How Low interest rate can be bad for small business

Summarized from the book (click to buy)

We are told that when interest rates are too low, they are encouraging entrepreneurs to take risk.

However, this impacts the business models differently. At one end are business models, like infrastructure projects, that cannot add threshold value in the initial years of the venture. The low interest rate regime, allows a valuable gestation period for such business models. Often, government artificially lowers interest rates for such projects. At the other extreme, there are weak business models, those that are viable only in low return scenario. These business models, however, die out once the interest rates start rising. In between, there are experimental and innovative business models. Some of these use the low interest rate period to forge better, more robust models. Such businesses thrive later. Others, however, end up going bust. The role of banks is to identify each of these business models and fund them while appropriately mitigating the risks. 

How low interest rate leads to mal-investment 

A bank takes risk by investing in a venture. Interest rate is also a reward bankers get, for taking the risk. Ideally, even in lower interest rate scenario, those projects with best risk-return trade-off should get financed. 

However, in reality, lower yielding large borrowings backed by reputed corporates get access to financing more easily than new ventures. This means, irrational mega-projects or mal-investments of large corporates get financed at the cost of genuine investments of new ventures. 

Typically, such irrational mega-projects consume a lot of credit requiring load syndication. This has twin benefits for bankers. First, there is a higher degree of comfort in being with the herd. Secondly, bankers do not have to go through credit appraisal of many small entities of questionable risk profile. This makes them assign a lower risk to these projects than appropriate. Intelligent investors will find that this contradicts with the "diversification as risk management" strategy. But being with herd has a stronger lure and is treated as risk mitigation (though wrongly).

Further, at lower interest rates, debt starts being used as an instrument to amplify equity returns.  

Thus the second blow to new ventures comes from crowding out. It implies that even in a low interest rate environment, small businesses and entrepreneurs may not have access to lower cost capital. Therefore this impacts the long-term strength of the economy. 

In high interest rate scenario, the irrational mega-projects seem less promising. Hence, contrary to popular belief, it may be easier for smaller businesses to compete in high interest rate scenarios. 

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Rant - Keynes is medicine - not food

I wish to restate that Keynesian recommendations are like medicine, to be taken only in dire circumstances when the economy is ill. It is not, I repeat NOT, a dietary recommendation for running a country in usual times.

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Tear all organization charts?

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Dow Jones Industrial Average since 1900

Barry Ritholtz links to this awesome chart from J.P.Morgan. It tells us so many things when you look at real long term. Have a look and my comments are below this:

The graph tells us so many things:

1. Before anything else, I must highlight that the average line for 1937-49, 1966-82 and 2000- present are drawn wrong. They have a positive bias. 1906-24 seems to have a negative bias.
2. More importantly, we seem to have ~20 years of stability and ~20 years of secular bull runs. By that measure, somewhere after 2015 we will see the start of the next bull run.
3. But we must correlate these with actual developments. If you draw some key developments on the charts we will see better picture. 
• Periods of technology development
• 1930s and 1940s period signifies the development of US highways and railroad. This is phase where Americans were still exploring new frontiers within their country.
• Similarly 1966-82 period was time when computing technology was taking shape.
• Similarly, 2000- present internet technologies are taking root.
• Productivity increase periods. These periods are different from technology development periods. Here known technologies are being exploited to create new thresholds for efficiency and productivity. Concurrently, new technologies are being incubated but those are not the dominant forces as yet.
• 1949 onwards was post war reconstruction. Here known things were required to be produced in ever increasing numbers to satisfy the demand in Europe and Americas itself.
• 1982 till 2000 was a period when IT came of age. Computing allowed wider management control, better designs, higher efficiency etc.

Overall quite an interesting chart. What do you think?

update: I made a appalling mistake of commenting on exponential line which I have deleted. The graph is in log scale.

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Understanding Car dealers

John Hempton asks why car dealers behave the way they do - fleece the customer. He has detailed the issue in that blogpost. I am going to attempt to answer this. But let me tell you it will be a convoluted answer.

First, you have to imagine the entire car business as a network of transactions. The transactions that make money for the car assembler (I refer to Fords, Nissans of the world) are way more upstream at supplier side based on economies of scale achieved in sharing parts etc. (where exactly depends on each assembler). Sales per se does not contribute the differential value and will not dramatically impact margin on the product as other drivers. Hence the recommendation is to reduce sales cost as much as possible. Let sales pay for itself. Invariably that means hiring people without testing their morals and skills.

Second, these types of people can turn against the company as well and fleece them. Hence strong processes are put in place to constrain them from fleecing the company. There is apparent lack of trust between sales person and the company (usually seen at the time cost is audited or controlled by finance people). For the salesperson, the only way to make extra money is to cheat the customer. The incentives are stacked that way. You can see the relative bargaining power stacking here. Bargaining power of company is higher than that of sales person and that of sales person is higher than customers.

Third, the incentives of sales person and that of company tie in well - sort of complement each other. Once customer buys the car, she is sort married to it for 4-5 years. That means parts, servicing etc. etc. 5 years of opportunity to milk the customer -  long-term fleecing. (ok I can use buzz word like customer lifetime value etc but you get the idea). For salesman the incentives match. He meets the customer once every 5 years and hence has no incentive to strike a long term deal. So short term fleecing happens here. Note the differences in Cash Flow Chain designs. The cash flow chain does not fully flow through sales network, it equally flows through service centers. This is what reduces the bargaining power of sales persons.

Fourth, if a sales person invents a new technique to enhance sales, then it is in the car companies and dealers interest to spread the idea to every other dealer and sales person. This nullifies the advantage that innovative sales person should ideally enjoy. The effect of any value add that spread across the entire product range, is that is ceases to be a differentiator. The only practices the company cannot promote are once it should actively demote. But even those do not remain differentiators.

Fifth, the buyer behaviour is not linked to salesman behaviour. When you buy a car, you buy the brand and particular model. You even have a specific colour in mind. You want a Honda Civic or you want a Toyota Land Cruiser or Specific colour in Mercedes E class etc. You are locked in to a certain extent. The salesman is not. I have said in the book that bargaining power extends right inside the customer's pocket. Here the branding and product differentiation and need segmentation has reduced the customer's power to a certain degree.

Sixth, there are few car dealers (hence collusion is easily possible). Further, the game happens within last 3-5% (usually) of the price. So customers give up as attraction of the product is higher than this. Sometimes sales person try to up the game to 10% (when they have done their target for the month/year or are confident of achieving the same). Scarcity in number of car dealers allows better bargaining power with dealers.

Seventh, at some points in the year the incentives of customer and car manufacturer match. For example at the end of financial year of the car maker. They want to push volumes and that allows customers to have a good deal. Similarly, slow months align the incentives of customer with those of the sales person.

It is convoluted but this is what I have concluded. Feel free to share your experience with car dealers and ask your questions in comments below. 

I discuss these issues in detail in my book "Understanding Firms - A Manager's model of the Firm". The book is available on amazon here. Now no longer free - but always valuable.

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Non-choice in next US presidential elections

First Matt Stoller has an amazing piece up at nakedcapitalism. He is highlighting how there is no debate on essentials in this election. His quote "the two candidates are speaking not to the voters, but to the big money". This is exactly what I wrote about in my book Subverting Capitalism and Democracy.  

Big money in politics

If you want to know how much big money is influencing the process, here is another discussion about money in politics by Hacking Society where the numbers given are as below (about 1.50minutes to 3 minutes):

1. 0.26% of Americans give more than $200 in election finance for congressional election.
2. 0.05% give maximum amount to any congressional candidate.
3. 0.01% give more than $10,000
4. 0.000063% or 196 people finance 80% of the superpack money in Presidential election.

These figures are astounding! Just imagine what are these 196 people getting for all this money. In their normal day job they examine microscopically ever dollar they spend and yet they are spending all this money for superpacks? 

What will be the policies of new President?

To understanding politicians and their actions, it is important to know who they put to work for them. If you have read or seen Harry Potter, you must have learnt how important house-elves are (Dobby and Kreacher). Many commentators cribbed how there was no change between the economic and financial advisors in Bush era and Obama era. Matt Stollers points out that "Obama appointed Erskine Bowles. - Clinton put Erskine Bowles, a conservative Democrat, in charge of the effort o work with Newt Gingrich to cut Social Security for recipients and pour some of the Social Security trust fund into the booming stock market".

So essentially, Americans are faced with nothing new in policy initiatives and at worst drastic cutbacks in social security and other benefits.

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Growth is not profitable?

[Now no longer free - but always valuable]

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Global Public Debt

Economist has, as usual, a great interactive chart about public debt. Here are two snapshots from that showing marked increase in the debt as % of GDP across the last decade. The last picture is for 2011.

Now it is interesting to note the following:

1. Some resource driven countries seemed to have reduced their debt. Some in Arabian peninsula and Russia come to mind.
2. Europe and US have increased their debts, as expected. Japan continues to have high debt over the entire decade. This could be because of two reasons - GDP falling and debt rising.
3. Britain has had it worse. It went from green to deep red. The reason again could be both GDP falling and Debt rising.
4. Now I want to have a corresponding chart of investment in drivers of GDP. I bet between 2007 and 2011 nothing has happened in this chart.

Debt is as good as the ability to pay

Debt is good if the ability to pay exists. The quantum of debt is immaterial so long as ability to pay is reasonably certain. When large amount of debt exists but ability to pay does not exist (usually it is merely broken), then creditors often offer more debt to strengthen the ability to pay. One can argue that in this case the answer to debt is more debt. More correctly, the answer to debt is a strong ability to pay.

If more debt is taken on without improving the ability to pay then it is sure a road to bankruptcy. A good way to start the process is to write down the debt acquired since 2007-08 crisis. I am sure ample data exists to understand how much was given to whom. It is no business of the tax payer to bear these costs. Corresponding treasury bills can be settled by raising equivalent debt liability on the firms receiving the money.

I am sure some will think this to be illegal. But it is not. It is just belated government action and can be ratified by respective parliaments.

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The story behind "Understanding Firms"

Today the book "Understanding Firms - A Manager's Model of the Firm" is available free for kindle users. So I thought let me share the story behind this book.

In my initial days, I was ready to work on any types of projects. I worked in warehouses, factory floors, maintenance shops etc. I was ready to take risks, but my supervisors were not. I found this to be one ridiculous problem. A person who was ready to work on diverse roles, who admittedly had done great work was not allowed to work. Initially I thought may be I did not do good work and supervisors were just being polite. But I realized that was not the case. Sadly, I realized this after I left the company and some of them told be the real reasons.

Then, I have agonized over loosing people who were such spectacular talents that losing them should be criminal. Yet, the company I worked for could not find a way to monetize the talent we had. Nor could they simply block this talent from leaving by paying them their worth. Watching them go to other companies was horrible experience.

I have lost many customers who were ready to take risk with us so that we could develop new products at their expense fully aware of the risks involved. But my firm backed out from such promising opportunities. It happened so many times that I became jaded and moved to other team. 

Then, my experience with cost managers is no less spectacular. I have seen managers approve of TV commercials scheduled at the time when the target audience was away at work on their farms far away from TV. At the same time, travel budgets were hard to come by for my team. I have seen cab bills being questions while the company was splurging on parties to build team spirit. I wanted to tell the bosses, if you don't trust your employees you are not going build team spirit by mandatory partying.

I know one firm was paying $1000 to shift desk three feet apart when all you needed to do was plug the computer in the next socket. I do not see any reason why this change should be classified as "desk change" and deserve $1000 for the shift. If this is not waste then I don't know what is.  In the same company I have seen managers ask their employees if they indeed ate as much as the bill they submitted when the bill was within allowance limits. I thought managers existed to reduce cost by reducing wasteful expenditures.

I have seen many companies sitting on gold-mine of products they just don't want to make. Trust me they don't want to make those products, I have tried breaking my head. I once asked a company will they take it up if I make a prototype with my own money and prove that it works.  

I have spent ages trying to rectify atrocious designs, seen compromised product specifications that don't solve customer's problem, good products priced out of customer's budget, bad products sold free, softwares that made the customer's cry (literally). Man-years spent on designing ERP systems that have no relationship with reality etc.  I can go on but you get the drift. 

The problem is not that these companies do such things. The problem is that these are very very successful companies, so imagine what happens at the unsuccessful ones. The problem is also that this is very widespread. So I thought, something more than pure economics is at work here. One thing led to another and another and soon here we are. 

These negative energies were the force that pushed me to explore. I write them here because you may have seen some of them. You may have also wondered why people do things they do. You may have also thought how come your very decent friend is hated as a boss. I hope to answer some of these questions. In the book I don't directly explain the above behaviors but I explain why some companies get away with it. I explain when these behaviors become threatening. 

I hope you enjoy the book and make your firm a better place, a more successful place. And if you need to discuss any thing with me, you can email me at rahuldeodhar [at] gmail [dot] com.

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My second book Free on Kindle - Friday and Saturday only

Please subscribe to my blog on Firms.

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Free on Kindle - Friday and Saturday only

Trouble with Mergers

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Helping Social media and Web consultants price better

I know a bunch of people who are consultants to firms, advising them about internet, social media and other marketing inputs. These people are really experts and not the general mass of wannabes who seem to flood the world recently. In my discussion with them I realize they always find themselves not able to price correctly as per the services they deliver. I was thinking about this and it leads me to the think that they essentially have two problems. 

First, these consultants are facing classical Porter's bargaining power problem. Their clients have high bargaining power and they are unable to match that. Further, the barriers to entry are super-low. Hence there is a lot of competition in this area which has a wide spectrum of people starting from the top experts I refer to above to plain cheats who don't have a clue about either social or media. The client does not have the expertise or mechanism to separate the wheat from the chaff. 

Second, the customers perceive some risk because of which they underpay. One source of risk that is clear to me is lack of skills or understanding to measure performance (what will they do) and deliverables (what will clients gain as a result).  Since clients perceive the lack of understanding as risk, they tend to underpay for the product to reduce it. Thus, if a web consultant has diagnosed "clutter" as reason preventing website sales, then she is not perceived to have contributed as much to deserve the payment she seeks.

Naturally the prescriptions must be simply to increase bargaining power and develop measures of performance and delivery. The key question is how? Here are some suggestions:

1. Dealing with uncertainty: Like I have said before, the only cure of uncertainty is certainty or disclosure.
• Improving diagnosis: I believe my friends must draw from medical practitioners' business model. The diagnosis is first part of problem and money spent here is almost always never disputed. The diagnosis has to elaborate and chargeable. Without diagnosis, they should not submit their quotations. Quite a many times, some consultants intuitively know the problem just by looking at the website or execution of social media strategy etc. and tend to skip diagnosis. I think the more the stress is laid on diagnosis the better.
• Pricing diagnosis: One problem faced with diagnosis is that clients have low expectations from websites and online sales or its impact on off-line sales. Hence they do not want to spend on diagnostics as much. Here, alliance with diagnostic services providers or technologies should help reduce the price for the consultants.
• Reducing performance uncertainty: Once diagnosis is reasonable then the solutions will have better visibility allowing my friends to explain what they are going to do and why. This should allay the performance uncertainty.
• Dealing with deliverables: Almost all clients these days measure the consultant's input in terms of what happens to their deliverable (say online sales or subscriptions etc). With these in mind, the clients formulate terms of reference for the consulting bids. The part the clients don't understand is that between deliverable and their terms of reference is a huge gap which consultants do not control. The problem is the consultants do not always communicate this to clients clearly. The agreement on deliverables must tie-in with what is controllable for the consultant.
• Take this example (given by one expert friend): If a website creates 10,000 hits, has 10% subscription rate hence creates 1000 subscribers. Further it has 10% conversion rate which makes 100 people buy a product worth (say $100) leading to revenue of $10,000. Further, assume the profit margin is 30% then profits from the website will be $3000. Then, each subscriber is worth $3,000 / 1000(subscribers) = $3. Each hit is worth $3,000/10,000(hits) = 30cents. So what will be your deliverable? Will it be conversions? Will it be subscriptions? Or will it be hits? The answer, as I mentioned earlier, depends on what is controllable for the consultant. If she can control the hits, then she should measure hits. If she can control how many will subscribe then that should be measured.
2. Increasing bargaining power: Even when all this is known, the underpay problem will persist. Porter's bargaining power issue looms over this business. Hence these consultants must find a way to increase bargaining power. This needs some brainstorming but few ideas from top of my head:
• Organize into a firm or Agency: A member of the collective group is more likely to have better bargaining power. The internal structure need not be that of a firm. However, it can be a collection of individuals with a common name. (This is more perceptive rather than actual). Having a brand umbrella should help. Tip: Size connects with bargaining power.
• Reputation: Clearly if Guy Kawasaki or Chris Brogan or Robert Scoble is advising the client they will pay more. So reputation will increase bargaining power. Some improve reputation with customer testimonials, others with referrals, others with interacting communities. Tip: Fame or recall = bargaining power
• Sub-branding the knowledge: The diagnostic methodology, the solution, core ideas within the communications need to be branded with scientific backing either as papers presented in conferences or as well-publicized concepts (think pagerank). These could be product-type brands (like pagerank) indicating pre-packaged solutions or service style (like aroma therapy brands) that indicate customized solution and delivery. Tip: Knowledge = bargaining power.

So let me know what you think.

Note: For more discussion on importance of bargaining power and risks as it relates to firms read my book Understanding Firms - A Manager's model of the Firm.

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Free download: Subverting Capitalism and Democracy

My first book Subverting Capitalism and Democracy is available free (kindle edition) on Amazon. Click and download and tell me what do you think. (Free only till Sunday July 22)

You can also buy my next book "Understanding Firms - A Manager's model of the Firm.

Update: It is no longer free but you can email me so I can intimate you when next promotion starts.

Problems with boss?

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Keynes returning?

Yves Smith has guest post by Paul Davidson author of The Keynes Solution. I generally liked the post and recommend you read it too. Here are some points I would like to make:

1. Republicans abhor government but still want to get elected. Sounds like wanting the job you hate doing.
2. It is never about taxes it is always about demand, if demand exists taxes are affordable. Don't eliminate taxes make them affordable by getting demand.
3. Prudent regulation is good idea. Else it is like a football match without referees and ground markings.
4. At 2008, either solution Keynes or otherwise would have worked. Today only alternative is Keynes.

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Combining managerial and economic theory of firm

Understanding Firm - A Manager's model of the Firm presents a new model combining managerial and economic theory of the firm.

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Buy my book "Understanding Firms - A Manager's Model of the firm".

Combining Managerial and Economic theory of the Firm

Understanding Firm - A Manager's model of the Firm presents a new model combining managerial and economic theory of the firm.

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Buy my book "Understanding Firms - A Manager's Model of the firm".

Understand Firms - A Manager's Model of the Firm

My book "Understanding Firms - A Manager's Model of the Firm has been launched.

Generations ago, the firm was conceived in the image of the army. Since then the army has moved on, but the firm hasn’t. Naturally, we experience severe difficulty while working with firms. Employees are dissatisfied, mergers fail, innovation is impossible, cost cutting is never enough and growth is not always profitable. May be we don’t understand the firm so well. 

The book presents a unique model at intersection of economic and managerial theory. The model uses five elements - the concept of transaction chains, Coase transaction cost hypothesis, Porter’s bargaining power theory, a new way of profiling transaction and new types of roles undertaken by employees. 

This model provides insights into which mergers will work, how to make them work, how to promote disruptive innovation, how to manage knowledge oriented teams etc. It explains why sometimes our strategy fails, why we are blind to competition and inefficiency. This model provides a new framework for thinking about firms. This framework will help us make firms better.

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Buy my book "Understanding Firms - A Manager's Model of the firm".

My book: Understanding Firms

My book Understanding Firms - A Manager's Model of the firm is now available. 

The book presents a unique model at intersection of economic and managerial theory. The model uses five elements - the concept of transaction chains, Coase transaction cost hypothesis, Porter’s bargaining power theory, a new way of profiling transaction and new types of roles undertaken by employees. 

This model provides insights into which mergers will work, how to make them work, how to promote disruptive innovation, how to manage knowledge oriented teams etc. It explains why sometimes our strategy fails, why we are blind to competition and inefficiency. This model provides a new framework for thinking about firms. This framework will help us make firms better.

I say the book is essential read for managers, investors and everyone who works in organizations. The kindle version is available at $5 (£ 3.50 and € 4.00) and print at $8 (£ 5.50 and € 6.50)

Let me know what do you think about ideas presented in the book.