Talking to Management, Part V: Understanding Large Shifts

Talking to Management, Part V: Understanding Large Shifts: The following was published at RealMoney on April 20th, 2007:

The Changing Business Environment

What do you think is the most important change happening in the competitive environment at present?

This query can highlight emerging issues and demonstrate how the company is adjusting to the changes. Again, you need to compare the answers of various managers against each other; an odd answer could either be ahead of the pack or out of touch. If you think the answer makes sense, it can open up new questions that further enhance your understanding of the industry and the role that the company you are interviewing plays in it.

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After Hurricane Katrina and other storms in 2005, ratings agencies toughened up their risk models, and catastrophe modeling companies increased their frequency and severity estimates. This created an even greater squeeze in the 2006 property reinsurance markets than what the losses of capital alone would have caused, as happened to the 2005 property reinsurance market from losses suffered in 2004. New entrants in the reinsuring property risk space found that they could write only half of the premium that their more seasoned competitors from the class of 2001 could. Further, property-centric writers found the capital required went up more for them than for their more diversified competitors.

There was less effective capital in property reinsurance at the end of 2005 than at the end of 2004, even though surplus levels were higher on net. Those who recognized the change in the rules of the game caught the rally in the stock prices as the price for reinsurance went up more rapidly than most expected for the 2006 renewal season.

What laws, regulations, or pseudo-regulations (such as debt ratings criteria) would you most like to see changed?

This is another attempt to understand what most constrains the growth of the enterprise (see Part 1 for a different angle on the question). The answer should be something that is reasonably probable, or else the management is just dreaming.

For an investment bank like Goldman Sachs Group Inc (NYSE:GS), an answer could be, “We want the ratings agencies to agree with our view of our risk management models, so that we can get a ratings upgrade and lower our funding costs.”

For a steel company in the early 2000s, the answer could have been, “The government needs to enforce the antidumping duties better.”

A media or branded goods company today might say, “Better efforts by the government to reduce piracy both here and abroad.”

For companies under cost pressure, such as General Motors Company (NYSE:GM) and Ford Motor Company (NYSE:F), the answer could be, “A better labor agreement that includes changes in the union rules, so that we can improve productivity.”

What technological changes are most driving your business now?

Technology often benefits its users more than its creators. Prior to computers, it took a lot more people to run banks and insurance companies. Now financial companies are a lot more efficient and hire fewer people than they used to as a result of the change. You as the analyst want to know about the next technological change that will lower costs or create new products in order to forecast increases in growth of profitability.

There are other technological changes, but the biggest one recently in business terms is the Internet. The creation of the Internet has changed the way people search for information. World Book Encyclopedia was owned by Berkshire Hathaway Inc. (BRK.A) (BRK.B) , which thought it had a pretty good franchise until Microsoft Corporation (NASDAQ:MSFT) and others came out with their own cheaper encyclopedias on a CD-ROM. Now even these are getting competed away by Wikipedia.

Who else is being harmed by the Internet? Newspapers are under threat from all sides. Classified ads have been marginalized by eBay Inc (NASDAQ:EBAY), Craigslist,Monster Beverage Corp (NASDAQ:MNST), etc. Regular advertising has been siphoned off by Google Inc (NASDAQ:GOOG), Yahoo! Inc. (NASDAQ:YHOO) and others.

What cultural changes are most driving your business now?

Cultural changes affect demand for products. As more and more women entered the workforce, demand increased for prepared foods and dining out options. Demand decreased for Tupperware parties and things sold door-to-door.

Cultural changes can also lower the costs of an operation. Outsourcing has lowered costs and improved time coverage for call centers, computer programming and many other service functions. The willingness of nations to embrace the cultural change of capitalism creates new markets that previously did not exist.

One more example, again from insurance: Insurance became a growth product when extended family ties weakened and nuclear families became the standard. Now as nuclear families break down and are replaced by a greater proportion of singles without children, some insurance markets are weakening (life) and others are strengthening (annuities, personal lines, individual heath and disability).

What regulatory changes are most driving your business now?

Before you talk to management, you should know the answer to this one. But what matters here is that you know that they know, too, and more importantly, are building that into the plans for the business.

To get you started, consider the possible impacts of some changes on a few industries. For a pharmaceutical company such as Merck & Co., Inc. (NYSE:MRK) or Pfizer Inc. (NYSE:PFE), this could be a change in the way that drugs get approved. It might be a larger political change, such as the recent election of the Democrats, which is expected to produce a change in Medicare reimbursement rates.

Increases in environmental regulation can affect the profits of extraction businesses significantly, whether agriculture, mining, silviculture, energy exploration and production and more. If it becomes easier to unionize, that can affect wage rates and productivity even more as work rules bite into effectiveness and flexibility of work; both of these can lower profits in labor-intensive businesses.

Now, these are pretty obvious examples, and most examples here will be obvious, because most regulation is done openly. The answers that a management gives can be a test as to whether they themselves know what is going on.

Sometimes the answers get a little more subtle. In personal lines insurance, it took analysts a long time to catch up with the safety trends that were bringing down the frequency and severity of losses, particularly graduated licensing for young drivers. Internally, the companies had figured it out long before they told the analyst community. The analysts who asked why severity and frequency of loss were so good and got an answer that allowed them to “connect the dots” to the regulatory change realized that there was a secular, not cyclical, change going on. Thus they were able to make money buying personal auto insurers, because the trend was likely to extend to more states.

Mergers and Acquisitions

Without naming names, what types of business alliances do you think could be most valuable in the future?

This helps flesh out competitive strategy. Managements will be reluctant to part with details, but usually are willing to explain their approach to supplier agreements, joint ventures and so on.

The answer to this question can also highlight the “missing pieces” for the current business, and how the management team is trying to source them. It can also shine a light on new products and services that management is considering.

Is it cheaper at present to grow organically or through acquisitions?

The right answer is almost always organic growth. Acquirers usually overpay, particularly in acquiring scale. Intelligent acquisitions are usually small and often private firms, where the sale is negotiated and not an auction. The goal is to gain new core competencies or markets that can grow profits in concert with the capital and other resources that the company can add to their new acquisition.

If a company answers “through acquisitions,” there had better be a reason it has an advantage in acquiring companies that its competitors don’t, which is rare. If it’s the only public company rolling up a sector (again rare), there should be some logic as to what discipline the company exercises in not overpaying for acquisitions.

In the early phase of a roll-up, prices are typically reasonable for the small firms being purchased. As the roll-up proceeds, the acquisitions that are easy, logical and cheap get done first. In later phases, if there is a mania, the hard, illogical and more expensive acquisitions get done.

It’s rare to have a roll-up in which some party doesn’t start overpaying badly at the end. Sometimes that signals the end of the roll-up phase, with a decline in the share price of the overpayer, destroying the value of the currency that it is using to acquire small entities; namely, its stock price.

How important is scale when you consider acquisitions?

Again, acquirers usually overpay for scale. The right answer is usually that it is not important, unless it is a commodity business and the acquirer is the low-cost competitor, and will wrench expenses out of the target company to make the target as efficient as the acquirer.


The difference between my approach and the approach of most analysts is that I think about the business and its strategy rather than the next quarter or year’s earnings. My methods probably won’t help you make money in the short run but will help you make money in the long run as you identify intelligent management teams that understand how to compete for the long term, rather than those that can manage only next quarter’s GAAP earnings.

Two additional side benefits to doing it my way: First, the management teams will like talking with you. I can’t tell you how many times managers have said they appreciated my businesslike approach to analyzing their companies. Second, it will translate back into an improved understanding of the business you presently work in, as you think about strategic issues there.

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.