Net Present Value and the Future of Acquisitions

Posted May.20, 2012 under ECONOMICS

Although Fiat lacks the scale compared to larger companies like Ford, Toyota, and Volkswagen, Fiat has innovative products that enable it to gain competitive advantages over it peers and also help the group differentiate its products from those competitors. Year-over-year Fiat-Chrysler sales are up by 20% with Jeep sales and their new Fiat 500 mini car newly launched in the US (James 2012). The Fiat-Chrysler merger has proven to be a success in this decade. The Chrysler-Fiat acquisition has received so much attention because it has been so controversial in the US. The US taxpayers will likely lose $1.3 billion in the government bailout of Chrysler. The US government sold its remaining 6% stake in the company to Fiat and wrapped up the 2009 bailout that was part of the Troubled Asset Relief Program (TARP) six years early. As part of the loan agreement, Chrysler was given until 2017 to return the bailout funds. The US government committed a total of $12.5 billion to the struggling Chrysler. The unique situation however was after the merger; Chrysler was able to raise private capital to repay some of the loan very quickly. The new Chrysler paid back $5.1 billion in loans in May (Censky, 2011). Originally, those funds, $11.2 billion have been returned through principal repayments, interest and cancelled commitments, according to the US Treasury department. Tim Massad, Treasury assistant secretary for financial stability, states that though $1.3 billion will not be recovered from the bankrupt Old Chrysler it is still a “major accomplishment” because the government originally expected it would lose much more on the auto bailout (Censky, 2011). Fiat owns a 53.5% stake in the company after paying the US Treasury a total of $560 million for the remaining shares (Censky, 2011). Thus, Fiat had a unique position to gain control of a company at a discount and added more products to their product portfolio without having to design new products for the automobile market. The Fiat-Chrysler is a good example of how competent management that has time to evaluate buying opportunities can gain competitive advantages in this global economy.

The Chrysler-Fiat merger has been one of the most interesting and one of the most important acquisitions in this decade. Chrysler has been the smallest of the Detroit-Three, in terms of production volumes while Fiat did not produce as many cars as Peugeot Citroen or Volkswagen, in Europe. However, after the merger Fiat-Chrysler replaced Honda, falling behind Ford, as the seventh largest automaker in 2010, and aims to be the sixth largest automaker by 2014 (PranaTharthiharanNatarajan. 3 Aug 2011). In this turbulent and uncertain business environment it is imperative for automakers to find global profit opportunities and undertake acquisitions of established brands as an alternative to building new brands and do it more effectively.
Merger and acquisition trends in the automotive industry

Fiat 500

Unfortunately mergers are not all successful as the Fiat-Chrysler merger. For example, Ford-Jaguar merger that did not have time to evaluate their deal paid a higher premium. In an interview with Bob Ainsworth, current Member of Parliament for Coventry and former Jaguar shop steward, asserted “I have little doubt that they thought that Jaguar was worth a lot more than it was” (Gomes, 2007). This lack of experience and capacity in weighing the strengths and weaknesses of the target in a short period of time strongly contributed to a poor evaluation process by Ford and resulted in the overestimation of the Jaguar brand and the underestimation of the investment requirements in terms of new model development, facilities and equipment (Gomes, 2007).

In contrast, Fiat had a huge advantage and bought Chrysler at a discount and is projected to reap its benefits. Using a projected NPV at a discounted rate of 10%. Chrysler proposed that with strategic partners, loans from the US government and reduced costs they could show a positive NPV. Chrysler showed a NPV of 17.3 Billion for the 8 year plan. This was one of the factors that helped Fiat effectively evaluate their acquisition decisions. Four years later based on production forecasts, the Fiat-Chrysler group is expected to have an increase of 61% by 2018, over 2010 production volumes, globally (Gomes, 2007). According to analysis, production volumes from the Americas is expect to drop over the next seven years, while production volumes from Asia is expected to have a remarkable increase from 2 % in 2010, to 9% of overall volumes in 2018 (Gomes, 2007). Fiat now has a unique opportunity with their new product portfolio to create growth opportunities in emerging markets globally.
Fiat –Chrysler Profile and Environment

Fiat is Italy’s largest private industrial enterprise and one of the founders of the European automotive industry. In its over 100 years of existence it has designed, built and sold cars, trucks, farm equipment, construction equipment, engines, transmissions and components, focusing on both technological innovation and environmental compatibility and in more than a century of history has also included trains and airplanes. The profound cultural shift that the company has undergone, along with the efforts it has made to achieve excellent levels of quality and expand its product line, have rewarded it and allowed it to reach important milestones. The numbers and extensive international recognition confirm this fact: yet also, and most importantly, so do the millions of customers who have chosen Fiat’s products (“Fiat, more than,” 2011).

Fiat is committed to operating its international business in accordance with the values of sustainable development: integrity, respect, a sense of responsibility, and care for the environment and the communities with which it comes into contact. The company’s leadership in this field has been confirmed by its continuing presence in the Dow Jones Sustainability World and Dow Jones Sustainability Europe indices. The DJSI World and DJSI Europe are the world’s most prestigious indices, admitting only companies judged best at managing their businesses according to sustainable criteria (“Fiat, more than,” 2011).

Meritocracy, leadership, competition, best-in-class performance and keeping promises: these are the five key principles, the five fundamental pillars that support Fiat’s profound cultural transformation. Business growth is first and foremost an issue of people, culture, and commitment: a willingness to view the future as a great opportunity for everyone (“Fiat, more than,” 2011).

After running Fiat for 21 years, Vittorio Valletta was succeeded in 1966 by Giovanni Agnelli II, the founder’s grandson. Under Agnelli’s leadership, the company’s annual sales came close to US$2 billion by 1968, and for a short time Fiat edged out Volkswagen as the world’s fourth largest automaker. At that time, Fiat’s cooperative arrangement with the French carmaker Citroen made it the world’s sixth largest non-American firm; the company operated 30 plants and employed 150,000 workers. Giovanni Agnelli II candidly credited Fiat’s success to the company’s near monopoly of its domestic market for half a century, but he warned that more sophisticated production methods were required if Fiat was to survive in the international market. He imposed a schedule for new models of two years from drawing board to assembly line and standardized many car parts to allow more interchange between models (S. Burgess.2011).
Giovanni Agnelli II also sought to further diversify Fiat’s products to lessen its dependence on autos and trucks, which accounted for 86 percent of its revenue. At the same time, he set about improving the company’s flagging sales performance in underdeveloped countries, and in 1969 he made two notable acquisitions. Fiat took full control of the Italian car manufacturer Lancia and announced a merger with Ferrari, the famous Italian racing car company. When Ferrari’s problems had surfaced in 1962, owner Enzo Ferrari had turned down the Ford Motor Company, but accepted financial backing from Fiat. Further losses forced Ferrari to sell, and his company was reconstructed as Fiat’s Racing Car division (S. Burgess.2011).

While the Ferrari and Lancia acquisitions were good for Fiat’s image both at home and abroad, its domestic situation worsened. The company had to contend with Italy’s 7.3 percent inflation rate and a series of strikes; 1972 production fell short by 200,000 vehicles. For the first time in its history, Fiat failed to show a profit or pay an interim dividend. Fortunately, news from abroad was good. Agnelli’s younger brother, Umberto Agnelli, who had doubled sales at Fiat France in 1965 to 1970 and constructed successful plants in Argentina and Poland, had gone on to direct American sales. The number of Fiats sold there doubled between 1970 and 1972 and Fiat cars became the fourth largest selling import in the United States. Umberto returned to Italy as second-in-command to help his brother with the pressing problems at home (S. Burgess.2011).

 

Since Chrysler’s start in the early 1900s, they have held a substantial amount of respect and leverage within the automobile industry. Some of the car brands that Chrysler makes are Dodge Ram, Chrysler 300, Dodge Avenger, Grand Caravan, Charger, Sebring, and Ram. Some of these vehicles have given Chrysler success within the auto market. Of the three largest United States carmakers, Chrysler ranks the smallest. This is compared to more prominent firms such as General Motors and Ford Motor Company. Chrysler lacked the superior technology and the required financial stability that their competitors had which led them into financial trouble. Without the needed funds to create new projects and gain more customer appeal this led them to decreased profits and their mainstream customer base and led them to debt. Another reason that led Chrysler’s customer appeal decrease is the bad reputation that Chrysler received for the quality of some of their car brands. This has led to a decrease in customer loyalty because they could not depend on the dependability of the brand’s cars. Chrysler needs to improve their vehicles in order to get the support of their biggest revenue, the customers (S. Burgess.2011).

The difficulties that Chrysler has experienced as far as decreased customer appeal, Fiat has experienced them as well. Fiat has gone through decreased sales and loyalty in the US. Some of the brands Fiat is highly known for are the Fiat 500, Fiat Punto, Lancia Delta, Maserati Gran Turismo, and Ferrari 458. Fiat first made its appearance in the United States in 1908. They were the first year that they started exporting their vehicles within the American market. Years later Fiat was given the proper licensing to start creating their line of cars in New York. Within this time frame Fiat was a successful carmaker in America. Shortly after problems arose and led to Fiat discontinuing its marketing in America. Fiat hasn’t had an appearance in the U.S. since the 1980s. The reason for Fiat’s dismissal from the US is because the public was having problems with the quality of Fiat’s cars. Due to these quality problems and lacked customer loyalty, Fiat felt it was best to leave their presence from the U.S. Even though they were still marketed their Maserati and Fiat brands in the U.S., their once popular lines still left. Thus has given them time to refocus their efforts to improve the quality and stability of their car lines which would help their reinvention into the American market (L. Ciferri, & B. Wernle, 2010).

Chrysler and Fiat both share some of the same competitors. Automotive international heavyweight firms consist of Mercedes- Benz, Lexus, Toyota, Hyundai, etc. Even though Fiat had removed itself from the U.S., two of its successful brands still are prominent in the U.S. This contributes to Fiat and Chrysler having some of the same competitors that affect potential profits. Chrysler has held a low position in the market due to the overall increased funds and technology that its competitors has available to them. Chrysler and Fiat were competitors to each other at one point within the automobile market. Both firms were vying for the appeal of the American customer base. They competed with car brands and mass appeal. Chrysler and Fiat which were once competing in the same market are not an alliance which could increase both the position of both firms in the automobile industry (L. Ciferri, & B. Wernle, 2010).

With the American market, consumers are looking for a reliable car that they can get their everyday errands done and am able to travel around in. Society values their opinion on automobiles by how there reliability and sustainability are. If qualities problems of any sort are occur consumers are quick to lose loyalty in the brand. Ethically that should make the corporation want to reevaluate their brands if there keeps having an occurrence of quality problems. This can significantly hurt the automobile firm because no one is going to want to invest money into a car that is known for having malfunctions. This is the reason that Chrysler and Fiat were ridiculed in the American market at one point. This meant that both brands didn’t have the capabilities to meet the culture’s needs. With the new alliance of Chrysler and Fiat, you can expect car models to be designed to meet the needs of the current culture and the people. Society wants a car that will be exactly what they expect it to be. Chrysler and Fiat are given the opportunity to show the world that there past poor reputation does not have to influence their future reputations (L. Ciferri, & B. Wernle, 2010).

The New Chrysler emerged from bankruptcy on June 10, 2009, with a new ownership structure with Fiat.
The federal government financed the deal with US$ 6.6 billion in financing, paid to the “Old Chrysler”, a new company called Old Carco LLC was set up to take over the remaining assets and liabilities, which remained in Chapter 11 bankruptcy. The transfer did not include eight manufacturing locations, or many parcels of real estate and equipment leases. Contracts with 789 US auto dealerships, which were being dropped, were not transferred. Table 1 shows a list of the actions taken by main stakeholders and their equity stakes in New Chrysler (D.Johnson, 2009).

The involvement of Fiat in the ownership structure has been a mixture of barter of technology and performance goals with equity stakes, along with onerous conditions to buy equities obtained from the other equity holders (US Treasury, Canadian Government and UAW).

So far, Fiat has fulfilled its end of the deal. As requested, the company has plans to fit Chrysler vehicles with fuel-efficient engines, expanded Chrysler sales overseas, and paid off loans from the US and Canadian governments. In return, Fiat has been allowed to raise its stake in Chrysler to a controlling 53.5 percent, up from 30 percent that came from its initial 20% plus meeting two performance goals. Fiat has the option to add another 5 percent of Chrysler when it produces a vehicle at a Chrysler factory in the United States that performs with at least at 40 mpg. This performance target is expected to be reached by the end of 2011(D.Johnson, 2009).

The remaining 41.5 percent stake is still in the hands of the United Auto Workers (UAW).Fiat also holds an option to acquire 40 percent of the original stake held by the UAW’s retiree health-care trust. The option is exercisable from July 1, 2012, to Dec. 31, 2016, and in amounts of as much as 8 percent in any six-month period, according to the filing (D.Johnson, 2009).

Strategic Issues and Reverence

With every new venture, any successful leader will tell you that team work is the key to corporate merger success. As quoted in the New York Times in January of 2012 the CEO of Fiat-Chrysler, Sergio Marchionne, concurred that “this thing runs as one house.” (Vlassic, 2012) Unlike previous acquisitions the Italian parent company, wanted the merger to improve their processes not necessarily creating new environments for Chrysler. The opinion of Marchionne was that there was an unprecedented opportunity for Fiat to take advantage of the volumes Chrysler could provide, which are essential to the future direction for the newly merged companies.

Analysts within the automotive industry were wary of the merger, since the organizations of the two companies were so diverse but also homogenous to their local markets. Chrysler has been a main stay within the American automotive industry for over a decade. Proud of their American heritage and staying true to their brand loyalty, Chrysler bases much of their success on confidence in their market leaders. Fiat, similar to Chrysler, holds strong ties to their consumers’ loyalty but in the luxury markets of European automobiles. The emphasis that many main stream media outlooks reported was that the CEO’s main resolve was that both companies were to operate as “co-equals.” Much different than any of the unsuccessful mergers for Chrysler prior, this opportunity with Fiat seems to be one of openness and optimism.
With this great optimism of course data must be present to support the sentiment. In the NYT article, Jim Hall the managing director of an automotive consulting firm 2953 Analytics, blamed the failed acquisitions of time past on the parent companies resistance to “figure out what to do with Chrysler because they had no interest in integrating it into their business.” (Vlassic, 2012) However, from day one Marchionne has said that his objective was to use the merger to provide leverage for both companies and operate the businesses as equal partners. This opened doors of opportunities for Chrysler to become more competitive with luxury automotive offerings, while Fiat could use the purchasing power house of Chrysler to acquire more parts to increase volume.
Once the two companies fully integrate, the most important decision facing this CEO is the dialect of where they will locate the corporate headquarters. Both companies hold such strength within their markets due to their “roots,” and both are receiving much criticism for a re-location to even be considered. It will be interesting to witness where this company will continue to grow in the years to come under the Fiat umbrella, and how these cosmetic barriers will come to some type of resolve.

Stakeholder Impact

The full acquisition of Chrysler by Fiat is still in process. Currently, Fiat holds a 58% share within Chrysler, with future plans to complete the ownership at 100% shares. “That will require either a public stock offering to cash out the remaining stake held by the United Automobile Workers’ health care trust, or a direct purchase of the trust’s stake by Fiat.” (Vlasic, 2012) This increased share has been progressively obtained over the last four years. The slow evolution will result in Fiat-Chrysler becoming the sixth largest automotive group globally. Before increasing the stake in Chrysler, Fiat demerged their power train entities which included; Fiat Power train Technologies, Case New Holland, and Iveco.

By 2011 once second quarter earnings were announced the most notable stand out element was the drastic surge in the Fiat groups net debt going from reported $2.89 billion in the first quarter to $6.27 in the second. The Fiat automobiles were reporting a $7.55 billion profit in the second quarter, bringing the trade value to twelve million dollars more in trade value than speculated. Chrysler’s contribution to the profit revenues was reported at $3.3 billion solely in the month of June with a trading profit of $150 million.

In previous years, major OEM’s have been working to increase the number of shared platforms within their organizations. One such venture is occurring within Fiat-Chrysler as well. By the projected 2019 fiscal year, they plan on taking their current number of shared platforms, total figures are 32 shared, and cut this number in half to only 13 offerings. This reduction also takes into consideration the release of 18 new models within the auto group giant. The results of this strategic move will be to increase volumes while streamlining processes. 86% of their production will be focused on the top five platforms alone.

For the stakeholders, all of the moves that this automotive group is making at the moments provide promising numbers for their portfolios in the years to come. Only allowing improvements to come in, and non-value added processes to be taken out, increasing their stakeholders investments in the organization. In the long run, if history remains a true indicator of times to come, by 2014 Fiat-Chrysler will hold a strong place as the sixth largest automotive group, with opportunities to be one of the last few standing when the synergistic trend becomes the driving force within the market, and they are already making moves to insure their spot in the market.

Conclusion

As mentioned prior, the acquisition of Ford and Jaguar is an illustration of a less than favorable merger. The parent company invested in the luxury driven British auto manufacturer with expectations of being able to grow sales volumes and ultimately increase stock shares for the struggling luxury auto maker. However, merely three months after the 2.38 billion dollar premium paid, Ford publicly acknowledged their error in an annual report. Forecasting a growth in sales, Ford had originally been quoted as defending the large investment based on projected share and stock value. Even analysts at the time praised Ford for their ingenuity, claiming the auto manufacturer would have needed to invest much more to produce a luxury line of their own. However, as true figures were assessed Ford disclosed their investment was $2 billion dollars more than the fair market value of $500 million.
Although many mergers and acquisitions experience the growing pains and buyers’ remorse similar to Ford, there are dissimilar cases such as Fiat Chrysler. Fortunate factors which were present prior to Fiat’s investment, specifically the United States government bail-out program offered to Chrysler, insured the purchasing negotiations were fair and within reason so that Fiat could in fact invest without penitence. “Marchionne’s revival plan for Chrysler feeds on itself and adjusts for the results” (Welch, 2009). With a current share in Chrysler of 58.5 percent, Fiat’s future investments are still in limbo due to negotiations with VEBO, the retiree healthcare trust affiliated with United Auto Workers union.

In conclusion, the Fiat Chrysler merger in its present state can be deemed one of the more successful mergers within larger corporations. With little money initially invested, and most of the performance standards being met, there is a strong indication that the co-equal companies will continue on a path of growth and improvements. If the only criticism analysts are able to publicly acknowledge in today’s media is concerning the trifles over future corporate headquarters, it would be safe to state Fiat Chrysler has a strong future ahead of itself.

 

References

Burgess. Scott. (2011, June 24). Chrysler’s rebirth shifts into next gear with new flexibility. The Detroit News. Retrieved July 1st, from Factiva database.

Censky, Annalyn (July 21, 2011) U.S. loses $1.3 billion in exiting Chrysler. Retrieved: http://money.cnn.com/2011/07/21/autos/chrysler_government_exit/index.htm

Ciferri, Luca & Wernle, Bradford. (2009, November 23). How Chrysler, Fiat design teams splits the world. Crain Communications, Inc. Retrieved June 30, 2011.

Fiat, more than a century of italian history. (2011). Retrieved from www.fiatspa.com
Gomes, Emanuel (2007) Improving Merger Process Management Skills over Time: a Comparison between the Acquisition Processes of Jaguar and of Land Rover by Ford. Irish Journal of Management. Volume: 28. Issue: 1

Healey James (2012) Chrysler sales boom 20%, Ford slips 4.6%, GM down 8.2%. USA TODAYRetrieved:http://content.usatoday.com/communities/driveon/post/2012/05/chrysler-general-motors-ford-april-sales-up/1#.T7PigMXz7N4

Johnson, Dale. (2009, February 13). Chrysler and Fiat rekindle an old flame; The Makers go way back together, to a rarely remembered conjugal arrangement in the early 60’s. Toronto Star. Retrieved July 1st 2011, from LexisNexis database.

PranaTharthiharanNatarajan (3 Aug 2011) Fiat-Chrysler Merger – Birth of a new Auto Giant http://www.frost.com/prod/servlet/market-insight-top.pag?docid=239447224

Vlasic, B. (2012, January 10). A merger once scoffed at bears fruit in Detroit. New York Times. Retrieved from http://www.nytimes.com/2012/01/10/business/chrysler-and-fiat-merger-shows-fruits-of-teamwork.html.

Welch, D. (2009, November 11). Fiat’s crazy Chrysler plan just might succeed . Retrieved May 19, 2012, from Bloomsberg Business Web site: http://www.businessweek.com/bwdaily/dnflash/content/nov2009/db20091111_508167.htm

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Is the Efficient-Market Hypothesis Justified True Belief?

Posted Apr.27, 2012 under ECONOMICS

The philosopher, George Santayana, once stated that “Those who cannot remember the past are condemned to repeat it.” Modern society can regain new insight from history, especially in efficient-market hypothesis, Behavior finance, and economic market theories. This paper will present a brief history of the “radicals” that changed economic thought and will provide a background to the modern debate of economic markets—are markets rational or irrational? I will prove that from antiquity to the modern era, investors have based their decisions on a false dilemma in their financial strategy by limiting themselves to an either/or option and how the misuse of language distorts human understanding of what it means to have rational justified beliefs about the reality of how things actually work. Investors should seek a Hegelian middle and find synthesis in both Efficient-Market hypothesis and the Behavioral finance theory as a pragmatic approach and let a “new truth” arise out of the debate.

Robert Heilbroner postulated that there were three different ways an economy can be organized. (1) Tradition: Children do the jobs their parents did, produced the products their parents produced, and both produced and consumed about the same quantity as earlier generations; (2) Government: Governments can command economic activity, can decide who will produce what, at what price, at what volume, and be produced by whom; (3) laissez-faire “let it be”: no one coordinates prices and rates of production or consumption; allow prices to float and thereby , by itself, regulate production and consumption, independent of any general decision-making powers (Heilbroner, 1999). These three methods will provide a philosophical framework to understand how economics have evolved throughout history.
In early economic thought many considered that markets were moved by reason by God or rational men. According to Plato (423–347 BC), “justice” is a result of a society being properly ordered by “reason” and he believed that everyone had a purpose and a designed task in society. He believed that society should be ruled by the State, led by Philosopher-Kings. This type of despotism controlled society’s commerce, political and cultural life (Popper, 1966). For Plato, this “reason” was the force that led human decisions that were derived by universal forms and what we experienced as humans was not the real world but only a mirror image of true reality. In contrast, Aristotle (384 – 322 BC) believed that what we experienced in the world was real “substance” defined by its “essence” and that everything that happens in the universe has a final cause or purpose that is an underlying force in ethics, physics, politics and economics. For example, according to Aristotle’s physics, if a rock falls down to the ground it is because it seeks to find its rightful place in the order of things. Both Plato and Aristotle believed that just as physical things have a cause and purpose in the order of things, so do all economic actions have a cause and purpose in the order of things (Alder, 1978).
This worldview morphed into the Christian era in where Thomas Aquinas (1225–1274) adopted an Aristotelian paradigm in his economic and philosophical thought. “A Just Price,” according to Aquinas was sufficient to cover the costs of the production.” Therefore, according to Aquinas, self-interest and greed leads to only social evils. Aquinas used the Aristotelian “golden mean,” not to over indulge in financial gain, but to seek out the interests of others for the benefit of the community collectively (Aquinas, 1993). Aquinas developed four cardinal virtues based on Aristotelian philosophy that was a major influence in the medieval society. Though this paradigm continued for centuries, it was soon to be challenged by the New Science and worldview of Galileo, Copernicus, Newton, and ultimately the modernity of the Enlightenment era.
Immanuel Kant, in his essay, What is Enlightenment? (1784) defined the Enlightenment in one famous phrase, “Sapere aude” (Latin) “Dare to Know” or “Dare to think for yourself.” It essentially means that we are no longer students that need to be tutored by our school masters but we now can think for ourselves. Just as the Enlightenment revolution yielded a new science shedding its axiom of the Aristotelian worldview, so the enlightenment shed its ancient notions of epistemology and how things actually worked in the world. This schism no longer viewed the world as having a final cause or purpose, but viewed a world as a machine set into motion driven by universal laws and laws of nature (The Mathematical Principles of Natural Philosophy, 2012). This new paradigm shift not only influenced science, religion, and politics but also financial markets and economics.
Adam Smith (1723 – 1790) wrote An Inquiry into the Nature and Causes of the Wealth of Nations (1776). Smith believed that independent economic actor will be guided as if by an “invisible hand” to produce public benefit. This means self-interested individuals acting without coordination will as “rational” persons be led in the direction that will actually benefit society best. For example, rational people will not make the same product because if everyone decides to make the same product it will drive the price down. The rational person will instead produce a different product that has a better chance of profitability. Thus, simply by the random interactions of self-interested individuals who are capable of figuring out what is advantageous to themselves and what is not, will develop not only a functioning economy but an economy that actually improves overtime. The most important philosophical notion that is underlying this idea is called “spontaneous order” (Calhoun 2003). Spontaneous Order was a beneficial order that could be the product of un-designed activity. In this process, no one controls this economic system. While there are background rules that govern independent action, there is no coordination of these actions and within these actions beneficent order emerges (Calhoun 2003).
Like Adams, Bernard de Mandeville (1670—1733) posed a theory that “private vices are public benefits.” Mandeville believed that a just and beneficial social order can be built on a basis of not individual virtue but individual self-interest. Self-interest or even “greed” might lead to public benefit. Mandeville’s thought went directly against Aristotle and Aquinas who both believed that greed or vices will only result in greed and vices. They believed that one could not create a beneficent system based on selfishness and vice. If one starts with vice as the base of their system he or she will produce a vice driven system. Both Aristotle and Aquinas believed that a beneficent order is a product of mind whether the mind from God or a mind of a human. If things are good and organized there must be some mind that made it so because the laws of nature are designed by God (Calhoun 2003). However, this thought was being challenged by thinkers of the Enlightenment. The notion of “spontaneous order” implies that one can have a system rooted in selfishness and yield a system that can produce things that benefit society—this concept sowed the seeds of capitalism (Calhoun 2003). Therefore, this revolutionary idea of an economy driven not from tradition, nor from a final cause or from God, nor from rulers or kings, un-designed from top and bottom, but simply from the result from its own massive current actions was called, the discovery of society by Karl Polanyi. According to Polanyni, this society creates itself. It has its own rules and laws, emergent properties, independent of government, God or the past (Polanyi, 2001).
Through Mandeville and the Enlightenment thinkers emerged a postmodern era of people who viewed reality not as a machine determined by causal laws but as a social organism full of infinite possibilities and where truth could never be certain through our senses or reason. In North America, the dominant philosophy is pragmatism, which is derived from the “Metaphysical Club” at the turn of the century. Members of this club were Oliver Wendell Holmes, Jr., William James, and Charles Peirce who defined modern American life and thought. The epistemology was articulated by James’ famous quote, “Truth is what works.” In the modern world when thinkers try to solve problems they do not try to find absolute truth or even universal laws, instead they seek high probabilities that guide their decisions with the most reliable data they can acquire. In economics, as in science, modern thinkers no longer try to prove or verify a hypothesis, but try to falsify a hypothesis (Popper, 1963). One may state a hypothesis and try to disprove it. The hypothesis that stands the test of time will be the accepted paradigm thinkers will use in their models of inquiry.
The two of the men that have shaped our economic paradigm in the 21st century are F.A. Hayek (1899–1992) and John Maynard Keynes (1883–1946). Hayek stated in his book, The Fatal Conceit, “The curious task of economics is to demonstrate men how little they really know about what they imagine they can design.” Keynes wrote, The General Theory of Employment, Interest, and Money (136) that has influenced fiscal policy especially in the US. Today classical economists believe that the driving force creating growth is production, while the Keynesian view postulates that spending leads to economic growth. The Keynesian model states that borrowing money vis-à-vis increasing tax revenue to redistribute it to consumers creates aggregate demand and growth. Giving the money to consumers will stimulate the economy via consumer spending. For example, Washington can spend $814 billion putting idle factories and people to work. But that requires first borrowing $814 billion of spending power out of the private sector.
Classical economists postulate that Keynesian theory does not boost income, it redistributes it in hope that consumers will spend in the economy. Classical economists criticize Keynesianism of borrowing or taking money from one group, and giving it to another group does nothing to increase economic output it’s not growth, it’s redistributing wealth (Hayek, 2001).
New classical theory believes that savings should fund good investment, thus creating goods and inventions that will spawn sound economic growth. The new classical model believes that spending is the problem that stifles growth and is logically flawed. It is the invisible hand in the market that will turn around the economy and increase growth.
Hayek, who opposes Keynesianism, believes that the free market will eventually correct itself and that Government involvement actually makes economic crisis worse in the long run. He believes that when Government uses the Keynesian model it creates boom and bust cycles that are harmful to the natural cycles of the free market (Hayek, 2001). In the past decade the US have been using Keynes’s theory by trying to “keep the boom going.” The Federal Reserve sets interest rates really low shortly after 911, and the government flooded the economy with its spending, creating inflation and creating “a false sense of growth” which ultimately collapsed, as it did in the housing and financial crisis. Classical economists would want the government to stop government involvement and creating this false growth. Just as classical economists and Keynesian economists debate about which system is better, so there is an ongoing debate between efficient-market theory and behaviorist theory proponents.
Harry Markowitz won the Nobel prize in Economics for developing the concept of mean variance optimization which seeks to diversify stocks in a portfolio to advert risk. This theory studied how markets actually work and is one of the important foundations to Efficient-Market hypothesis. According to the Efficient-market hypothesis, the market is moved by buyers and sellers who have obtained similar data to make rational decisions on their financial strategies. The Efficient-Market hypothesis advocates hold to the fact that investors cannot beat the S&P 500 on a regular basis or outsmart the market by making better guesses then the prices are indicating. Therefore, because buyers and sellers have the same information, it creates an environment where prices of stocks or other securities are fair (Fox, 2002). Efficient-Market hypothesis was first introduced by Eugene Fama, a professor at the University of Chicago. “In an efficient market,” wrote Chicago professor Eugene Fama, “prices ‘fully reflect’ available information.” Therefore in an efficient market, one cannot beat the market unless you have inside information. It is economic sophistry (Fox, 2002).
According to Efficient-Market proponents, market efficiency helps people allocate resources to gain and accumulate wealth. They do not have to be smart to “beat” the market every year to be wealthy. They can have a reasonable returns by choosing to buy index funds or ETFs (Exchange-Traded Fund) which mimic the total stock market in a diversified portfolio. Many investors choose to buy Exchange-Traded Funds (ETF) because they have no load fees and are less expensive while yielding good returns. These investors do not believe in buying expensive funds with loads and expense fees when most fund managers do not beat the S&P 500. These investors believe that instead of trying to outsmart the market they simply try to imitate it. The first index fund for institutional investors was started in 1971 by Wells Fargo Investment Advisors in San Francisco. The first such fund for retail investors was the Vanguard Index Trust launched five years later (Fox, 2002).
In contrast, Behavioral finance tries to develop models based on human psychology as it relates to financial markets and disagrees with the Efficient-Market claim that markets are moved by rational choices driven by market data available to the public. Yale Efficient-Markets skeptic Robert Shiller’s 2000 bestseller, Irrational Exuberance is concerned with risk and uncertainty in human affairs and has never been a proponent of the orthodoxy which either claims that bubbles “do not exist” or that “markets should be left to themselves since they instantly and efficiently incorporate all known information”, as the Efficient Market Hypothesis holds. In 1981, Shiller disproved efficient-market theory that the market driven by people who logically and rationally use earnings and other net-present value of dividends available to both buyers and sellers. Shiller demonstrates in his quantitative analysis that there is an error in earnings forecast models from 1870-2010 because while the earnings grew at a steady pace the actual stock prices fluctuated much more that what was forecasted ( Shiller, 2005).

Shiller explains that the fluctuation is not through an efficiency-market model but because of the way people behaved based on the current news of the day not through calculated net-present value of dividends, but was the result of a social force or speculative bubble. Shiller’s main point is the stock market is not an imperial science or rational; no model is an optimal predictor of how the market will perform in the future (Shiller, 2005).
In 2002, Daniel Kahneman won the Nobel Prize in Economics for his work in Behavior finance. Investors since then have wanted to learn more about the techniques to build a more risk-adjusted portfolio. Like Shiller, Kahneman and other behavior finance proponents believe that we do not always act as rational economic-beings, sometimes we act as human-beings and act irrationally. We make decisions based on biases that do not reflect real world facts. While modern portfolio theory, seeks to understand how markets work, Behavior finance seeks to understand how people work (Curtis, 2004). The Greek philosopher Heraclitus stated that the only thing that is constant is change itself and according to him, “everything is in a state of flux.” If this is so, investors must plan their strategy around a business model that has no guarantees and a market and economy that is always changing. Investors must always factor in unpredictable events and consider possible extreme outliers that may play in larger roles that may affect their investments (Taleb, 2010). There were many of these outliers in the last decade: the unpredictable subprime mortgage crisis in 2008 that led to the economic bust, companies such as Lehman Brothers shocked the financial world by declaring bankruptcy, and the tragic terrorist attack of 911. If the world is in a state of flux, we need to be cautious and not be over confident “human-beings.” Therefore, for the Behaviorist, the market cannot be rational or efficient because of the constant change in the market and the reactive and capricious behavior of human beings.
Ludwiq Wittenstien stated that the major problems of philosophy are problems of language and logic (Wittgenstien, 2009). Essentially, the problem that is rooted in the debate between Efficient-Market hypothesis and Behavioral finance is a language problem that tries to explain the true reality of how things work in the market. Behavioral finance accuses Efficient-Market hypothesis as untrue on its assumption that markets are efficient and is moved by rational forces.
The Behaviorist’s accusation is flawed because it tries to subjugate the Efficient-Market hypothesis to its standard of truth and claims that it has no rational justification to make the claim that markets are efficient or rational. Behaviorists use a double standard to make their point because while they accuse the Efficient-Market proponents of not having a rational justification for efficient markets, their claim that markets are moved by events and human behavior is not based on any rational justification. Therefore the debate is more about what warrants a justified belief in relation to how the market works. This debate is nothing new and we can go back to the enlightenment era to shed light on our modern debate.
David Hume (1711-1776) was a philosophical skeptic and had a rigorous method of how one could acquire knowledge by two categories: relations of Ideas (necessary truths 2+2=4) and matters of fact (Hume, 1999). We will apply Hume’s method to The Efficient-Market hypothesis as it mirrors the Behaviorist’s criticism. The Efficient-Market method primarily uses induction, probabilities, and necessary connections. For example, the S&P 500 has historically yielded a 12% return. For many investors, this fact has led many investors to believe in the Efficient-Market hypothesis. Hume, however, would claim that Efficient-Market hypothesis has no rational justification because there is no way we can know that the future will resemble the past and experience cannot validate future events. According to Hume, neither the future nor necessity can be experienced, therefore we can have no knowledge of either. Hume states that we have no reason or rational justification to believe that the sun will rise tomorrow. Therefore, just because the S&P 500 yielded a 12% return in the past does not justify a rational belief that it will yield a 12% return in the future because according to Hume correlation does not imply causation (Hume, 1999). Hume would say that because we have no method of experiencing the claim that markets are efficient or led by rational forces then we must “commit it then to the flames: for it can contain nothing but sophistry and illusion”(Hume, 1999). In other words, for investors who follow the Efficient-Market hypothesis, there is no rational justification and all outcomes are mere allusions. Therefore, Efficient-Market hypothesis is only based on presuppositions and habit—it is not an empirical science and is not based on rational knowledge.
Though Hume admits that there is no rational justification that the sun will come up tomorrow, he still believes it will. He separated the rational belief from basic beliefs. Hume states, “Nature is always too strong for principles.” In other words, people do not act on objective facts they act sometimes on basic beliefs. Because we have experienced the market performing at a rate of 12% in the past, our minds form a custom or habit where we expect the same actions in the future. These customs and habits guide our beliefs. Nature creates these beliefs in our minds. Even so, there is no rational explanation for these beliefs. Therefore it is not an invisible hand that drives the market but mother nature creating these beliefs about how the market operates.
In conclusion, we are left with two fundamental and plausible options: basic beliefs with no rational justification, “the sun will rise tomorrow” and “past and experience cannot validate future events.” The debate is skewed by the terminology and the definition of what it means to be “rational”. For Efficient-Market hypothesis proponents, it is rational to believe that the sun will rise tomorrow; for the behaviorist it is not. For behaviorists, basic beliefs (common sense) do not warrant certainty. This poses a philosophical conundrum, however, at the end of the day investors want the most reliable method possible to produce successful portfolios—“truth for them is what works.” Investors should use both rational beliefs and basic beliefs (common sense) and should seek to synchronize both the efficient-market hypothesis and the Behavior finance theory because both can be useful in developing successful portfolios. Investors should all agree to some extent that sometimes the market is irrational and they should try to hedge and limit risk as much as possible. Though efficient-market hypothesis is not perfect with its anomalies and outliers, it is still the most reliable and effective model to use in financial portfolio strategies. We should not accept the radical skepticism of David Hume, nor should we abandon common sense, however, we should question why we make certain choices and test them under scrutiny. Investors should invest as though the market is rational and in a pragmatic approach, create financial strategies to buy and hold, diversify, buy ETFs, pay attention to costs, and adopt behavioral finance strategies by building risk-adjusted portfolios.

References

Alder, Mortimer J. (1978) Aristotle for Everybody. MacMillian. NY, NY.

Aquinas, Thomas.(1993). Selected Philosopher Writings. Oxford University Press. NY. NY.

Calhoun, Lawrence. (2003) Modernism to Postmodernism. Blackwell Publishing. Berlin Germany.

Curtis, Gregory. (2004) Modern Portfolio Theory and Behavioral Finance. Retrieved: http://knightsbridgesearch.com/site/downloads/4.pdf

Fox Justin. (2002). Is The Market Rational? No, say the experts. But neither are you–so don’t go thinking you can outsmart it. FORTUNE Magazine. Retrieved: http://money.cnn.com/magazines/fortune/fortune_archive/2002/12/09/333473/index.htm

Hayek, FA. (2001) The Road to Serfdom. Routledge Classics. NY. NY.

Hume, David. (1999). An Enquiry Concerning Human Understanding. Oxford University Press. NY. NY.
Polanyi. Karl. (2001). The Great Transformation: The Political and Economic Origins of Our Time. Beacon Press. Boston Mass.

Popper, Karl (1966). The Open Society and its Enemies. Princeton New Jersey.
Popper, Karl (1963). Conjectures and Refutations: The Growth of Scientific Knowledge. Routledge. NY, NY.
Robert Heilbroner . (1999) The Worldly Philosophers: The Lives, Times And Ideas Of The Great Economic Thinkers, Touchstone, NY, NY.

Shiller, Robert J. (2005) Irrational Exuberance. Random House. NY, NY.

Taleb, Nassim .(2010). The Black Swan, Random House, NY, NY.

The Mathematical Principles of Natural Philosophy. (2012). In Encyclopædia Britannica. Retrieved from http://www.britannica.com/EBchecked/topic/369153/The-Mathematical-Principles-of-Natural-Philosophy

Wittgenstien, Ludwiq (2009). Philosophical Investigations. Blackwell Publishing. NY. NY.

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How to transform your team from “going through the motions” to becoming passionate culture changers

Posted Mar.10, 2012 under LEADERSHIP

Most companies in retail put their basic sales process and coaching model in the forefront of daily work life. They always seem to be acronyms on back rooms filled with posters or in countless emails and on the tip of every manager’s tongue. Mainly newly hire sales associates are trained on this in their first few weeks as a process of assimilation. Sadly, many are trained this same process for years of their employment until they leave of are terminated. Hubert Dreyfus from UC Berkley postulates a 5-stage model of effective skill acquisition, novice / competent proficient / expert / master; however, many companies require a blanket model for all sales associates that are on different levels of skills. Many standard sales process and coaching models are more geared to the sales associates that is at a “novice/competent” level. For newly hire sales associates this can be very effective, but in a situational leadership method, there should be a more advanced coaching for sales associates that is at a more advanced “proficient / expert / master” level. For advanced sales associates, their required daily activities and sales process becomes a process of “transparent coping” where they do not think about the activity, they become the activity, and the activity becomes second nature to them. The problem with this is sometimes they get bored with many tasks because they are no longer challenged. They feel some tasks are pointless, sometimes view them as punishment, and are not helping them to advance their skills. Furthermore, they feel the required forms, scripted talking points and company platitudes have almost succumbed to mechanistic and impersonal procedures. If managers implement a more intuitive model that promotes human creativity and ownership it may create a type of Hawthorne effect that would spawn more passion and self development that motivates the sales associate to use an inquisitive approach to learning. For advanced sales associates, managers need to focus on a comprehensive coaching and incentive plan that presents advanced skill acquisition that embodies exciting and challenging goals. The focal point of this plan should encompass rewards and recognition which increases team morale and commitment. Managers are looking for something they can implement that is juxtaposed with the “best place to perform and grow” value, not just a blanket universal strategy for all sales associates that are on different skill levels. I believe that the roadblock from going from good to great is not an employee problem, it’s a process and motivation problem and we need to find a better solution to clear the road to in order to form sales associates into authentic sales leaders that will become organizational climate changers.

There is an interesting idea from Mark Murphy in his book, Hundred Percenters. Instead of SMART goals, he advocates HARD goals for the advanced sales professionals. HARD goals are:

Heartfelt — My goals will enrich the lives of somebody besides me—
customers, the community, co-workers and managers.
Animated — I can vividly picture how great it will feel when I achieve

my goals.
Required — My goals are absolutely necessary to help this company.
Difficult — I will have to learn new skills and leave my comfort zone to
achieve my assigned goals for this year.

This is a winning approach because of its creative progressive approach but this approach also has been statistically validated through regression analysis. What ever the approach, I would like a model that would include a progressive style, backed by quantitative method, and promotes T-Mobile values, such as, (1) Sales recognition and incentive, (2) New learning and skill acquisition for retail sales competencies, (3) Fun is good principal, (4) Self managed goal setting, and (5) 360 degree performance appraisals.

Putting these ideas and philosophies in place should promote sustained growth and cultivate a spirit of creative innovation within the organization. The measured result show reflect a sales staff that is self motivated and empowered to lead change and thrust the organization into being a good company into a great company.

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Sustainability and Profitability: Two Innovative and Essential Business Drivers

Posted Mar.06, 2012 under LEADERSHIP

In today’s business environment: sustainability equals innovation but may not always equal profitability every time. However, smart companies must embrace sustainability or be left behind. Going “Green” means decreased costs and increased revenues and this article tries to influence executives to get on the bandwagon with other companies that are ahead in eco-friendly business strategies.

For some business leaders, sustainable manufacturing and eco-initiatives are seems to be time wasters, revenue drainers, and may place companies at an unfair advantage with other global countries that do not face environmental regulations. Today the US government is forcing companies to comply with environmental laws and regulations so companies will implement sustainability initiatives. Many companies embrace this change and show substantial organizational and technological innovations that effect companies in a positive ways within their culture, finances and company image.

In a recent Harvard Business Review article, Why Sustainability is Now the Key Driver of Innovation, Nidumolu and Rangaswami outlines a five-stage process on how companies can create sustainable initiatives to join the ranks of progressive companies like GE, HP, P&G, IBM, and Fedex that have capitalized on this “Green” revolution. The five stages are: (1) viewing compliance as opportunity, (2) making values chains sustainable, (3) designing sustainable products and services, (4) developing new business models, and (5) creating next-practice platforms.

The article provides real world examples on how these companies have been able to turn obstacles into opportunities and have been able to capitalize on this emerging “green” economy. The fifth stage in particular underscores the concept of “next-practices,” practices that change existing paradigms as opposed to “best practices” practices that follow the status quo. In conclusion, “’Green’ is Good.” An Eco-Friendly initiative is good for company image and adds to the bottom line through lean and anti-waste methodology. In this new economy there is a demand for sustainable business practices and companies must implement these initiatives in their business model to stay ahead of their competition.

References

Nidumolu, Ram and Rangaswami M.R.(2009). Why Sustainability is Now the Key Driver of Innovation. Harvard Business Review, Sept.

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Why Obama’s economic policies has failed to put us on a path to recovery: the federal tax code.

Posted Dec.10, 2011 under ECONOMICS

by Igor Sill.

Despite the massive fiscal stimulus our economy remains on the brink of entering yet another recession, with unemployment being the major economic culprit, the rising deficit, pending need for federal tax increases, and of course, the Eurozone’s uncertainty lingering in the backdrop. Why has Obama’s economic policies failed to put us on a path to recovery? Fundamentally, the issues are intertwined with our federal tax system.
As 2011 draws to an end, we now realize that those 67 tax breaks (Social Security payroll tax, Alternative Minimum tax, etc, etc.) may not get extended by their expiration deadline of Dec 31, 2011. What we may not realize is that those tax breaks represent just a miniscule section of the 68,000 pages in the US Treasury’s Internal Revenue Service’s tax code. As a result, your first paycheck of 2012 will be noticeably smaller, and if the tax code is not corrected or totally reformed, that paycheck will continue to dwindle in the years to come. Also, 75 new taxable regulations were introduced during Obama’s administration to date adding annual costs of $38 billion. All of which erodes an already anemic economy and stifles employment prospects.
America’s tax code is an outdated archaic mess, having grown to become an unwieldy and ineffective bureaucratic institution. The code is needlessly complex because of deductions, credits, exceptions, loopholes and demanding special treatment for a few. As a result, the tax code contributes to our government’s huge size as a result of this burden of administering its complexity and its subsequent revisions and enforcement. It’s no wonder that folks are up in arms, both, our citizenry and legislators.
Resolving the tax code issue would actually have a very positive affect on our deficit by lowering the Treasury’s operating overhead significantly, eliminating the massive special interest credits/expense and increasing the revenue inflow. President Reagan recognized the need and validity of this approach back in 1981 when he proposed the Economic Recovery Tax Act (ERTA), the Reagan tax cuts, a 25% across the board decrease in personal marginal tax rates. Even with the then massive cold war military expense buildup and the subsequent dilution of the Act as enacted, the Reagan tax cuts showed that reducing excessive tax rates stimulates economic growth, reduces tax evasion and tax avoidance schemes, and can actually increase tax revenues from the rich.
As to the misguided notion that 99% of Americans support 1% of the rich in tax payments, the truth can be found by Googling “Who pays federal income tax?” a link to the National Taxpayers Union displays the actual stats: The top 1% of the wealthiest income earners pay 38% of US tax revenues, the top 5% pay 59%, the top 10% pay 70%, the top 25% pay 86%, the top 50% pay 97.3% and the bottom 50% pay 2.7% of all federal tax revenues. The largest share of the tax burden is shouldered by top 5% of the wealthiest Americans who are paying well over half of the federal income tax revenues, while the poor pay virtually nothing in federal income taxes. If you take a further investigative look it becomes clear that once federal spending is taken into consideration, those “1% of wealthiest Americans” are paying vastly more into government and consuming virtually nothing, while the bottom 50% receive the largest amounts of that spending and paying virtually no federal tax. Those are the facts: http://ntu.org/tax-basics/who-pays-income-taxes.html
We need tax reform that is fair, simplified, flat, low, easy to understand and collected from all US citizens above the poverty line, while eliminating income taxes for those below the poverty line. We need to drastically reduce entitlements and entitlement programs, lower the corporate tax rate so that the US can regain its competitiveness in the global markets, while reducing our unemployment. We currently out spend on foreign military activities more than the actual net income of all US corporations combined. Let’s continue to invest heavily in our country’s security, our educational system, shoring up our borders, deporting illegal aliens involved in criminal activities, drastically cutting entitlements, while withdrawing our military occupation of other countries. We can then begin enjoying a more prosperous era of economic growth, less government involvement along with a simplified tax system we can all live with, much like Ronald Reagan intended.

Article written by Igor Sill.
Igor Sill studied Economics and Political Science at UC Berkeley, and received his Masters from Oxford University as a Merton College fellow. He is a member of the Royal Economics Society, and the Oxford Finance & Investment Society, and studied Reaganomics. He founded Geneva Venture Management and resides in San Francisco, California.

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