic locomotive populated with many well-educated and independent people.

The taxes the British levied totaled only 50,000 pounds sterling annually. Imports from Britain into the Colonies totaled 3 million pounds sterling annually, one-half of which were lost when Americans boycotted British goods.

Completing their homework in a hands-on manner would probably have caused Britain to handle the situation differently and retain America as one of its Colonies.

“Good to Great” by James Collins is the book that referenced “The March of Folly”. Worthwhile reading, it studies how companies built themselves into great companies.

Characteristics of successful companies:

• Disciplined focus,
• No hubris,
• Openness in that everything is discussed,
• A self-effacing CEO only interested in the company’s success - who is not a tyrant,
• Accountability for tangible results,
• Staff the right people – wrong people get fired,
• Only deal in brutal facts and truth, simplicity,
• A culture of freedom and responsibility,
• Have defined what the company is “best” at.

Managing & The Firestone Debacle

David Wessel's article in the Wall Street Journal on January 10, 2002, titled “The Hidden Cost of Labor Strife” describes how incorrectly reducing labor costs results in higher operating costs.

Fortune Magazine often cites various examples of correctly reducing costs in difficult times, while encouraging employees to remain sympathetic, helpful, supportive of your decisions.,

At Emerson Electric, we never had employees be sympathetic and helpful when we sought wage cuts, job rule changes or downsizing. However we never encountered labor strife and rarely a strike. Chuck Knight was a ferociously difficult CEO with his officers. But he was very reasonable and fair, with lower level salaried or hourly employees.

As a result, we never offered harsh and unreasonable terms in any negotiation. We were trained to manage with a union including candid, frequent communication. We stopped trying to decertify unions essentially because of the poor return on investment. If the union chose to strike, we had built a strike hedge and organized non-union employees to staff the plant. We never lost a strike.

This Wall Street Journal article is based on the findings of two Princeton University professors. Firestone Tire offered harsh, one-sided rule changes, wage cuts with new 12-hour shifts in an effort to reduce its Decatur, IL costs. They defeated the strike. Workers were forced to return to work and accept the new terms. As a result, this plant produced the bulk of the defective tires that resulted in 40 deaths.

Fortune Magazine cites the reasons companies are rated 'Best to Work For': (1) Employees are treated with dignity and respect, (2) The CEO is personable and uses “random walk” to talk to employees informally. Employees said they want to see the CEO, touch him and talk to him, (3) Knowing what is going on in the company and how it is doing. The reasons for decisions. Communicating the why for a downsizing and the alternatives. (4) In bad times management and employees are treated the same. (5) All of which leads to “trust” of management, an important factor. (6) Money or salary was not a prime factor.

Interestingly, terminated employees in a downsizing within these 'Best To Work For' operations, were often understanding and productive, even while working their last day on the job.

Companies considered by employees to be the 'Best To Work For' tend to be best performers.

See Fortune's "100 Best Companies to Work For”