http://www.articletrader.com/ Articles at ArticleTrader en-us http://www.articletrader.com/finance/different-financial-systems.html http://www.articletrader.com/finance/different-financial-systems.html Mon, 02 Apr 2007 00:00:00 -0500
there are two models of financial systems to choose from, a banking oriented system and a market oriented system .I am going to explain how real countries fit the alternatives by examining the countries with the four largest and the most well developed economics in the world -Germany ,Japan, the united kingdom and the united states .

Germany
Germany is very much a banking oriented financial system .at the core of the system is the hausbank .there the concept of hausbank a business relies on a single bank (its hausbank)as its primary source of all forms of external finance .thus a relationship between a business firm and its hausbank is a very powerful one .unlike countries where banking relationship is strictly limited
to debt financing, the hausbank system fosters bank participation in the strategic activities of German firms through stock ownership and control ;bankers can also sit on company supervisory
boards.

bank ownership participation is both direct and indirect .it is direct because banks can and do own a significant share of many German companies ;in particular ,banks own about 10 percent of public companies in Germany . however indirect ownership is also more important .many individuals and institutions in Germany deposit their stock holdings in a trust account with a bank .as part of this custody arrangement, the voting rights associated with these shares are conveyed to the bank .thus banks exercise control over German companies by combining the direct voting rights from share ownership with the proxy votes they acquire through their custody
accounts.

Banks in Germany are organized into four major categories: commercial banks, saving banks, cooperative banks and specialized banks. commercial banks consist of the there biggest German banks (grossbanken) deutsche bank ,Dresdner bank ,and commerz bank .these three banks are also significant players internationally .some of the regional banks are also quite large
and are active participants in international market . The saving banks are typically owned by
regional and town governments and operate locally .originally established as thrift institutions collecting deposits and making mortgage loans .they now offer full commercial banking services
Although their orientation is still emphasized thrift activities. The cooperative banks were first established in 19 century to collect savings and extend credit to individuals .the last kind is
the specialized banks whose most important types of them are mortgage banks that make residential and real estate loans .the mortgage banks are financed principally by bonds. they also include banks that emphasize consumer lending ,small business loan guarantees, export finance ,
and industry -specific finance .

The dominance of banks in Germany comes at the expense of the securities market .the stock, bond, and commercial paper market in Germany can best be described as suppressed. there are eight regional stock exchanges, dominated by the Frankfurt exchange .the corporate bond market is minuscule ,as is the commercial paper market perhaps because until 1992 regulations and taxes made it ridiculously expensive to issue these securities .as a result most German companies are highly dependent on their banks for credit .

The dominance of the banking system in Germany is enhanced by a regulatory framework that permits universal banking .in Germany banks are not only permitted to own non financial companies, but are also permitted to underwrite corporate securities to underwrite insurance
Through a subsidiary. The ability to underwrite securities enables a German bank to handle all of a company’s financial needs effectively throught its business life cycle.

Japan
The two most important features of Japanese financial system are the keiretsu form of industrial organization and the emphasis on a firm relationship with its main bank a keiretsu is a group of companies that are controlled through interlocking ownership, that is, the companies own stock in each other. This type of industrial organization encourages strong loyalty among the companies in the group, including favoritism in customer supplier relationships.

Like the German financial system, the Japanese system emphasizes firm loyalty to a single bank
, the main bank in fact each keiretsu has a main bank that typically owns stocks in other members of the group .as in Germany the Japanese banks may own equity in non financial companies. Every month the top managers of the firms in the group get together with large shareholders and chief creditors at the president club meeting .while these meetings are not part of the formal
governance structure ,they act very much like the supervisory board in German companies where planned projects and general firm policy are discussed.

The banking system is divided into three basic categories, the very largest city banks, the regional banks, and the special purpose financial institutions. A disproportionately large fraction of the world’s biggest banks are Japanese city banks like sanwa bank,dai-ichi kangyo bank ,Fuji bank
and sumitomo bank. The special purpose institutions include the three long term credit banks ,specialized small business institutions ,and specialized agriculture ,forestry, and fishery
institutions. only relatively recently have Japanese regulations permitted companies to issue commercial papers and corporate bonds .

Unlike Germany stock market in Japan is quite large .the Tokyo stock exchange is comparable in size to the New York stock exchange and is sometimes larger depending on the stock price levels
and the exchange rate. Japan has also adopted laws similar to the US glass steagall act separating commercial banking from investment banking. as in the US system however the separation between securities underwriting and commercial banking is eroding .as of 1993 commercial banks in Japan were permitted to underwrite corporate securities in an affiliate ,subject to specific permission from the ministry of finance (the regulator of banks in Japan along with the bank of Japan.)

United Kingdom
Unlike the economies in Germany and Japan, the financial system of the United Kingdom is very much market oriented, although banks play a very important role .London is somewhat unique because it serves as both a domestic financial market for UK business as well as the center for
the Euro bond market .because of a regularity environment that encourages foreign participation
and competition in financial services ,the domestic markets are not really distinct from foreign markets. UK companies issue Euro bond market and foreign companies, as well as domestic, list
stock on the London stock exchange .

The banking system consist of five categories: clearing banks, merchant banks, other British banks, foreign banks, and other deposit taking institutions .the clearing banks dominated by Barclay's bank, national west minister, midland bank, and Lloyd’s bank are universal banks and conduct securities activities through investment banking subsidiaries, in addition to having extensive branch networks thought the United Kingdom. The merchant banks provide wholesale
banking services to large corporations, including offering loan commitments and guarantees, derivatives products and international trade finance .in many ways they are more like US investment banks than traditional commercial banks .the other British banks,as their name implies ,are an eclectic group consisting of some institutions similar to merchant banks and others ,which are specialized institutions that emphasize such activities as consumer lending.
The other deposit taking institutions are mostly building societies, which are mutual organizations similar to saving and loan associations in the United States. banks in the united kingdom do not for the most part own non financial corporations .while there are no explicit restrictions prohibiting bank equity ownership, the bank of England (the regulator of banks in united kingdom) has generally discouraged the practice in order to promote a safer banking system .the lack of formal restrictions explicitly prohibiting bank stock ownership must be viewed in the overall context of
British bank regulation.

United States
Suffice it to say that the very large stock, bond, and commercial paper markets made the united states the prototype of a market oriented system .moreover the securitization of residential mortgages and other types of financial assets ,such as credit card receivable and auto loans ,have further strengthened the importance of the traded securities markets. on the other hand although US banks are not the primary providers of external finance to large corporations ,they do play a key role in external finance for small and mid size companies .and, of course the glass-steagall act prohibits commercial banks from owning equity in non financial companies ,although bank holding companies are permitted very limited ownership privileges.

Eastern Europe and other emerging economies
with the break up of communism and the soviet union ,the eastern European countries were faced
with daunting challenge of building a financial system from square one .one of the first initiatives
was to develop privatization programs designed to transform government owned companies into privately owned firms . these privatization programs typically involved distribution of shares to the major stock holders (employees ,managers ,and creditors )in the industrial firm that are privatized .most of the early privatization efforts focused on small and midsized companies rather than the large industrial companies .

As best, Eastern Europe can be viewed as an information-poor environment where even activities of large firms are cloaked and fog .rating agencies for most parts don't exist. Reputation building is extremely difficult because most companies have not existed long enough to develop reputations -except for producing shoddy goods under communism. More over the lack of managerial talent and experience in Eastern Europe suggests that investor monitoring will be especially critical in these countries.


In banking oriented systems banks are the principal lenders to both small and large businesses, and banks own and control large corporations. in markets-oriented systems large companies are diffusely held, and they borrow most of their funds in the securities markets rather than from banks .with their huge banking system and extensive bank ownership of business enterprise Germany and Japan are decidedly banking oriented systems .the relative importance of securities markets in the united kingdom and the united states makes these systems market oriented.



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Remortgage

Source: http://www.articletrader.com ]]> http://www.articletrader.com/finance/the-market-of-securities.html http://www.articletrader.com/finance/the-market-of-securities.html Thu, 29 Mar 2007 00:00:00 -0500 to particular assets. Debt securities include bonds and mortgages. Ownership securities include common stock certificate sand the titles to marketable assets. In addition preferred stock is a hybrid security which entitles its owner to a mixture of
both ownership and creditorship privileges.

Debt, according to the dictionaries, is a condition that exists when one person owes
something to another person .the dictionaries go on to explain that security is a paper
that is given as a pledge of repayment ,or as evidence of debt or ownership. These definitions suggest that the phrase debt securities must refer pieces of paper that
evidence certain parties owe something to certain other parties.

Investors buy securities in order to earn to earn interest income from the security .that is the investor lends money to the borrower who issued the security. But the investor
expect to have the loan rapid with interest. There are many different kinds of marketable debt securities .they pay different rates of interest, they are available in different denominations, they have different length of time until they come due for repayment.

Dictionaries explain that things which are liquid flow freely from one place to another
without being significantly compressed or exchanged . Following this general definition, money is the most liquid of all securities because it is readily acceptable
at its face value in markets everywhere . Essentially, money is a perfectly liquid asset
that flows freely from hand to hand without losing any of its value in the process .money is more liquid than, say long-term bonds ,which have uncertain market
pieces that can deviate significantly from their face values and thus can be difficult to convert back into the amount of money which was paid for the bond .thus bonds may be an illiquid investment ,especially when they are not traded in active markets .highly
marketable securities that have short terms until they mature and involve little or no risk of default are said to be moneylike and are called money market securities .

Negotiable certificate of deposit are called negotiable CDs in the financial world are
receipts from a federally insured commercial for a deposit of 100,000 usd or more
with special provisions attached . One of the provisions is that the deposit will not be
withdrawn from the bank before some specific maturity date. Negotiable CDs are bought and sold in active secondary markets similar to the way treasury bills are traded.

BANKER,S ACCEPTANCES are written premises to repay borrowed funds which borrowers give to banks then if the potential borrower takes down the loan (that is actually borrows the money )the lending bank is said to accept the banker’s acceptances. later if the lending bank wants to withdraw the money before the loan expires, it sells the written promise to repay the loan (that is the banker’s acceptance) to another investor . banker’s acceptances may be resold to any number of new investors before the loan comes due and is repaid ;there is an active secondary market in these moneylike pieces of debt .

COMMERCIAL PAPER refers to the short promissory notes issued by blue cheap corporations. commercial paper is a form of unsecured corporate borrowing that typically has an original maturity of between 5 to 270 days, with 30 days the most in common .most commercial papers are bought by institutional investors, especially money market mutual funds, but non financial firms and state an local governments also buy significant amounts .commercial papers does not have much of a secondary market.

FED FUNDS the common name for federal funds loans are the overnight loans between commercial banks. Fed funds are simply bank reserve loaned from banks with excess reserves to banks with insufficient reserves. The interest rate on these
1-day bank loans are called the federal fund rate.

REPURCHASE AGREEMENTS are commonly known as repos are devices that
are usually used by security dealers to help finance part of their multimillion dollar
inventories of marketable securities for one or few days .repos that last longer than overnight are also in common . These longer term repos are called term repos and can span 30 days.


TREASURY BILLS are extremely liquid short term notes that mature in 13, 26 or 52 weeks from the date of issue .the treasury usually offer new bills every week selling them on a discount from face value basis .furthermore, T-bills are issued only on a "book entry" basis - the buyer never actually receives the security, only a receipt.

CERTIFICATE OF INDEBTEDNESS are issued at par (or face) value .later after they
are issued ,certificates are traded in the market at prices which vary minute by minute. certificate usually bears fixed interest rate. The fixed interest rate is printed on the certificate and never varies .it is called the COUPON RATE.

TREASURY NOTES are similar to certificate of indebtedness except with regard to
their time until maturity , T-notes are bonds that typically have a maturity of from 1 to 7
years. They are marketable debt security that pays coupon interest semiannually, just like the certificate

Euro-dollar loans are also sometimes called petrodollar loans, Asian dollar loans, or hot money flows .all these terms refer to large, short term loans which are dominated in dollars. These loans are usually arranged with banks with large international operations.

Treasury bonds differ from notes and certificates with respect to maturity. They generally run from 7 to 30 years from date of issue to maturity. Another significant difference is that some issues are callable at time prior to maturity.


Repurchase agreements are commonly known as repos. Repos are devices that are usually used by securities dealers to help finance part of their multimillion dollar inventories of marketable securities for one or a few days. In repo transactions the investor is essentially making a short –term loan to the securities dealer that employs part or all of the securities dealer’s inventory as collateral for the loan.
Repos that last longer than overnight are common too. These longer term repos are called term repos and can span 30 days, or even longer sometimes. These repurchase agreements, especially the term repos, are marketable securities that are actively traded by telephone calls between the money market trading desks of different banks and brokerages across the United States.

U.S. Government Securities
Government securities represent the amount of indebtedness of our governmental bodies. The owners of securities are creditors; the governmental bodies and debtors. United States government securities are of such high quality that their yield is often used as an example of a default-free interest rate.

Nonmarketable Issues
Approximately 30 percent of the public debt consists of nonmarketable issues. These can not be traded in securities market; they are not transferable; they can not be used as collateral for a loan; they can be purchased only from the treasury and they can be redeemed only by the treasury.

Marketable Issues
These issues make up 70 percent of the federal debt. They are usually purchased from outstanding supplies through a dealer or broker. However the purchaser may subscribe for new issues through any one of the twelve Federal Reserve banks in the United States.
The holder of marketable government securities stands to gain not only from the interest
Paid on these bonds, like the owner of nonmarketable bonds, but also from the price appreciation (higher selling price that purchase price), unlike the owner of nonmarketable bonds. The bid-and-ask prices for these marketable issues are published daily in newspapers like the New York Times and the Wall Street Journal.

Treasury bills are extremely liquid short-term notes that mature in 13, 26, or 52 weeks from the date of issue. The treasury usually offers new bills every week, selling them on a discount from face value basis. Further more, T-bills are issued only on a “book entry” basis—the buyers never actually receive the security, only a receipt. The treasury agent records the purchasers, transactions and issues receipt to the Treasury bill buyers instead of an actual T-bill security.

T-bills are never sold at a premium over their face values—only at a discount. The discount to the investors is the difference between the price they have paid and the face amount they will receive at maturity.

Certificate of indebtedness are issued at par (face) value. Later, after they are issued, certificates are traded in the market at prices which vary minute by minute. Certificates usually bear fixed interest rates. The fixed interest rate is printed on the certificate and never varies—it is called the coupon rate. The coupon rate tells what percent of the certificate’s face value will be paid out in two semi annual coupon interest payments each year.

Treasury notes are similar to certificate of indebtedness except with regard to their time until maturity. T-notes are bonds that typically have a maturity of from 1 to 7 years. They are marketable debt securities that pay coupon interest semiannually, just like the certificates. The treasury issues T-notes periodically, and some issues are currently outstanding and are traded actively.

Treasury bonds comprise about 10 percent of the federal debt. Bonds differ from notes and certificates with respect to maturity; they generally run from 7 to 30 years from the date of issue to maturity. Another significant difference is that some issues are callable at times prior to maturity. If the bonds are selling in the market above par, their yield to maturity is calculated to the nearest call date. If they are selling at a discount, the yield to maturity is calculated on the basis of their maturity date. The yield to maturity is a compound average rate of return calculated over the bond’s entire life.



Municipal Securities

The bonds of states, counties, parishes, cities, towns, townships, boroughs, villages, and any special municipal corporation tax districts (such as toll bridge authorities, college dormitory authorities, sewer districts, ad infinitum) are all referred to by security traders as municipals. They include the obligations of state and local commissions, agencies, and authorities as well as state and community colleges and universities.

Federal laws provide that the income derived from the obligation of a political subdivision be exempt from federal income taxes. This tax exemption applies to the coupon interest income, but not to any capital gains which may be earned, from municipal bonds. Thus, munis, as they are commonly called, are widely held by wealthy individuals and partnerships whose income may be taxed at the high personal tax rates.

The interest on municipal bonds can be paid in two ways – by giving a check to the bond registered owner or by cashing in the coupons attached to a bearer bond as they come due.

General obligation bonds often referred as to full faith and credit bonds because of the unlimited nature of their pledge, general obligation securities originate from government units that have unlimited power to tax property to meet their obligations and that promise to pay without any kind of limitation.

Limited obligation bonds the term limited obligation bonds is applied when the issuer is in some way restricted in raising revenues used to pay its debts. Revenue bonds are the most significant form of limited obligation. The distinguishing aspect of such bonds is that they are entitled to the revenue generated only to the specific property that is providing service for which rates or fees are paid. These bonds are widely used to finance municipally owned utilities, such as water works, electricity, gas, swage disposal systems, and even public swimming pools.

Municipal bonds pay income to their investors in two forms—interest payments and capital gains (or losses). They are just like the marketable U.S treasury bonds in this respect.

Bonds Issued By Corporations
Essentially a bond is what is commonly called an "I owe you". More particularly, a bond is a marketable, legal contract that promises to pay whoever owns it a stated rate of interest for a defined period and then to repay the principal at the specific date of maturity. Bonds differ according to their term concerning provisions for repayment, security pledged, and other technical aspects. They represent the formal legal evidence of debt and are the senior securities of the firm.

The Indenture, or deed of trust, is the legal agreement between the corporation and the bondholders. Each bond is part of a group of bonds issued under one indenture. Thus, they all have the same rights and protection from issuing company. Sometimes, however, bonds of the same issue may mature at different dates and have correspondingly different interest rates.
The indenture is a long, complicated legal instrument made up of careful worded phrases containing the restrictions, pledges, and promises of the contract;The trustee also takes any appropriate legal action to see that the terms of the contract are kept and that the rights of the bondholders are upheld. Because the individual bond holders are usually not in a position to make sure that the company does not violate its agreements and because the bondholders can not take substantial legal action, if the firm does violate them, the trustee does assumes these responsibilities.
Bond interest is usually paid semiannually, though annual payments are also popular. The method of payment depends upon weather the bond is a registered or coupon bond. The interest on registered bonds is paid to the holder by check. Therefore, the holder must be registered with the trustee of the bond issue to ensure proper payment. The registered bonds can be transferred only by registering the name of the new owner. In contrast, coupon bonds have a series of attached coupons that are clipped off at the appropriate times and sent to a bank for collection of the interest.
If the coupon interest is paid to whoever may happen to be the bearer of the bond without checking to see who is its registered owner, the bonds are called bearer bonds. The ownership of bearer bonds may be transferred simply by physically handing them over to the new owner.

Coupon Rate ;The coupon rate is the interest paid on the face value of a corporate or a U.S. treasury bond. It is one fixed dollar amount that is paid annually as long as the debtor is solvent. (Corporations, income bonds or adjustment bonds are the only exceptions.) The coupon rate is decided upon after the issuing corporation's investment banker has taken into account risk of default, the credit standing of the company, the convertible options, the investment position of the industry, the security backing of the bond, and the market rate of interest for the firm's industry, size, and risk class. After all these factors have been taken into account, a coupon rate is set. With the objective that it will be just high enough to attract investors to pay the face value of the bond. Later the market price of the bond may change from its face value, as market interest rate change, while the contractual coupon rate remains fixed.
Generally, the higher (or effective rate of return, as it is also called), the riskier the security. Yield rather than coupon rate is more significant in buying bonds. If the bond is selling at a discount, its market price is below its face value. In this case, the yield is higher than the coupon rate. If it is selling at a premium, the market price of the bond is above its face value. In this case the coupon rate is higher than the yield.

Maturity Maturities vary widely. The actual term to maturity of a new bond issue
changes after the bond is issued because as long-term bonds come closer and closer to their maturity dates, they become medium-term and then short-term bonds. Nevertheless, a bond is usually grouped by its maturity that existed on the date the bond was newly issued. Short-term bonds are any bonds maturing within 5 years. They are common in industrial financing and may be secured or unsecured. Medium-term bonds mature in 5 to about 10 years. If the bond is originally issued as a medium-term bond, it is usually secured by a real estate, or equipment mortgage, or it may be backed by other security. Long-term bonds may run 20 years or more. Capital heavy industries with long expectations of equipment life, such as railroads and utilities, are the greatest users of these forms of bonds.

Call Provision A call provision may be included in the indenture. This provision allows the debtor to call or redeem the bonds at a specified amount (above par) before maturity date. The difference between the par value of the bond and the higher call price is called the call premium. The call provision is advantageous to the issuing firm but potentially harmful to the investor. If interest rates should decline, it may be wise for the firm to call in its bonds and issue new ones at the lower market interest rate. This action, however, leaves investors with funds they can invest only at the lower interest rate.

Sinking Funds Sinking fund bonds are not special type of bonds but just a name given to describe the method of repayment. Thus any bond can be sinking fund bond if it is specified as such in the indenture. Sinking fund bonds arise when the company decides to retire its bond issue systematically by setting aside a certain amount each year for that purpose. Sinking fund bonds have been in common in industrial financing that involve some risk because risky debt issues are more attractive to investors with a promise of faster payments.

Serial Maturities Serial bonds are appropriate for issuers that wish to divide their bond issue into a series, each part of the series maturing at a different time.

Secured bonds
The most important classification of corporate bonds is whether they are secured or unsecured. That is, what security, if any, has been pledged to help pay investors if the company should be unable to live up to its obligations, or should default?
If the indenture provides for a lien on a certain designated property, the bond is a secured bond. A lien is a legal right given to the bond holders, through the trustee, to sell the pledged property to obtain the amount of money necessary to satisfy the unpaid portion of interest or principal. Pledged security is naturally used to make the bonds more attractive to investors by making them safer investments.

Mortgage bonds
A bond issue secured with a lien on real property or buildings is a mortgage bond. If all the assts of the firm are collateral under the terms o the indenture, it is called a blanket mortgage. The total asset need not be pledged, however; only some of the land or buildings of the company may be mortgage for the issue. They can be first, second, or subsequent mortgages each with its respective claim to the assets of the firm in case of default. A first mortgage is the most secure because it enjoys first claim to assets. A mortgage bond may be open-end, limited open-end, or closed-end, or may contain an after acquired property clause.
An open-end mortgage means that more bonds can be issued on the same mortgage contract. The creditors are usually protected by restrictions limiting such additional borrowing. The open-end mortgage will normally also contain an after acquire property clause, which provides that all property acquired after the first mortgage was issued, be added to the property already pledged as security by the contract. A limited open-end mortgage allows the firm to issue additional bonds up to a specified maximum (for example, up to 50 percent of the original cost of the pledged property). A closed–end mortgage means no additional borrowing can be done on that mortgage.


Collateral Trust Bonds
When the security deposited with the trustee of a bond issue consists of the stocks and bonds of other companies, these newly issued secured bonds are called collateral trust bonds. Since the assets of holding companies are usually largely in the form of stocks and bonds of their subsidiaries, holding companies are the main issuers of these bonds.

Unsecured bonds
Debenture bonds, or more simply, debentures, are unsecured bonds. They are issued with no lien against specific property provided in the indenture. They may be seen as a claim on earnings and not assets. This is not to say that the bondholders are not protected in case of default but, rather, that they are general creditors.

Subordinated debentures
Subordinated debentures are simply debentures that are specifically made subordinate to all other general creditors holding claims on assets. These other creditors are usually suppliers of financial institutions that have granted credit and loans to the firm.

Bonds with special characteristics
Several types of bonds have special characteristics of bonds plus some special distinguishing characteristic. These types of bonds are given special names. For example, if a mortgage bond is secured so that it covers only part of the property of the firm or only a specific section of a railroad, it is called a divisional bond.

Direct lien bonds These are special bonds secured by one piece of property such as a railroad terminal, dock, or bridge. Such a bond might then be referred to as a terminal bond or bridge bond. If two or more companies own the property that is securing the bond, such as a railroad bridge, it is called a joint bond.

Prior lien bonds These are bonds that have been places ahead of the first mortgage, usually during the recognization of a bankrupt firm. Only with the permission of the first mortgage bondholders can prior lien bonds be issued, taking priority over the first mortgage claim on asset.

Junior mortgage bonds These bonds have a secondary claim to asset and earnings behind senior mortgage bonds. Because it is poor public relations for an issue to bear the title second mortgage, these issues typically have names such as refunding mortgage or consolidated mortgage.











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Secured Loans

Source: http://www.articletrader.com ]]> http://www.articletrader.com/business/management/basic-management-skills-part-2.html http://www.articletrader.com/business/management/basic-management-skills-part-2.html Sat, 09 Dec 2006 00:00:00 -0600
Quality is primarily viewed in terms of corporate culture, multi-departmental ad-hoc task forces and the salvation of entire companies. This article, instead, will view these ideas as they might be applied by a Team Leader with a small permanent staff.

Quality has become the philosophers' stone of management practice with consultants and gurus vying to charm lead-laden corporations into gold-winning champions. Stories abound of base companies with morose workers and mounting debts being transformed into happy teams and healthy profits; never a day goes by without a significant improvement, a pounds-saving suggestion or a quantum leap in efficiency. With this professed success of "Quality" programmes, there has evolved a proscriptive mythology of correct practise which has several draw backs:

the edicts call for nothing less than a company wide, senior-management led programme
the adherence to a single formula has a limited effect, precludes innovation outside these boundaries, and reduces the differentiation which such programmes profess to engender
the emphasis on single-task, specially formed groups shifts the focus away from the ordinary, daily bread-and-butter
Of course, these criticisms do not invalidate the ideas of Quality but are simply to suggest that the principles might well be viewed from a new angle - and applied at a different level. This article attempts to provide a new perspective by re-examining some of the tenets of Quality in the context of a small, established team: simply, what could a Team Leader do with his/her staff.

What is "Quality"?
In current management writings "Quality" has come to refer to a whole gambit of practices which themselves have resulted in beneficial side-effects; as a Team Leader, you will want to take advantage of these benefits also.

The Customer
In simple terms, attaining Quality has something to do with satisfying the expectations of the customer. Concern for the wishes and needs of customers becomes the focus for every decision. What the customer wants, the company provides. This is not philanthropy, this is basic survival. Through careful education by competitors, the customer has begun to exercise spending power in favour of quality goods and services; and while quality is not the sole criterion in selecting a particular supplier, it has become an important differentiator.

If one ten-pence ball-point runs dry in one month and another ten-pence ball-point lasts for three then the second ball-point is the make which the customer will buy again and which he/she recommends to others - even if it costs a little more. The makers of the first ball-point may have higher profit margins, but eventually no sales; without quality in the product, a company sacrifices customers, revenue and ultimately its own existence. In practical terms, Quality is that something extra which will be perceived by the customer as a valid reason for either paying more or for buying again.

In the case where the product is a service, Quality is equated with how well the job is done and especially with whether the customer is made to feel good about the whole operation. In this respect Quality often does cost more, but the loss is recouped in the price customers are prepared to pay and in the increase of business.

Reliability
The clearest manifestation of Quality is in a product's reliability: that the product simply works. To prevent problems from arising after the product is shipped, the quality must be checked before-hand - and the best time to check quality is throughout the whole design and manufacturing cycle. The old method of quality control was to test the completed product and then to rework to remove the problems. Thus while the original production time was short, the rework time was long. The new approach to quality simply asserts that if testing becomes an integral part of each stage of production, the production time may increase but the rework time will disappear. Further, you will catch and solve many problems which the final "big-bang" quality-check would miss but which the customer will find on the first day.

To achieve this requires an environment where the identification of errors is considered to be "a good thing", where the only bad bugs are the ones which got away. One of the most hallowed doctrines of Quality is that of zero defects. "Zero defects" is a focus, it a glorious objective, it is the assertion that nothing less will suffice and that no matter how high the quality of a product, it can still be improved. It is a paradox in that it is an aim which is contrary to reason, and like the paradoxes of many other religions it holds an inner truth. This is why the advocates of Quality often seem a little crazy: they are zealots.

People as Resource
While Quality has its own reward in terms of increased long-term sales, the methods used to achieve this Quality also have other benefits. In seeking to improve the quality of the product, manufacturers have found that the people best placed to make substantial contributions are the workforce: people are the most valuable resource. It is this shift in perspective from the management to the workforce which is the most significant consequence of the search for quality. From it has arisen a new managerial philosophy aimed at the empowerment of the workforce, decision-making by the front line, active worker involvement in the company's advancement; and from this new perspective, new organizational structures have evolved, exemplified in "Quality Circles".

Without digressing too much, it is important to examine the benefits of this approach. For such delegation to be safely and effectively undertaken, the management has to train the workforce; not necessarily directly, and not all at once, but often within the Quality Circles themselves using a single "facilitator" or simply peer-coaching. The workforce had to learn how to hold meetings, how to analyse problems, how to take decisions, how to present solutions, how to implement and evaluate change. These traditionally high-level managerial prerogatives are devolved to the whole staff. Not only does this develop talent, it also stimulates interest. Staff begin to look not only for problems but also for solutions. Simple ideas become simply implemented: the secretary finally gets the filing cabinet moved closer to the desk, the sales meetings follow an agenda, the software division creates a new bulletin board for the sports club. The environment is created where people see problems and fix 'em.

Larger problems have more complex solutions. One outcome of the search for Quality in Japan is the system of Just-In-Time flow control. In this system, goods arrive at each stage of the manufacturing process just before they are needed and are not made until they are needed by the next stage. This reduces storage requirements and inventory costs of surplus stock. Another outcome has been the increased flexibility of the production line. Time to change from one product run to the next was identified as a major obstacle in providing the customer with the desired range of products and quantities, and so the whole workforce became engaged in changing existant practices and even in redesigning the machinery.

The Long Term
However, I believe that the most significant shift in perspective which accompanies the introduction of Quality is that long term success is given precedence over short term gains. The repeat-sale and recommendation are more important than this month's sales figures; staff training and development remain in place despite immediate schedule problems; the product's reliability is paramount even over time-to-market. Time is devoted today to saving time in the future and in making products which work first and every time.

Team Quality
While the salvation of an entire corporation may rest primarily with Senior Management, the fate of a team rests with the Team Leader. The Team Leader has the authority, the power to define the micro-culture of the work team. It is by the deliberate application of the principles of Quality that the Team Leader can gain for the team the same benefits which Quality can provide for a corporation.

The best ideas for any particular team are likely to come from them - the aim of the Team Leader must be to act as a catalyst through prompts and by example; the following are possible suggestions.

Getting Started
There will be no overnight success. To be lasting, Quality must become a habit and a habit is accustomed practise. This takes time and training - although not necessarily formal training but possibly the sort of reinforcement you might give to any aspect of good practise. To habituate your staff to Quality, you must first make it an issue. Here are two suggestions.

The first idea is to become enthusiastic about one aspect at a time, and initially look for a quick kill. Find a problem and start to talk about it with the whole team; do not delegate it to an individual but make it an issue for everybody. Choose some work-related problem like "how to get the right information in time" and solicit everybody's views and suggestions - and get the problem solved. Demand urgency against a clear target. There is no need to allocate large amounts of resource or time to this, simply raise the problem and make a fuss. When a solution comes, praise it by rewarding the whole team, and ensure that the aspects of increased efficiency/productivity/calm are highlighted since this will establish the criteria for "success". Next, find another problem and repeat.

The second idea is the regular weekly meeting to discuss Quality. Of course meetings can be complete time wasters, so this strategy requires care. The benefits are that regularity will lead to habit, the formality will provide a simple opportunity for the expression of ideas, and the inclusion of the whole group at the meeting will emphasize the collective responsibility. By using the regular meeting, you can establish the "ground rules" of accepted behaviour and at the same time train the team in effective techniques.

One problem is that the focus on any one particular issue may quickly loose its efficacy. A solution is to have frequent shifts in focus so that you maintain the freshness and enthusiasm (and the scope for innovative solutions). Further benefits are that continual shifts in emphasis will train your team to be flexible, and provide the opportunity for them to raise new issues. The sooner the team takes over the definition of the "next problem", the better.

Initial Phases
The initial phases are delicate. The team will be feeling greater responsibility without extra confidence. Thus you must concentrate on supporting their development. Essentially you will be their trainer in management skills. You could get outside help with this but by undertaking the job yourself, you retain control: you mould the team so that they will reflect your own approach and use your own criteria. Later they will develop themselves, but even then they will understand your thinking and so your decisions.

One trap to avoid is that the team may focus upon the wrong type of problem. You must make it clear any problem which they tackle should be:

related to their own work or environment
something which they can change
This precludes gripe sessions about wages and holidays.

As with all group work, the main problem is clarity. You should provide the team with a notice board and flip-charts specifically for Quality problems. These can then be left on display as a permanent record of what was agreed.

If you can, steer the group first to some problem which has a simple solution and with obvious (measurable) benefits. A quick, sharp success will motivate.

Team Building
To succeed, a Quality push must engage the enthusiasm of the entire team; as Team Leader, you must create the right atmosphere for this to happen. Many aspects of team building can be addressed while Quality remains the focus.

You must create the environment where each team member feels totally free to express an idea or concern and this can only be done if there is no stigma attached to being incorrect. No idea is wrong - merely non-optimal. In each suggestion there is at least a thread of gold and someone should point it out and, if possible, build upon it. Any behaviour which seeks laughter at the expense of others must be swiftly reprimanded.

One crude but effective method is to write down agreed ground rules and to display them as a constant reminder for everyone, something like:

all criticism must be kind and constructive
all our-problems are all-our problems
BUGS WANTED: DEAD OR ALIVE (but not for long)
if it saves time later, do it now
Another method is to constantly talk about the group as the plural pronoun: "we decided", "we can do this", "we'll get back to you". This is especially effective if it is used in conversation with outsiders (especially management) within ear-shot of the team. Praise and reward the whole team; get the team wider fame by a success story in an internal newspaper.

Most importantly, you must enable failure. If the team is unable to try out ideas without rebuke for errors, then the scope of their solutions will be severely limited. Instead, a failure should be an opportunity to gain knowledge and to praise any safe-guards which were included in the plan.

Mutual Coaching
An important aspect of team interaction is the idea of mutual support. If you can instill the idea that all problems are owned by the entire team then each member will be able to seek help and advice when needed from every other team member. One promoter of this is to encourage mutual coaching. If one team member knows techniques or information which would be useful to the rest, then encourage him/her to share it. Specifically this will raise the profile, confidence and self-esteem of the instructor at the same time as benefiting the entire group. And if there is one member who might never have anything useful to impart - send him/her to a conference or training session to find something.

Statistics
One of the central tenets of Quality programmes is the idea of monitoring the problem being addressed: Statistical Quality Control. Quite simply, if you can't measure an improvement, it probably isn't there. Gathering statistics has several benefits in applying Quality:

it identifies (the extent of) the problem
it allows progress to be monitored
it provides an objective criterion for the abandonment of an idea
it can justify perceived expense in terms of observed savings/improvements
it motivates staff by providing a display of achievement
and, of course, some problems simply disappear when you try to watch them.

The statistics must be gathered in an objective and empirical manner, the outcome should be a simple table or graph regularly updated to indicate progress, and these results must be displayed where all the team can watch. For example, if your team provides product support, then you might monitor and graph the number of repeat enquiries or the average response time. Or if you are in product development, you might want to monitor the number of bugs discovered (i.e. improvement opportunities).

In the long term, it may be suitable to implement the automatic gathering of statistics on a wide range of issues such as complaints, bug reports, machine down-time, etc. Eventually these may either provide early warning of unexpected problems, or comparative data for new quality improvement projects. It is vital, however, that they focus upon an agreed problem and not upon an individual's performance or else all the positive motivation of staff involvement will be lost.

Projects
Clarity of purpose - this is the key to success. You need a simple, stated objective which everybody understands and which everybody can see achieved.

Any plan to improve the quality or effectiveness of the group must contain:

the objective
the method
the statistical display for monitoring the outcome
the agreed criteria for completion or curtailment
By insisting on this format, you provide the plan-owners with a simple mechanism for peer recognition (through the displayed notice board) and yet enable them to manage their own failure with grace.

For a small established team, the "customer" includes any other part of the company with which the team interacts. Thus any themes regarding customer satisfaction can be developed with respect to these so called internal customers. In the end, the effectiveness of your team will be judged by the reports of how well they provide products for others.

A simple innovation might be for a member of your team to actually talk to someone from each of these internal customer groups and to ask about problems. The interfaces are usually the best place to look for simply solved problems. The immediate benefit may be to the customer, but in the long run better communications will lead to fewer misunderstandings and so less rework.

Building Quality
Quality costs less than its lack; look after the pennies and the profits will take care of themselves. To build a quality product, you must do two things:

worry the design and the procedures
include features to aid quality checking
It is a question of attitude. If one of the team spots a modification in the design or the procedures which will have a long term benefit, then that must be given priority over the immediate schedule. The design is never quite right; you should allocate time specifically to discussing improvement. In this you should not aim at actual enhancements in the sense of added features or faster performance, but towards simplicity or predicting problem areas. This is an adjunct to the normal design or production operations - the extra mile which lesser teams would not go.

Many products and services do not lend themselves to quality monitoring. These should be enhanced so that the quality becomes easily tracked. This may be a simple invitation for the "customer" to comment, or it could be a full design modification to provide self-checking or an easy testing routine. Any product whose quality can not be tracked should naturally become a source of deep anxiety to the whole team - until a mechanism is devised.

One of the least-used sources of quality in design and production in the engineering world is documentation. This is frequently seen as the final inconvenience at product release, sometimes even delegated to another (non-technical) group - yet the writing of such documentation can be used as an important vehicle for the clarification of ideas. It also protects the group from the loss of any single individual; the No.7 bus, or the head-hunter, could strike at any time.

In devising a mechanism for monitoring quality, many teams will produce a set of test procedures. As bugs emerge, new procedures should be added which specifically identify this problem and so check the solution. Even when the problem is solved the new procedures should remain in the test set; the problem may return (perhaps as a side effect of a subsequent modification) or the procedure may catch another. Essentially the test set should grow to cover all known possibilities of error and its application should, where possible, be automated.

Role Change
As your team develops, your role as leader changes subtly. You become a cross between a priest and a rugby captain, providing the vision and the values while shouting like crazy from the centre of the field. Although you retain the final say (that is your responsibility), the team begins to make decisions. The hardest part, as with all delegation, is in accepting the group decision even though you disagree. You must never countermand a marginal decision. If you have to over-rule the team, it is imperative that you explain your reasons very clearly so that they understand the criteria; this will both justify your intervention and couch the team in (hopefully) good decision-making practices.

Another role which you assume is that of both buffer and interface between the team and the rest of the company: a buffer in that you protect the team from the vagaries of less enlightened managers; an interface in that you keep the team informed about factors relevant to their decisions. Ultimately, the team will be delegating to you (!) tasks which only you, acting as manager, can perform on its behalf.

Quality for Profit
By applying the principles of Quality to an established team, the Team Leader can enjoy the benefits so actively sought by large corporations. The key is the attitude - and the insistence on the primacy of Quality. As a Team Leader, you have the power to define the ethos of your staff; by using Quality as the focus, you also can accrue its riches.

How To Write Right

Writing is an essential skill upon which all engineers and managers rely. This article outlines simple design principles for engineering's predominate product: paper.

"Sex, romance, thrills, burlesque, satire, bass ... most enjoyable".

"Here is everything one expects from this author but thricefold and three times as entertaining as anything he has written before".

"A wonderful tissue of outrageous coincidences and correspondences, teasing elevations of suspense and delayed climaxes".

(reviews of Small World by David Lodge)

This has nothing to do with engineering writing. No engineering report will ever get such reviews. The most significant point about engineering writing is that it is totally different from the writing most people were taught - and if you do not recognize and understand this difference, then your engineering writing will always miss the mark. However, this article outlines a methodical approach to writing which will enable anyone to produce great works of engineering literature.

Why Worry?
Writing is the major means of communication within an organisation; paper is thought to be the major product of professional engineers; some estimate that up to 30% of work-time is engaged in written communication. Thus it is absolutely vital for you as a Professional Engineer to actively develop the skill of writing; not only because of the time involved in writing, but also because your project's success may depend upon it. Indeed, since so much of the communication between you and more senior management occurs in writing, your whole career may depend upon its quality.

Two Roles
In an industrial context, writing has two major roles:

it clarifies - for both writer and reader
it conveys information
It is this deliberate, dual aim which should form the focus for all your writing activity.

There are many uses for paper within an organization; some are inefficient - but the power of paper must not be ignored because of that. In relation to a project, documentation provides a means to clarify and explain on-going development, and to plan the next stages. Memoranda are a simple mechanism for suggestions, instructions, and general organisation. The minutes of a meeting form a permanent and definitive record.

Writing is a central part of any design activity. Quality is improved since writing an explanation of the design, forces the designer to consider and explore it fully. For instance, the simple procedure of insisting upon written test-plans forces the designer to address the issue. Designs which work just "because they do" will fail later; designs whose operation is explained in writing may also fail, but the repair will be far quicker since the (documented) design is understood.

If you are having trouble expressing an idea, write it down; you (and possibly others) will then understand it. It may take you a long time to explain something "off the cuff", but if you have explained it first to yourself by writing it down - the reader can study your logic not just once but repeatedly, and the information is efficiently conveyed.

Forget the Past
Professional writing has very little to do with the composition and literature learnt at school: the objectives are different, the audience has different needs, and the rewards in engineering can be far greater. As engineers, we write for very distinct and restricted purposes, which are best achieved through simplicity.

English at school has two distinct foci: the analysis and appreciation of the great works of literature, and the display of knowledge. It is all a question of aim. A novel entertains. It forces the reader to want to know: what happens next. On the other hand, an engineering report is primarily designed to convey information. The engineer's job is helped if the report is interesting; but time is short and the sooner the meat of the document is reached, the better. The novel would start: "The dog grew ill from howling so ..."; the engineer's report would start (and probably end): "The butler killed Sir John with a twelve inch carving knife".

In school we are taught to display knowledge. The more information and argument, the more marks. In industry, it is totally different. Here the wise engineer must extract only the significant information and support it with only the minimum-necessary argument. The expertise is used to filter the information and so to remove inessential noise. The engineer as expert provides the answers to problems, not an exposition of past and present knowledge: we use our knowledge to focus upon the important points.

For the Future
When you approach any document, follow this simple procedure:

Establish the AIM
Consider the READER
Devise the STRUCTURE
DRAFT the text
EDIT and REVISE
That is it. For the rest of this article, we will expand upon these points and explain some techniques to make the document effective and efficient - but these five stages (all of them) are what you need to remember.

Aim
You start with your aim. Every document must have a single aim - a specific, specified reason for being written. If you can not think of one, do something useful instead; if you can not decide what the document should achieve, it will not achieve it.

Once you have established your aim, you must then decide what information is necessary in achieving that aim. The reader wants to find the outcome of your thoughts: apply your expertise to the available information, pick out the very-few facts which are relevant, and state them precisely and concisely.

The Reader
A document tells somebody something. As the writer, you have to decide what to tell and how best to tell it to the particular audience; you must consider the reader.

There are three considerations:

What they already know affects what you can leave out.
What they need to know determines what you include.
Wha
t they want to know suggests the order and emphasis of your writing.
For instance, in a products proposal, marketing will want to see the products differentiation and niche in the market place; finance will be interested in projected development costs, profit margins and risk analysis; and R&D will want the technical details of the design. To be most effective, you may need to produce three different reports for the three different audiences.

The key point, however, is that writing is about conveying information - conveying; that means it has to get there. Your writing must be right for the reader, or it will lost on its journey; you must focus upon enabling the reader's access to the information.

Structure
Writing is very powerful - and for this reason, it can be exploited in engineering. The power comes from its potential as an efficient and effective means of communication; the power is derived from order and clarity. Structure is used to present the information so that it is more accessible to the reader.

In all comes down to the problem of the short attention span. You have to provide the information in small manageable chunks, and to use the structure of the document to maintain the context. As engineers, this is easy since we are used to performing hierarchical decomposition of designs - and the same procedure can be applied to writing a document.

While still considering the aim and the reader, the document is broken down into distinct sections which can be written (and read) separately. These sections are then each further decomposed into subsections (and sub-subsections) until you arrive at simple, small units of information - which are expressed as a paragraph, or a diagram.

Every paragraph in your document should justify itself; it should serve a purpose, or be removed. A paragraph should convey a single idea. There should be a statement of that key idea and (possibly) some of the following:

a development of the idea
an explanation or analogy
an illustration
support with evidence
contextual links to reinforce the structure
As engineers, though, you are allowed to avoid words entirely in places; diagrams are often much better than written text. Whole reports can be written with them almost exclusively and you should always consider using one in preference to a paragraph. Not only do diagrams convey some information more effectively, but often they assist in the analysis and interpretation of the data. For instance, a pie chart gives a quicker comparison than a list of numbers; a simple bar chart is far more intelligible than the numbers it represents. The only problem with diagrams is the writer often places less effort in their design than their information-content merits - and so some is lost or obscure. They must be given due care: add informative labels and titles, highlight any key entries, remove unnecessary information.

Draft, Revise and Edit
When you have decided what to say, to whom you are saying it, and how to structure it; say it - and then check it for clarity and effectiveness. The time spent doing this will be far less than the time wasted by other people struggling with the document otherwise.

The following are a few points to consider as you wield the red pen over your newly created opus.

Layout
The main difference between written and verbal communication is that the reader can choose and re-read the various sections, whereas the listener receives information in the sequence determined by the speaker. Layout should be used to make the structure plain, and so more effective: it acts as a guide to the reader.

Suppose you have three main points to make; do not hide them within simple text - make them obvious. Make it so that the reader's eye jumps straight to them on the page. For instance, the key to effective layout is to use:

informative titles
white space
variety
Another way to make a point obvious is to use a different font.

Style
People in business do not have the time to marvel at your florid turn off phrase or incessant illiteration. They want to know what the document is about and (possibly) what it says; there is no real interest in style, except for ease of access.

In some articles a summary can be obtained by reading the first sentence of each paragraph. The remainder of each paragraph is simply an expansion upon, or explanation of, the initial sentence. In other writing, the topic is given first in a summary form, and then successively repeated with greater detail each time. This is the pyramid structure favoured by newspapers.

A really short and simple document is bound to be read. This has lead to the "memo culture" in which every communication is condensed to one side of A4. Longer documents need to justify themselves to their readers' attention.

The Beginning
Let us imagine the reader. Let us call her Ms X.

Ms X has a lot to do today: she has a meeting tomorrow morning with the regional VP, a call to make to the German design office, several letters to dictate concerning safety regulations, and this months process-data has failed to reach her. She is busy and distracted. You have possibly 20 seconds for your document to justify itself to her. If by then it has not explained itself and convinced her that she needs to read it - Ms X will tackle something else. If Ms X is a good manager, she will insist on a rewrite; if not, the document may never be read. action).

Thus the beginning of your document is crucial. It must be obvious to the reader at once what the document is about, and why it should be read. You need to catch the readers attention but with greater subtlety than this article; few engineering reports can begin with the word sex.

Unlike a novel, the engineering document must not contain "teasing elevations of suspense". Take your "aim", and either state it or achieve it by the end of the first paragraph.

For instance, if you have been evaluating a new software package for possible purchase then your reports might begin: "Having evaluated the McBlair Design Suite, I recommend that ...".

Punctuation
Punctuation is used to clarify meaning and to highlight structure. It can also remove ambiguity: a cross section of customers can be rendered less frightening simply by adding a hyphen (a cross-section of customers).

Engineers tend not to punctuate - which deprives us of this simple tool. Despite what some remember from school, punctuation has simple rules which lead to elegance and easy interpretation. If you want a summary of punctuation, try The Concise Oxford Dictionary (1990); and if you want a full treatise, complete with worked examples (of varying degrees of skill), read You Have A Point There by Eric Partridge.

For now, let us look at two uses of two punctuation marks. If you do not habitually use these already, add them to your repertoire by deliberately looking for opportunities in your next piece of writing.

The two most common uses of the Colon are:

1) To introduce a list which explains, or provides the information promised in, the previous clause.

A manager needs two planning tools: prescience and a prayer.
2) To separate main clauses where the second is a step forward from the first: statement to example, statement to explanation, cause to effect, introduction to main point.
To err is human: we use computers.
The two most common uses of the Semicolon are:
1) to unite sentences that are closely associated, complementary or parallel:

Writing is a skill; one must practise to improve a skill.
Engineers engineer; accountants account for the cost.

2) to act as a stronger comma, either for emphasis or to establish a hierarchy
The report was a masterpiece; of deception and false promises.
The teams were Tom, Dick and Harry; and Mandy, Martha and Mary.

Spelling
For some, spelling is a constant problem. In the last analysis, incorrect speling distracts the reader and detracts from the authority of the author. Computer spell-checking programmes provide great assistance, especially when supported by a good dictionary. Chronic spellers should always maintain a (preferably alphabetical) list of corrected errors, and try to learn new rules (and exceptions!). For instance (in British English) advice-advise, device-devise, licence-license, practice-practise each follow the same pattern: the -ice is a noun, the -ise is a verb.

Simple Errors
For important documents, there is nothing better than a good, old-fashioned proof-read. As an example, the following comes from a national advertising campaign/quiz run by a famous maker of Champagne:

Question 3: Which Country has one the Triple Crown the most times?
Won understands the error, but is not impressed by the quality of that company's product.

Sentence Length
Avoid long sentences. We tend to associate "unit of information" with "a sentence". Consequently when reading, we process the information when we reach the full stop. If the sentence is too long, we lose the information either because of our limited attention span or because the information was poorly decomposed to start with and might, perhaps, have been broken up into smaller, or possibly better punctuated, sentences which would better have kept the attention of the reader and, by doing so, have reinforced the original message with greater clarity and simplicity.

Word Length
It is inappropriate to utilize verbose and bombastic terminology when a suitable alternative would be to: keep it simple. Often the long, complex word will not be understood. Further, if the reader is distracted by the word itself, then less attention is paid to the meaning or to the information you wished to convey.

Jargon
I believe that a digital human-computer-interface data-entry mechanism should be called a keyboard; I don't know why, but I do.

Wordiness
When one is trying hard to write an impressive document, it is easy to slip into grandiose formulae: words and phrases which sound significant but which convey nothing but noise.

You must exterminate. So: "for the reason that" becomes "because"; "with regards to" becomes "about"; "in view of the fact that" becomes "since"; "within a comparatively short period of time" becomes "soon".

Often you can make a sentence sound more like spoken English simply be changing the word order and adjusting the verb. So: "if the department experiences any difficulties in the near future regarding attendance of meetings" becomes "if staff cannnot attend the next few meetings". As a final check, read your document aloud; if it sounds stilted, change it.

Conclusion
Writing is a complex tool, you need to train yourself in its use or a large proportion of your activity will be grossly inefficient. You must reflect upon your writing lest it reflects badly upon you.

The Art of Delegation

Delegation is a skill of which we have all heard - but which few understand. It can be used either as an excuse for dumping failure onto the shoulders of subordinates, or as a dynamic tool for motivating and training your team to realize their full potential.

"I delegate myne auctorite" (Palsgrave 1530)

Everyone knows about delegation. Most managers hear about it in the cradle as mother talks earnestly to the baby-sitter: "just enjoy the television ... this is what you do if ... if there is any trouble call me at ..."; people have been writing about it for nearly half a millennium; yet few actually understand it.

Delegation underpins a style of management which allows your staff to use and develop their skills and knowledge to the full potential. Without delegation, you lose their full value.

As the ancient quotation above suggests, delegation is primarily about entrusting your authority to others. This means that they can act and initiate independently; and that they assume responsibility with you for certain tasks. If something goes wrong, you remain responsible since you are the manager; the trick is to delegate in such a way that things get done but do not go (badly) wrong.

Objective
The objective of delegation is to get the job done by someone else. Not just the simple tasks of reading instructions and turning a lever, but also the decision making and changes which depend upon new information. With delegation, your staff have the authority to react to situations without referring back to you.

If you tell the janitor to empty the bins on Tuesdays and Fridays, the bins will be emptied on Tuesdays and Fridays. If the bins overflow on Wednesday, they will be emptied on Friday. If instead you said to empty the bins as often as necessary, the janitor would decide how often and adapt to special circumstances. You might suggest a regular schedule (teach the janitor a little personal time management), but by leaving the decision up to the janitor you will apply his/her local knowledge to the problem. Consider this frankly: do you want to be an expert on bin emptying, can you construct an instruction to cover all possible contingencies? If not, delegate to someone who gets paid for it.

To enable someone else to do the job for you, you must ensure that:

they know what you want
they have the authority to achieve it
they know how to do it.
These all depend upon communicating clearly the nature of the task, the extent of their discretion, and the sources of relevant information and knowledge.

Information
Such a system can only operate successfully if the decision-makers (your staff) have full and rapid access to the relevant information. This means that you must establish a system to enable the flow of information. This must at least include regular exchanges between your staff so that each is aware of what the others are doing. It should also include briefings by you on the information which you have received in your role as manager; since if you need to know this information to do your job, your staff will need to know also if they are to do your (delegated) job for you.

One of the main claims being made for computerized information distribution is that it facilitates the rapid dissemination of information. Some protagonists even suggest that such systems will instigate changes in managerial power sharing rather than merely support them: that the "enknowledged" workforce will rise up, assume control and innovate spontaneously. You may not believe this vision, but you should understand the premise. If a manager restricts access to information, then only he/she is able to make decisions which rely upon that information; once that access is opened to many others, they too can make decisions - and challenge those of the manager according to additional criteria. The manager who fears this challenge will never delegate effectively; the manager who recognizes that the staff may have additional experience and knowledge (and so may enhance the decision-making process) will welcome their input; delegation ensures that the staff will practise decision-making and will feel that their views are welcome.

Effective control
One of the main phobias about delegation is that by giving others authority, a manager loses control. This need not be the case. If you train your staff to apply the same criteria as you would yourself (by example and full explanations) then they will be exercising your control on you behalf. And since they will witness many more situations over which control may be exercised (you can't be in several places at once) then that control is exercised more diversely and more rapidly than you could exercise it by yourself. In engineering terms: if maintaining control is truly your concern, then you should distribute the control mechanisms to enable parallel and autonomous processing.

Staggered Development
To understand delegation, you really have to think about people. Delegation cannot be viewed as an abstract technique, it depends upon individuals and individual needs. Let us take a lowly member of staff who has little or no knowledge about the job which needs to be done.

Do you say: "Jimmy, I want a draft tender for contract of the new Hydro Powerstation on my desk by Friday"? No. Do you say: "Jimmy, Jennifer used to do the tenders for me. Spend about an hour with her going over how she did them and try compiling one for the new Hydro Powerstation. She will help you for this one, but do come to me if she is busy with a client. I want a draft by Friday so that I can look over it with you"? Possibly.

The key is to delegate gradually. If you present someone with a task which is daunting, one with which he/she does not feel able to cope, then the task will not be done and your staff will be severely demotivated. Instead you should build-up gradually; first a small task leading to a little development, then another small task which builds upon the first; when that is achieved, add another stage; and so on. This is the difference between asking people to scale a sheer wall, and providing them with a staircase. Each task delegated should have enough complexity to stretch that member of staff - but only a little.

Jimmy needs to feel confident. He needs to believe that he will actually be able to achieve the task which has been given to him. This means that either he must have the sufficient knowledge, or he must know where to get it or where to get help. So, you must enable access to the necessary knowledge. If you hold that knowledge, make sure that Jimmy feels able to come to you; if someone else holds the knowledge, make sure that they are prepared for Jimmy to come to them. Only if Jimmy is sure that support is available will he feel confident enough to undertake a new job.

You need to feel confident in Jimmy: this means keeping an eye on him. It would be fatal to cast Jimmy adrift and expect him to make it to the shore: keep an eye on him, and a lifebelt handy. It is also a mistake to keep wandering up to Jimmy at odd moments and asking for progress reports: he will soon feel persecuted. Instead you must agree beforehand how often and when you actually need information and decide the reporting schedule at the onset. Jimmy will then expect these encounters and even feel encouraged by your continuing support; you will be able to check upon progress and even spur it on a little.

When you do talk to Jimmy about the project, you should avoid making decisions of which Jimmy is capable himself. The whole idea is for Jimmy to learn to take over and so he must be encouraged to do so. Of course, with you there to check his decisions, Jimmy will feel freer to do so. If Jimmy is wrong - tell him, and explain very carefully why. If Jimmy is nearly right - congratulate him, and suggest possible modifications; but, of course, leave Jimmy to decide. Finally, unless your solution has significant merits over Jimmy's, take his: it costs you little, yet rewards him much.

Constrained Availability
There is a danger with "open access" that you become too involved with the task you had hoped to delegate. One successful strategy to avoid this is to formalize the manner in which these conversation take place. One formalism is to allow only fixed, regular encounters (except for emergencies) so that Jimmy has to think about issues and questions before raising them; you might even insist that he draw-up an agenda. A second formalism is to refuse to make a decision unless Jimmy has provided you with a clear statement of alternatives, pros and cons, and his recommendation. This is my favourite. It allows Jimmy to rehearse the full authority of decision making while secure in the knowledge that you will be there to check the outcome. Further, the insistence upon evaluation of alternatives promotes good decision making practices. If Jimmy is right, then Jimmy's confidence increases - if you disagree with Jimmy, he learns something new (provided you explain your criteria) and so his knowledge increases. Which ever way, he benefits; and the analysis is provided for you.

Outcomes and Failure
Let us consider your undoubtedly high standards. When you delegate a job, it does not have to be done as well as you could do it (given time), but only as well as necessary: never judge the outcome by what you expect you would do (it is difficult to be objective about that), but rather by fitness for purpose. When you delegate a task, agree then upon the criteria and standards by which the outcome will be judged.

You must enable failure. With appropriate monitoring, you should be able to catch mistakes before they are catastrophic; if not, then the failure is yours. You are the manager, you decided that Jimmy could cope, you gave him enough rope to hang himself, you are at fault. Now that that is cleared up, let us return to Jimmy. Suppose Jimmy gets something wrong; what do you want to happen?

Firstly, you want it fixed. Since Jimmy made the mistake, it is likely that he will need some input to develop a solution: so Jimmy must feel safe in approaching you with the problem. Thus you must deal primarily with the solution rather than the cause (look forward, not backwards). The most desirable outcome is that Jimmy provides the solution.

Once that is dealt with, you can analyse the cause. Do not fudge the issue; if Jimmy did something wrong say so, but only is very specific terms. Avoid general attacks on his parents: "were you born this stupid?", and look to the actual event or circumstance which led to the error: "you did not take account of X in your decision". Your objectives are to ensure that Jimmy:

understands the problem
feels confident enough to resume
implements some procedure to prevent recurrence.
The safest ethos to cultivate is one where Jimmy actually looks for and anticipates mistakes. If you wish to promote such behaviour, you should always praise Jimmy for his prompt and wise action in spotting and dealing with the errors rather that castigate him for causing them. Here the emphasis is placed upon checking/testing/monitoring of ideas. Thus you never criticise Jimmy for finding an error, only for not having safe-guards in place.

What to delegate
There is always the question of what to delegate and what to do yourself, and you must take a long term view on this: you want to delegate as much as possible to develop you staff to be as good as you are now.

The starting point is to consider the activities you used to do before you were promoted. You used to do them when you were more junior, so someone junior can do them now. Tasks in which you have experience are the easiest for you to explain to others and so to train them to take over. You thus use your experience to ensure that the task is done well, rather than to actually perform the task yourself. In this way you gain time for your other duties and someone else becomes as good as your once were (increasing the strength of the group).

Tasks in which your staff have more experience must be delegated to them. This does not mean that you relinquish responsibility because they are expert, but it does mean that the default decision should be theirs. To be a good manager though, you should ensure that they spend some time in explaining these decisions to you so that you learn their criteria.

Decisions are a normal managerial function: these too should be delegated - especially if they are important to the staff. In practice, you will need to establish the boundaries of these decisions so that you can live with the outcome, but this will only take you a little time while the delegation of the remainder of the task will save you much more.

In terms of motivation for your staff, you should distribute the more mundane tasks as evenly as possible; and sprinkle the more exciting onces as widely. In general, but especially with the boring tasks, you should be careful to delegate not only the performance of the task but also its ownership. Task delegation, rather than task assignment, enables innovation. The point you need to get across is that the task may be changed, developed, upgraded, if necessary or desirable. So someone who collates the monthly figures should not feel obliged to blindly type them in every first-Monday; but should feel empowered to introduce a more effective reporting format, to use Computer Software to enhance the data processing, to suggest and implement changes to the task itself.

Negotiation
Since delegation is about handing over authority, you cannot dictate what is delegated nor how that delegation is to be managed. To control the delegation, you need to establish at the beginning the task itself, the reporting schedule, the sources of information, your availability, and the criteria of success. These you must negotiate with your staff: only by obtaining both their input and their agreement can you hope to arrive at a workable procedure.

When all is done for you
Once you have delegated everything, what do you do then?

You still need to monitor the tasks you have delegated and to continue the development of your staff to help them exercise their authority well.

There are managerial functions which you should never delegate - these are the personal/personnel ones which are often the most obvious additions to your responsibilities as you assume a managerial role. Specifically, they include: motivation, training, team-building, organization, praising, reprimanding, performance reviews, promotion.

As a manager, you have a responsibility to represent and to develop the effectiveness of your group within the company; these are tasks you can expand to fill your available time - delegation is a mechanism for creating that opportunity.

The Human Factor

In the management of a small team, the human factor is crucial to success. This article considers possible motivators and a simple framework for dealing with people.

When you are struggling with a deadline or dealing with delicate decisions, the last thing you want to deal with is "people". When the fight is really on and the battle is undecided, you want your team to act co-operatively, quickly, rationally; you do not want a disgruntled employee bitching about life, you do not want a worker who avoids work, you do not want your key engineer being tired all day because the baby cries all night. But this is what happens, and as a manager you have to deal with it. Few "people problems" can be solved quickly, some are totally beyond your control and can only be contained; but you do have influence over many factors which affect your people and so it is your responsibility to ensure that your influence is a positive one.

You can only underestimate the impact which you personally have upon the habits and effectiveness of your group. As the leader of a team, you have the authority to sanction, encourage or restrict most aspects of their working day, and this places you in a position of power - and responsibility. This article looks briefly at your behaviour and at what motivates people, because by understanding these you can adapt yourself and the work environment so that your team and the company are both enriched. Since human psychology is a vast and complex subject, we do not even pretend to explain it. Instead, the article then outlines a simple model of behaviour and a systematic approach to analysing how you can exert your influence to help your team to work.

Behaviour
Consider your behaviour. Consider the effect you would have if every morning after coffee you walked over to Jimmy's desk and told him what he was doing wrong. Would Jimmy feel pleased at your attention? Would he look forward to these little chats and prepare simple questions to clarify aspects of his work? Or would he develop a Pavlovian hatred for coffee and be busy elsewhere whenever you pass by? Of course you would never be so destructive - provided you thought about it. And you must; for many seemingly simple habits can have a huge impact upon your rapport with your team.

Take another example: suppose (as a good supportive manager) you often give public praise for independence and initiative displayed by your team, and suppose (as a busy manager) you respond brusquely to questions and interruptions; think about it, what will happen?

Probably your team will leave you alone. They will not raise problems (you will be left in the dark), they will not question your instructions (ambiguities will remain), they will struggle on bravely (and feel unsupported). Your simple behaviour may result in a quagmire of errors, mis-directed activity and utter frustration. So if you do want to hear about problems, tell the team so and react positively when you hear of problems in-time rather than too-late.

Motivation
When thinking about motivation it is important to take the long-term view. What you need is a sustainable approach to maintain enthusiasm and commitment from your team. This is not easy; but it is essential to your effectiveness.

Classic work on motivation was undertaken by F. Herzberg in the 1950's when he formulated the "Motivation-Hygiene" theory. Herzberg identified several factors, such as salary levels, working conditions and company policy, which demotivated (by being poor) rather that motivated (by being good). For example, once a fair level of pay is established, money ceases to be a significant motivator for long term performance. Herzberg called these the "Hygiene" factors to apply the analogy that if the washrooms are kept clean, no one cares if they are scrubbed even harder. The point is that you can not enhance your team's performance through these Hygiene factors - which is fortunate since few team leaders have creative control over company organization or remuneration packages. What you can influence is the local environment and particularly the way in which you interact with your team.

The positive motivators identified by Herzberg are: achievement, recognition, the work itself, responsibility, and advancement. These are what your team needs; loads-o-money is nice but not nearly as good as being valued and trusted.

Achievement
As the manager, you set the targets - and in selecting these targets, you have a dramatic effect upon your team's sense of achievement. If you make them too hard, the team will feel failure; if too easy, the team feels little. Ideally, you should provide a series of targets which are easily recognised as stages towards the ultimate completion of the task. Thus progress is punctuated and celebrated with small but marked achievements. If you stretch your staff, they know you know they can meet that challenge.
Recognition
Recognition is about feeling appreciated. It is knowing that what you do is seen and noted, and preferably by the whole team as well as by you, the manager. In opposite terms, if people do something well and then feel it is ignored - they will not bother to do it so well next time (because "no one cares").
The feedback you give your team about their work is fundamental to their motivation. They should know what they do well (be positive), what needs improving (be constructive) and what is expected of them in the future (something to aim at). And while this is common sense, ask yourself how many on your team know these things, right now? Perhaps more importantly, for which of your team could you write these down now (try it)?

Your staff need to know where they stand, and how they are performing against your (reasonable) expectations. You can achieve this through a structured review system, but such systems often become banal formalities with little or no communication. The best time to give feedback is when the event occurs. Since it can impact greatly, the feedback should be honest, simple, and always constructive. If in doubt, follow the simple formula of:

highlight something good
point out what needs improving
suggest how to improve
You must always look for something positive to say, if only to offer some recognition of the effort which has been put into the work. When talking about improvements, be specific: this is what is wrong, this is what I want/need, this is how you should work towards it. Never say anything as unhelpful or uninformative as "do better" or "shape up" - if you cannot be specific and say how, then keep quiet. While your team will soon realize that this IS a formula, they will still enjoy the benefits of the information (and training). You must not stint in praising good work. If you do not acknowledge it, it may not be repeated simply because no one knew you approved.

The work itself
The work itself should be interesting and challenging. Interesting because this makes your staff actually engage their attention; challenging because this maintains the interest and provides a sense of personal achievement when the job is done. But few managers have only interesting, challenging work to distribute: there is always the boring and mundane to be done. This is a management problem for you to solve. You must actually consider how interesting are the tasks you assign and how to deal with the boring ones. Here are two suggestions.
Firstly, make sure that everyone (including yourself) has a share of the interesting and of the dull. This is helped by the fact that what is dull to some might be new and fascinating to others - so match tasks to people, and possibly share the worst tasks around. For instance, taking minutes in meetings is dull on a weekly basis but quite interesting/educational once every six weeks (and also heightens a sense of responsibility). Secondly, if the task is dull perhaps the method can be changed - by the person given the task. This turns dull into challenging, adds responsibility, and might even improve the efficiency of the team.

Responsibility
Of all of Herzberg's positive motivators, responsibility is the most lasting. One reason is that gaining responsibility is itself seen as an advancement which gives rise to a sense of achievement and can also improve the work itself: a multiple motivation! Assigning responsibility is a difficult judgement since if the person is not confident and capable enough, you will be held responsible for the resulting failure. Indeed, delegating responsibility deserves another article in itself (see the article on Delegation).
Advancement
There are two types of advancement: the long-term issues of promotion, salary rises, job prospects; and the short-term issues (which you control) of increased responsibility, the acquisition of new skills, broader experience. Your team members will be looking for the former, you have to provide the latter and convince them that these are necessary (and possibly sufficient) steps for the eventual advancement they seek. As a manager, you must design the work assignment so that each member of the team feels: "I'm learning, I'm getting on".
Problems
We are going to look at a simple system for addressing people-problems. It is a step-by-step procedure which avoids complex psychological models (which few managers can/should handle) and which focuses upon tangible (and so controllable) quantities.

One work of warning: this technique is often referred to as Behavioural Modification (BM) and many balk at the connotations of management-directed mind control. Do not worry. We are simply recognising that staff behaviour IS modified by the work environment and by your influence upon it. The technique is merely a method for analysing that influence to ensure that it is positive and to focus it to best use.

In any group of people there are bound to be problems - as a manager, you have to solve or at least contain them. You ignore them at your peril. Such problems are usually described in terms like: "Alex is just lazy" or "Brenda is a bad-tempered old has-been". On the one hand, such people can poison the working environment; the other hand, these descriptions are totally unhelpful.

The underlying philosophy of BM is that you should concentrate upon specific, tangible actions over which you have influence. For instance "Alex is lazy" should be transformed into "Alex is normally late with his weekly report and achieves less than Alice does in any one week". Thus we have a starting point and something which can be measured. No generalities; only specific, observable behaviour.

Before proceeding, it is worth checking that the problem is real - some "problems" are more appearance than substance, some are not worth you time and effort. So, stage 1 is to monitor the identified problem to check that it is real and to seek simple explanations. For instance Alex might still be helping someone with his old job.

Stage 2 is often missed - ask Alex for his solution. This sort of interview can be quite difficult because you run the danger of making personal criticism. Now you may feel that Alex deserves criticism, but does it actually help? Your objective is to get Alex to work well, not to indulge in personal tyranny. If you make it personal, Alex will be defensive. He will either deny the problem, blame someone else, blame the weather, tell you that he knows best or some combination of the above. If, on the other hand, you present the situation in terms of the specific events, you can focus upon Alex's own view of the problem (why is this happening?) and Alex's own solution (what can Alex do about it - can you help?).

Stage 2 will sometimes be sufficient. If Alex ha

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Source: http://www.articletrader.com ]]> http://www.articletrader.com/business/management/strategic-leadership-and-decision-making-framing-perspectives.html http://www.articletrader.com/business/management/strategic-leadership-and-decision-making-framing-perspectives.html Sat, 09 Dec 2006 00:00:00 -0600 "You're wrong to say that you see nothing else. You see everything, although you may not be able to interpret it." Munoz didn't budge from where he was; he merely indicated the painting with a movement of his chin. "I think it comes down to points of view. What we have here are different levels, which are contained within each other: the painting contains a floor that is a chessboard which, in turn, contains people. Those people are sitting at a chessboard that contains chess pieces. The whole thing is contained in that round mirror to the left. And to complicate things further, another level can be added: ours, where we stand to contemplate the scene or the successive scenes. And beyond that there's the level on which the painter imagined us, the spectators of his work (Perez-Reverte 1994).
INTRODUCTION
The Pentagon's approach to change-its frame of reference- is evolutionary rather than revolutionary:
Without a peer in the world or the threat of global war, the American military still does its conventional war-gaming with planning models developed during the Cold War. It retains many of the weapons systems and structures initially designed to deter and combat a long-gone Soviet menace. The Pentagon's battle doctrines still rest fundamentally on notions of massing military might against the kind of sophisticated opposing army that went away with the breakup of the Soviet Union, although each of the military branches in exprimenting with new organizational forms and high-tech methods of warfare (Graham 1997).
The notion of framing something is to focus on a moment in time, a scene, or a set of ideas. It can involve deliberate use of psychological, and intellectual skills, on the one hand, or less conscious skills within a sense of perception. Framing is a set of skills employed to one degree or another by the politician, photographer, chef, advertising executive, historian, teacher, coach, artist, academic, author, and by ordinary people. For example, the skill and depth used in appraising an event aid in helping to understand what might be taking place well beyond the limited knowledge of those who are involved in only part of the event itself. "The essential tool of the information manager is the ability to frame. To determine the entire meaning of a subject is to make sense of it, to judge its character and significance. To hold the frame of a subject is to choose one particular meaning (or set of meanings) over another. We manage meaning when we assert that our interpretations should be taken as real over other possible interpretations" (Fairhurst 1996).
The Quadrennial Review seems to be framed by using the traditions, experience, culture, and interpretations of the Department of Defense, and of the military services who are part of the DOD. But others might frame the same events from other points of reference or perspective:
21st-century military challenges will differ from past ones and so require changes in U.S. organization, weaponry, and fighting techniques" (Graham 1997).
This framing of the same set of data by those outside the Department of Defense or those in the Congress or academics leads to the debate about the future shape of national security. All parties frame what they see from their own unique set of experiences, tendencies, and interests.
FRAME OF REFERENCE
Frames originate as a result of both our nature, and the experiences we have that nurture us; some are natural (genetic), others are learned, and many revolve around the nature/nurture influence on how we see the world and its events. In addition, there are some frames that can be contrived, deliberately learned and used as a way of more consciously trying to interpret events.
The most common frame of reference is each person's way of observing, interpreting, and acting in the world. "One's frame of reference includes all that one believes or knows to be true of the worlds; the sorts of things that are in it, both animate and inanimate, and how they behave; what has happened in the past; and what is likely to happen in the future" (Moore, et al. 1985).
One's frame of reference carries with it limitations that can impair the individual in recognizing and dealing successfully with the environment. There are gaps in our perception, knowledge, experience, ability to process information, and to report accurately on what we have seen or heard as, for example, a witness to an accident, or to a tale told by a colleague. What did we really see, or hear, and how may it have been affected by prejudice, or a momentary distraction, or by some previous encounter with what looks much like the current situation, but in fact is different? The fact that we use a frame of reference, with all its limitations, as the basis for decisions and actions which may turn out to be false, is important at all levels of management and leadership.
Alexander George, in Presidential Decisionmaking, discusses a particular kind of limitation in a frame of reference which he calls attribution errors, the difference between a dispositional and situational frame of reference. In looking at a situation, George suggests that we are inclined to view our own attitudes favorably, those of an antagonist in a less favorable way; this is his notion of disposition. The situations in which we find ourselves also affect what we do. A simple example: we most often believe that our "home" athletic team plays fairly and competitively, while our opponent's players are disposed to play "dirty."
SENSEMAKING
"In real world practice, problems do not present themselves to the practitioners as givens. They must be constructed from the materials of problematic situations which are puzzling, troubling, and uncertain. In order to convert a problematic situation to a problem, a practitioner must do certain kind of work. He must make sense of an uncertain situation that initially makes no sense" (Weick 1995). Situations involving spousal abuse (unexplained bruises, absences from work, mood swings, and the like), child abuse, alcoholism, rumors of unethical conduct, or even the Unabomber, represent a phenomenon in which a set of discrepant clues are spotted but sensible connections are not immediately made.
Sensemaking takes time. It arises out of an accumulation of barely perceptible items, of plausible speculations, on information gathered from sources not part of the current situation, and on contradictory issues of reputation associated with a respected profession (e.g., military or the clergy). It is the task of the leader to interpret or translate this complex of information, to unravel the ball of twine, to make sense of the situation.
The role of the leader is to interpret, on the one hand, and to alter or guide the manner in which his followers understand the world by giving it a compelling "face." A leader is one who gives others a different sense of the meaning of that which they do by recreating it in this different "face," in the same way a painter or sculptor or poet gives those who follow him or her a different way of "seeing." The leader is a sense-giver. The leader embodies the possibilities of "escape" from what might otherwise appear to be incomprehensible, or from what might otherwise appear to be a chaotic, indifferent, or incorrigible world over which we have no control. (Thayer, 1988).
The role of a strategic leader in a volatile, uncertain, complex, and ambiguous environment is to be a sense-maker of phenomena, to connect the dots of random events and activities, and to bring coherence to apparent disarray. Sherlock Holmes might be a worthy exemplar. He used a rigorous, determined method, plus his own ingenuity and sensemaking to solve the most complex crimes. Notes from a flute, or the dog 'not' barking, or a smudge on the inside of a glass were often enough. Scientists in studying the confusing deaths of African males in the 1980s ultimately made sense of what they were seeing, finally identifying the Ebola virus and the symptoms of AIDS. Their sensemaking provided a new frame of reference for identifying the medical mystery.
OTHER FRAMES
There are any number of other frames that are used , and they are simply mentioned here:
• Time is a frame of reference. The past, present, and future affect our way of looking at things. Age affects how we look at the world. Youth frames the world in optimistic terms; in middle age, people become more realistic and come to terms with the way things are. If we have 'little' time we frame what we are looking at with a sense of urgency, and may focus on things that apply only to the short term. In the absence of a crisis, we may be inclined to put off time, to procrastinate, and miss opportunities.
• A code of conduct, or a moral-ethical frame of reference, often frames our view of things. Such rules of behavior may incline us to see things in our terms of right and wrong, good and bad, and acceptable or not acceptable. Codes of conduct are often affected by larger questions of values, culture, religion, and ethnic contexts. A global frame of reference confuses the traditions, mores, and practices of the people of many nations.
• At a professional level, certain frames are introduced for participation in such fields as medicine, the military, or law, or in the political environment. For example, a particular school of economics might be more Keynesian than another; a school of political science might be more real-politik than another. Certain elements of the military profession might be more devoted to warfare than to logistics. Thus, professions give still another set of lenses through which to view the world.
THE USE OF FRAMES
Framing seems to be a useful stratagem to use in making sense of complex problems and conditions. The inclination and artistry that some have in recognizing patterns and putting things into perspective is useful in making fundamental and significant changes. Framing is a kind of orientation or mindset, a set of skills used effectively in addressing complex problems.
In terms of national security, a series of events flows from the end of the Cold War, and notions of a multi-polar, uni-superpower strategic environment. These concepts lead to a rethinking of national security interests, and of consequent changes in force size, budget, infrastructure, and the like. This rethinking is a reframing of the defense component of the United States, a restructuring of physical, human, and policy dimensions of the military. The Executive Summary of the monograph, "Restructuring for a New Era Framing the Roles and Missions Debate," provides this terse rendering of the issue: Today, the United States faces a major challenge: restructuring its defense establishment to function efficiently and effectively in a new, dynamic security environment. This paper offers a framework for meeting that challenge, and offers restructuring as the frame to use in dealing with the ambiguous and complex conditions and assumptions that now exist. Restructuring seeks to utilize a frame, to gain control of a very fractious and volatile environment.
CREATED FRAMES
Some frames can be created. Those in the book, Reframing Organizations (Bolman and Deal), suggest a useful set of four frames to consider in analyzing organizations, their environment as a whole, or even individual events within their environment: The Structural Frame, the Political Frame, Human Relations Frame, and the Symbolic Frame. Each of the frames has a particular salience in itself; their combination into a multi-frame approach is perhaps their greatest strength.
Structural Frame. The Heritage Foundation, a conservative think tank in Washington, D.C., recently announced a budget proposal that would cut more than 500 billion dollars in spending over the next five years, while leaving Social Security untouched, cutting taxes by nearly $200 billion, increasing defense spending by $123 billion, shutting down the Rural Utilities Service, consolidating 160 federal job training programs, and trimming "corporate welfare."
Perhaps the most dramatic part of the proposal is the reduction in the number of cabinet-level agencies from the current 14 to only five: the departments of State, Defense, Treasury, Justice, and Health and Human Services. Three new bureaus would be created as independent agencies-Agriculture, Natural Resources, and National Statistics; and there would be some number of other independent agencies (Chandler 1997).
This structural frame addresses fundamental questions of national organization, how and where and why responsibilities are assigned, what connections and relationships are explicit, what certainty there is about the mission and aims of the organization, and the specific ways and means designed to help the organization achieve its goals. Every organization develops a design, and a set of mechanisms to cope with its environment. Businesses, military units, governments, and public or private associations all have structure and organization as a visible frame for their operational philosophy and processes.
The structural frame is based on scientific principle, and on the work of industrial psychologists like Frederick W. Taylor, or sociologists like Max Weber. These theoreticians espoused such ideas as time and motion studies, and the division of work into clear manageable units. This frame also is associated with the notion of bureaucracy, and depends on rationality and the sense that any problem can be solved by any group of people if it is simply organized into the most appropriate structural frame.
According to Bolman and Deal, the structural frame has these assumptions:
• Organizations exist primarily to accomplish established goals.
• For any organization a structural form can be designed and implemented to fit its particular set of circumstances (such as goals, strategies, environment, technology, and people).
• Organizations work most effectively when environmental turbulence and personal preferences are constrained by norms of rationality. (Structure ensures that people focus on getting the job done rather than on doing whatever they please.)
• Specialization permits higher levels of individual expertise and performance.
• Coordination and control are essential to effectiveness. Depending on the task and environment, coordination may be achieved through authority, rules, policies, standard operating procedures, information systems,, meetings, lateral relationships, or a variety of more informal techniques.
• Organizational problems originate from inappropriate structures or inadequate systems and can be resolved through restructuring or developing new systems. (Bolman and Deal, 1991).
These assumptions and structural frames are reflected in organizational charts, or wiring diagrams, which spell out relationships between and among components of an enterprise, and the people who inhabit various 'boxes'. The structure usually contains a carefully crafted set of tasks within each sector of the organization, along with the procedure and protocols used to accomplish the mission.
Political Frame. The D.C. Board of Education announced that it would close 16 schools to eliminate excess space in the school system and generate millions of dollars for repairs. The Emergency Transitional Education Board of Trustees met to consider the proposal. The proposed changes have already been denounced by some parents, community leaders, D.C. Council members, and members of the elected Board of Education. Critics have said officials are moving too quickly and not consulting parents enough. In addition, the mayor, the Teachers Union, and other organizations indicated their displeasure with the idea. Previous efforts to close schools in the District have failed.
The structural frame is ordered and rational by nature. This structured organization is, in the end, overtaken by the implicit, informal, machinations of office politics, of the exercise of power that works outside the formidable walls of the bureaucracy. It is aptly illustrated as the phenomenon of the water-cooler, that proverbial meeting place where people talk over what is really going on, and decide how work will or will not get done.
Bolman and Deal describe this as the political frame, a "screaming political arena:" Five propositions summarize this perspective:
• Organizations are coalitions composed of varied individuals and interest groups (for example, hierarchical levels, departments, professional groups, gender and ethnic subgroups.).
• There are enduring differences among individuals and groups in their values, preferences, beliefs, and perceptions of reality. Such differences change slowly, if at all.
• Most of the important decisions in organizations involve the allocation of scarce resources: they are decisions about who gets what.
• Because of scarce resources and enduring differences, conflict is central to organizational dynamics, and power is the most important resource.
• Organizational goals and decisions emerge from bargaining, negotiation, and jockeying for position among members of different coalitions (Bolman and Deal 1991).
These political polarities are represented in global terms by such distinctive classifications as labor and management, separate military groups, and different branches of government. The reality of tension between and among parts of an organization, and the complex nature of that tension, underscores the condition that not all who are part of an enterprise see the structure in the same way. However, a strategic leader does have a considerable number of tools at his disposal; the office does confer some positional power which allows for setting agendas, taking initiatives, and co-opting the activities of others. Furthermore, strategic leaders can form coalitions with others, network informally, and negotiate and bargain to achieve agreement on certain plans of action. The leader, even with a structure of advisors and officers, a budget and other resources, may not be able to achieve as much success as he or she might wish,despite having the legal power. Others are able to utilize other forms of power, including public opinion and political influence to achieve what they might want, which could be contrary to what the leader desires.
Human Relations Frame. Organizations are formed to meet certain objectives for their members: workers in a corporation or other business, graduate students in a university, sailors in a navy, or youngsters who want to play baseball in a community. An organization provides the setting where participants gain access to training, education, sports, labor, or resources. There is an implicit, if not explicit, connection between an organization and the people who belong to it. On the one hand, the organization has the potential to bring some good to its members, but it also has the potential to "use" and even abuse its workers, students, or citizens at various times. And, while people can contribute to an organization through their energies, ideas, skills and talents, as citizens of a community, it sometimes happens that many ignore service they can perform on behalf of others and 'take' what they can from the organization.
The human relations frame has certain assumptions:
• Organizations exist to serve human needs (rather than the reverse.)
• Organizations and people need each other. (Organizations need ideas, energy; people need salaries, work opportunities.)
• When the fit between the individual and the organization is poor, one or both will suffer; individuals will either be exploited, or will seek to exploit the organizations, or both.
• A good fit between the individual and the organization benefits both: human beings find meaningful and satisfying work, and organizations get the human talent and energy that they need (Bolman and Deal 1991).
The human relations frame suggests the most valued asset an organization has is its people: "By showing trust in and respect for all employees, managers can empower people to do their jobs to the very best of their ability. . . . By cultivating and investing time in employees, managers strengthen the foundation of the entire enterprise" (Augustine 1997). The human relations frame advances the notion that the structure of an organization may be a gleaming but empty shell if it does not serve to enhance the people who are part of the organization, or conversely if it does not allow the people to contribute their energy, ideas, talents, and enthusiasm to the organization.
In addition to the premise that man is by nature gregarious, that he seeks to join with others in social enterprises, the human relations frame suggests that there is a more fundamental notion, that of human need. The psychologist, Abraham Maslow, posits a hierarchical set of human needs, with the higher needs being able to be satisfied only after lower needs are met. Maslow organizes the hierarchy as follows:
1. Physiological needs, such as food and water
2. Safety needs, such as being free from fear
3. Belonging and love needs; positive relations with others
4. Esteem needs valuing self and others
5. Self-actualization and developing to one's fullest.
The U.S. Army's slogan, 'Be All You Can Be," Jesse Jackson's mantra, "I am somebody," or the challenge of many educators, "All Children can Learn," addresses self-actualization and the implied satisfaction of all the other needs.
There is a discernible orientation toward human relations awareness in organizations of all kinds. Structure has changed, often because of economic considerations. This has led to more participative management, an implicit sense that bringing people together to solve problems can lead to improvements in quality, increases in productivity, decreases in time lost because of injury, illness, or other negative influences. Specific negative attributes in the workplace are forcefully addressed as issues of human and/or civil rights, equal opportunity, sexual harassment, gender opportunity, health, training, etc. A broad democratization of workplaces, both public and private, classrooms, and athletic teams; and, components of industry and the defense department are defining a different human relations environment with more accountability, quality, zero-defects production, self-managing work teams, and project management.
More recently this notion of fit or compatibility between the organization and the individual has been described by Professor Ouichi in his Theory Z, a management philosophy successfully blending Japanese and American approaches to management. Theory Z reflects the central assumptions of the human resources frame: that individuals want their productive time to be a rewarding experience, that they want to contribute to the success of whatever enterprise they may be associated with, and that if the structure is engineered appropriately they will be able to achieve those goals. Theory Z suggests that humanized working conditions not only increase productivity and profits to the company but also to self-esteem for employees. What Theory Z calls for is a redirection of attention to human relations in the corporate world as well.
Symbolic Frame. Sotuknang destroyed the world because the Hopis forgot to do their duty. They forgot the songs that must be sung, the pahos that must be offered, the ceremonials that must be danced. Each time the world became infected with evil, people quarreled all the time. People became powaqas, and practiced witchcraft against one another. The Hopis left the proper Road of Life and only a few were left doing their duty in the kivas. And each time, Sotuknang gave the Hopis warning. He held back the rain so his people would know his displeasure. But everybody ignored the rainless seasons. They kept going after money, and quarreling, and gossiping, and forgetting the true way of the Road of Life. And each time Sotuknang decided that the world had used up its strit and he saved a few of the best Hopis, and then he destroyed all the rest. Lomatewa stared into the eyes of the Flute Clan boy. "You understand this?" I understand," the boy said (Hillerman, 1988).
There is this symbolic frame, or lens, to view an organization, a most unconventional one to those who see the environment as organized and structured, rational and linear. In an environment, though, that is volatile, uncertain, complex, and ambiguous, the ordinary frames may not fully explain the course of events as they cascade through the chasms of history. Rather than idyllic and placid streams, leaders experience wild, unpredictable, and even contrary currents. Rather than looking at things through the eyes and careful measurements of a time and efficiency expert, for example, we often seem to be viewing a world epitomized by symbols of ethnicity, tribalism, religion, or even myth. This so-called symbolic frame is based on a set of things embedded in the 'culture' of organizations. Rituals, protocols and manners invite us to look beyond visible and tangible elements to find out what really might be important; unlike the political frame it does not smack of cynicism, but provides an insight to persons or events invested with 'magical' power.
The symbolic frame is based on the following assumptions:
• What is most important about any event is not what happened, but what it means.
• Events and meanings are loosely coupled: the same events can have different meanings because of the way individuals interpret their experiences.
• Many of the most significant events and processes in organizations are ambiguous or uncertain, it is often difficult or impossible to know what happened, why it happened, or what will happen next.
• The greater the ambiguity and uncertainty, the harder it is to use rational approaches to analysis, problem solving, and decision making.
• Faced with uncertainty and ambiguity, human beings create symbols to resolve confusion, increase predictability, and provide direction. Events may remain illogical, random, fluid, and meaningless, but human symbols make them seem otherwise.
• Many organizational events and processes are important more for what they express than for what they produce: they are secular myths, rituals, ceremonies, and sagas that help people find meaning and order in their lives (Bolman and Deal 1991).
The symbolic frame looks at events-what people do, how they form and organize themselves, how they govern, how they reward and punish-and tries to discern what that means. It gauges the importance and significance of the symbols, rituals, customs, practices, and traditions of a particular organization. Anyone observing the Congress of the United States, for example, recognizes a set of protocols and observances that lend civility, order, and dignity to the complexity of lawmaking: people are addressed in certain ways, despite heated emotions; seniority is revered and acknowledged in itself before it becomes a factor in naming Committee Chairs; elaborate rules govern debate and discussion; and rituals abound, such as a phone call to the President of the United States by the Speaker of the House that closes a session of the Congress.
SYSTEMS FRAME
As something of a final thought Bolman and Deal suggest the presence of a "fifth" frame that combines elements of each of the other frames. Based on systems theory and cybernetics, the fifth frame suggests, in effect, the use of all the frames in looking at, or trying to gain the most appropriate frame of reference to use in analyzing a particular situation.
For example, on June 25, 1996, a terrorist truck bomb exploded outside the northern perimeter of KhobarTowers, Dhahran in Saudi Arabia, a facility housing U.S. and allied forces supporting the coalition air operation in northern Iraq. There were 19 fatalities and approximately 500 wounded. The perpetrators escaped. There have been a series of investigations revolving around such questions as to whose responsibility it was to provide security, whether that was adequately provided for by the base commander, what cultural and other issues might have been factors, and what role the United States should have in continuing operations in Saudi Arabia.
The structural frame would analyze the physical attributes of the base, the procedures that were in place, the security precautions that had been implemented, and the like; this frame could trace the series of meetings and understandings on what was to be done to protect the American base from terrorists. The human relations frame would reveal the extent to which the base commander considered and communicated the dangers of threats to those stationed there, and communicated the steps that were in place to protect them. The political frame might reveal the major constituencies, leadership, and the management of disagreement; further more, leaders might have decided not to push, or to move more slowly in implementing certain things because of sensitivity between components of the Air Force, elements in the Saudi Government, the Central Command, and others who might have had differing views about threats of terrorism, and adequate protection. The symbolic frame might be particularly relevant in the sense that perceptions of the threat, and adequacy of protection, and even the kinds of protection might have been perceived differently by Americans and by the host Saudis.
USE OF THE FRAMES
While we may have an inclination to use one frame over another to look at a situation, we might not make full sense of a situation by doing so. If nothing else, knowledge of the frames should alert the strategic leader of the importance of applying all the frames to a situation in order to leverage the best possible solution.
Some frames may have more relevance in certain situations than others. In a scenario in which employee morale is poor, the human relations frame might have more significance. Rather than reorganize and restructure to improve production or conditions, it may be more important to find out what is really bothering the employees, and then include them in the process.
A familiar argument among leaders is whether a review of policy or practice should be a "top-down" or a "bottom-up" process. From a more traditional and structural frame, the inclination is that it be studied by senior managers, perhaps supported by consultants hired by the leadership, with the results implemented based on the recommendations; a top-down approach. On the other hand, the political frame would argue that change might best be done by a review of things by those who are closest to the problem. Workers, for example, might decide that they could be more efficient if the lighting was improved, or if certain pieces of equipment were rearranged in the work area. This is a bottom-up approach. The symbolic frame suggests that the best way to show an interest in real reform is not to isolate it to either bottom or top, but to include both ends in the process. The role of the strategic leaders is diverse enough for them to be at various times an architect (structural frame), catalyst (human relations frame), advocate (political frame), prophet and poet (symbolic frame) (Bolman and Deal 1991).
SUMMARY AND CONCLUSIONS
Frames can be differentiated as natural, learned, or created. Frames can be used effectively to address most problems, and the more complex the problem, the more points of view and frames of reference have to be employed. Some frames of reference contain bias or misperceptions or prejudice, even when done in good faith; how else to explain the imprisonment of large numbers of Japanese and Italian Americans in the Second World War, or the Tuskegee experiments on black Americans? Some frames of reference are flawed due to the lack of information about the fundamental problem and their second, and third and fourth order impacts. Some frames are overused; how else to explain the tendency of leaders to revise the structural frame when coming into an organization? Some frames, such as the human relations frame, may be underused; how else can you explain the failure to include employees, or students, or citizens in matters that concern them?
Making sense of the environment is one of the critical tasks of the strategic leader. Awareness of the value of framing (and reframing) as ways of looking at the world, and skill in using sensemaking techniques, are critical to success at the strategic level.


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Source: http://www.articletrader.com ]]> http://www.articletrader.com/business/management/the-strategic-leader-as-an-individual.html http://www.articletrader.com/business/management/the-strategic-leader-as-an-individual.html Sat, 09 Dec 2006 00:00:00 -0600 Times of great change create an enduring need to do more leader development, more often.
Sullivan and Harper
DEVELOPMENT
An excellent concept of development comes from George B. Forsythe's article "The Preparation of Strategic Leaders." Forsythe argues that one's definition of development depends on the way one frames the concept. One frame is to take a learning perspective, and to consider leader development as "the acquisition of knowledge, skills, and values associated with-effective leadership." This type of development is "adding new tools to the tool box." When we identify strategic performance requirements, using this approach, we are specifying the new knowledge and skills strategic leaders will need.
But leadership at the strategic level is more than the acquisition of knowledge and skill; it consists of "qualitatively different ways of doing business." There is a second frame, and that is a developmental perspective. This perspective concentrates not on the knowledge acquired, but how to interpret it and what to do with it. "The developmental approach is concerned more with who the leader is and how the leader makes sense out of the world. It thus is concerned more with expanding frames of reference, perspective taking, building mental maps, and the development of conceptual capacity rather than with the acquisition of skills and knowledge. This process of leader development involves adaptive change in the leader's frame of reference as he or she advances to higher levels in the organization."
What provides the impetus for this adaptive change? Most often, it is the recognition that existing frames of reference are not sufficient to deal with the performance demands placed on the individual. Think of it as being "outside your comfort zone." When a leader is confronted with VUCA characteristics of the strategic environment that existing frameworks cannot explain, there is an impetus for development and adaptive change to develop frameworks which can deal with the demands. How does one go about developing the new frames of reference and increased conceptual capacity? It involves two steps: self-assessment and development planning. Self-assessment will be discussed in the next chapter.
Development planning and self-assessment provide the insights that lead to adaptive change. Feedback from self-assessment either confirms things you already knew about yourself, or provides you new insights. If you stop at that point, however, you have not begun the process of growth and change. It's only when you commit to development that the real value of the assessment process is realized. The critical question to focus on is: "How can I maximize my personal and professional growth?"
Development involves life-long change, with each part of life having attendant satisfaction and challenges.The first step in planning for development is self-assessment. The self-assessment process, however, goes beyond the use of feedback assessment instruments. When you engage in self-assessment, look at all the areas of your life. The rationale is simple: your life is an integrated whole, a system. Your goals, aspirations, challenges, and opportunities in one area will have an impact on other areas. One key question to address in development is, "How can I achieve a balance in my life?"
PROFESSION
What is going on in your professional life? That you have been selected to attend ICAF means that you are among the high performers from your service or agency. You are well established in your profession, and have moved into the middle management ranks.
Most of your experience has been at the direct leadership or "operator" level. By direct leadership we mean the level of leadership where interactions are at the personal, face-to-face level. In the services, direct leadership extends up through the lieutenant colonel/commander level. When you can interact with members of your command, you're operating at the direct leadership level. Many of you also may have had staff assignments or assignments in a functional area of expertise (such as maintenance or logistics). Most of you will not have had the opportunity to serve at the strategic decision making level in major commands or on joint staffs. Having reached the top of the direct level of leadership, you need to be ready to transition to a higher level.
There are two different areas where the road may take you in the near future in your profession. Some of you will go on to command at the colonel/captain level, which may mean moving into a more indirect leadership role. At this mid, or organizational, leadership level, the performance requirements and demands of the position are often different than at the direct level (think back to Stratified Systems Theory). Many of you also will be operating on a high level staff such as a major command staff, a DOD agency, or on the Joint Staff at the strategic level. Part of your development must prepare you to operate at this level.
Civilian students may have had a different career path up to this point, but also are at a transition point. Many have been functional specialists. Those who are acquisition specialists, logistics specialists, budget analysts, or systems analysts may have spent careers in a narrow specialty. You also are at a transition point because you need to move to a higher organizational level, advance in your profession, and broaden your frame of reference.
SELF
What are you likely to be going through, individually and personally, at this stage in your life? Gail Sheehy's fascinating and insightful book, New Passages: Mapping Your Life Across Time, is organized around the stages of life and the passages that occur between those stages. One of her assertions is that the traditional life cycle we took for granted does not apply today. There have been such dramatic changes in how long people live that the old markers of age are outdated. To understand what is likely to be occurring in your life at a particular age, your frame of reference has to be your generation. You can't judge what is happening in your life by examining your parents' experiences; yours will be entirely different.
Sheehy predicts that at about age 45 most of us will go through a transition from what she calls First Adulthood to Second Adulthood. She calls this transition middlescence, in a play on words on adolescence. Her theme is that with increasing longevity, those in their 40s can look forward to an entire new adulthood from 45 to 85+. Ms. Sheehy views this move into second adulthood as an opportunity for tremendous growth and development. No longer should we view reaching our late '40s as the beginning of a long decline into old age, but rather the beginning of a new adult life that can be just as productive as our first adult life.
BALANCE
"How can we achieve a balance in our lives?" What should have emerged from reflecting on what is going on in your life is that there are multiple demands, challenges, and opportunities. How can you pursue multiple goals in different life areas simultaneously? The answer is, you can't. What normally happens is we pursue goals in one area at the expense of the other areas, and our lives get out of balance in either our profession, family, community, or self.
The balance most of us find the hardest to achieve is the balance between profession and family. The demands of the profession for many are such that there is no time left to spend with one's family, or at least not sufficient quality time. You may be experiencing a problem of balance at ICAF. This year represents an opportunity to reflect, learn, and grow. But you also may have had expectations that you could take time off from the demands of your normal jobs and get reacquainted with your families this year. How do you achieve a balance, take the opportunities this year provides for professional growth, yet also grow in other areas? The only way to resolve this dilemma is through prioritizing. Establish goals in each of your life areas, then determine which are the most important. If you find that your life is out of balance, trade offs in one area may provide the opportunity for achieving goals in other areas.
SOME KEY QUESTIONS
In addition to asking yourself how you can achieve a balance in your life, there are some key questions. One of these is, "What are the major challenges I will face in the future?" A large part of development is preparing yourself to face anticipated major challenges. For example, we have suggested that one major professional challenge may be to prepare yourself to operate in the strategic arena at a higher organizational level. An example of a major challenge in the family area may be caring for aging parents. An essential first step in planning for development and growth is anticipating the challenges one will face in the future.
Another question to ask is, "What can I control?" Some things in your life are out of your control. You can't reverse the aging process. However, you definitely can make lifestyle choices that can slow down (or accelerate) how rapidly you age. And, in the professional area, you may not have much say about where you will be assigned, but you can control how well prepared you will be for a particular assignment. An essential part of development planning is determining where you have choices and when you can exercise some control over your life.
LOOKING INTO THE FUTURE
"Where do I want to be in the future?" This is the second step in planning your life journey: envisioning the future. Shift your attention to tomorrow. Look to the future, and ask yourself, "Where do I want to be in 5 years? In 10 years? In 20 years?" Remember Sheehy's conceptualization of the Second Adulthood as extending from age 45 to 85+. What do you want to do in your second adulthood? Essential to the successful passage into second adulthood is viewing the passage as opening up possibilities and choices, not limiting opportunities and restricting choices. Increasing longevity has given us opportunities that our parents never had: the time to build an entire second productive adult life. This provides tremendous opportunities for growth, if we can only avail ourselves of those opportunities. Determine where you could be in five or ten years, or where you would like to be.
Skeptics are saying, "Why envision a future that you can't achieve?" If envisioning the future is dreaming about unachievable outcomes, then it is a waste of time. But if you look more closely at those who achieve their dreams, you will find that they didn't stop with dreaming about where they'd like to be in the future. They asked themselves, "What can I do to get there and reach my goals?" They then developed and implemented a plan to achieve what they wanted to accomplish.
COMMITTING TO DEVELOPMENT
This brings us back to a few more critical questions you need to ask. First, "Do I really want to commit to development?" There are substantial opportunities for growth and development during your year at ICAF. McCall, Lombardo, and Morrison, in The Lessons of Experience: How Successful Executives Develop on the Job, present a model for development which involves three choices.
The first choice is to recognize your shortcomings or identify areas where there is room for growth and improvement. All of us have strengths and weaknesses, and if we're going to overcome our weak areas and our shortcomings, the first choice we must make is to identify those weaknesses. Figure 1: the authors believe that sooner or later you will be forced to confront your weaknesses, because they eventually will be revealed in one way or another.
CHOICE: Finding out about
shortcomings. <------> AVOID
Wait for a castastrophe to
reveal a weakness OR Actively pursue an
accurate protrait of self
- SOONER OR LATER (BIG MISTAKE). - JUMP INTO NEW SITUATIONS
- SOONER OR LATER (MISSED - DIG FOR INFORMATION
PROMOTION, NEGATIVE - SEEK FEEDBACK
APPRAISAL, DEMOTION, - INTROSPECT
TERMINATION).
The second choice is to accept responsibility for your shortcomings. If you deny any responsibility for your weaknesses, then there's no reason to try and do anything about them. You must accept responsibility for your weaknesses and determine their causes if you're going to overcome them.

CHOICE: Accepting responsibility
Diagnosis of Shortcomings <------> DENY
RESULT OF A LACK OF OR RESULT OF PERSONALITY, LIMITED
KNOWLEDGE, ABILITY, OR SITUATIONAL MISFIT?
EXPERIENCE, OR SKILLS?
The third choice is what to do about your weaknesses. The authors suggest four types of strategies based on the diagnosis of why the weakness exists: build new strengths, anticipate situations, compensate, and change self.
CHOICE: What to do about it about <-->IGNORE
build new
strengths anticipate situations compensate change self
find situations where learning new things is essential. ask "dumb" questions. avoid certain situations. intensive counseling, coaching.
find ways to get help and support while learning. seek advice, counsel. delegate to others. personal change effort.
spend time learning. choose staff who cover weaknesses. change just enough to get by.
use others' expertise. change the situation.
Committing to development means recognizing areas for development, taking responsibility for growth in those areas, and forming a plan on how to effect that development. If you are committed to development, the final two questions are:
• How can I best use my year at ICAF?
• How can I maximize my opportunities for personal and professional growth?
The answers you reach to these questions will determine if this year really becomes a year of transition, growth, development, and change.
CONCLUSION
As we stated at the beginning of the chapter, the ICAF experience is about development. As you've gone through the chapter, we hope it stimulated some thought about development, and helped you think about the question we initially asked you to focus on: "How can I maximize my personal and professional growth during my year at ICAF?" As you continue through the Strategic Leadership and Decision Making Course and the ICAF year, we hope you will continue to focus on development, and take every opportunity you can to truly maximize your professional and personal growth.


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Source: http://www.articletrader.com ]]> http://www.articletrader.com/business/management/teams-and-decision-making-in-the-strategic-environment.html http://www.articletrader.com/business/management/teams-and-decision-making-in-the-strategic-environment.html Sat, 09 Dec 2006 00:00:00 -0600 CREATING AND MANAGING TEAMS
Despite America’s individualist ethos, American managers appear to have an insatiable appetite for information about teams. Since the mid-1980s, there has been an exponential growth in the number of articles published on teams in the workplace. The internet reveals endless numbers of consultants offering techniques to create teams out of "ordinary" workers or enhance the productivity of existing teams. Many of these articles on teams only advocate the use of teams as a solution to the new challenges confronting organizational leaders, and most authors fail to explain how leaders can successfully create teams.
Creating and managing teams in the workplace can lead to effective outcomes, but the success and longevity of teams in organizations will depend on how thoroughly organizational leaders understand how to extract the gains teams can provide. If leaders don’t understand the skills they need to possess, as well as the group processes that are required to create and maintain teams, then teaming will be destined only to be the management fad of the 90’s.
Should you care about this? Absolutely!! First of all it’s a matter of competitiveness. As leaders from your host organizations you should be trying to use high-performance teams to create and sustain competitive advantage. At a time when downsizing and consolidation decisions are followed by the statement, "doing more with less," leaders should be looking at every way to derive synergy from the organization. Leveraging human capital as teams will be one of the strategies that leaders have to try to gain and sustain advantage over competing nations, competing industries, and competing organizations.
Many of you may be comfortable with creating and managing teams in your service branch or agency, but you need to realize that creating and managing interservice and interagency teams present unique challenges and requires different leadership techniques. Chances are that leaders of these kinds of teams will have a harder time developing a common definition of issues and acceptable solution options among members. Furthermore, team members’ commitments are often divided between their home agency and the interagency team. The results of competitive team dynamics can be reduced efficiency in achieving goals, watered down recommendations in an attempt to address all issues or, if the issue is too contentious, disbanding the interagency team.
Knowing when to use teams and how to manage them are techniques supporting this strategy. This chapter and the three that follow are intended to broaden and deepen your conceptualization of what constitutes a team and team decision making.
TEAMS ARE COMPLEX
Most of us have been members of a group that we’ve labeled a team, whether it was a sports team, a committee, a task force at work, or an advocacy group in the community. Essentially the label of team is given to a group of people who interact well. But it is important to use a more precise definition of a team for two reasons:
• We can discern the features a team possesses that distinguish it from a group.
• We can identify the features of a high performance team.
Groups are "an expression of the needs and aspirations of the people who comprise them" (Walton and Hackman). Teams, on the other hand are a special kind of group, with three additional characteristics. First, teams are typically formed by management directive. Second, team members share responsibility for the specific outcomes and operations. Third, teams typically exist in an empowering work context. That is, teams are found in organizations that "emphasize the mutuality of interests between employers and employees . . . [where] all members, not just managers, have means to influence work related decisions . . . [where] there is open information and two way communication about organizational policies and practices; and hierarchical differences are minimized in ways that encourage all to feel that they are full members working together toward shared objectives"(Walton and Hackman).
All teams are not alike. First, they can differ on the type of outcomes they’ve been organized to achieve. Some teams, such as advisory panels, committees and employee involvement groups are assembled to provide advice and involvement to managers in the organization. Another type of team, the projects and development team, is an assembly of professionals who work on assigned or original projects. Finally, teams can be created to produce an outcome that is organized action. This type of team includes: sports teams, negotiating teams, expedition teams, and surgery teams.
Teams should be properly configured and managed for the type of organizational output that they are intended to produce.
Overall, teams in organizations create outcomes that exceed the collective capability of individuals who work within the formal line structure of an organization. For example, the Department of Defense benefits from the productivity defense contractors generate through teams. Honeywell Corporation, a subcontractor for the Air Force’s B-2 bomber, is a case in point:
TYPES OF WORK TEAMS AND THEIR CHARACTERISTICS
TYPE OF OUTCOME AND EXAMPLES COMBINATION OF MEMBER EXPERTISE TEAM’S DEGREE OF INTEGRATION WITH OTHER WORK UNITS TEAM’S WORK CYCLE
ADVICE AND INVOLVEMENT
Advisory Panels
Committees
Employee Involvement Groups Low Differentiation of Expertise Among Members Low Level of Integration Can Vary in Length
PRODUCTION OR SERVICE
Assembly Teams
Maintenance Crews
Flt Attendant Crews Low Differentiation of Expertise Among Members High Level of Integration Work Cycles Typically Repeated or Continuous; Cycles Often Briefer Than The Team Life Span
PROJECT
Research Groups
Task Forces
Architect Teams High Differentiation of Expertise Among Members Low Level of Integration Work Cycles Typically Differ For Each Project
ORGANIZED ACTION
Sports Teams
Negotiating Teams
Expedition Teams
Surgery Teams
Cockpit Crews High Differentiation of Expertise Among Members Low Level of Integration Brief Performance Events, Often Repeated Under New Conditions, Requiring Extended Training and/or Preparation
Adapted from: Sundstrom, E., DeMuse, K.P, and Futrell, D. (1990) Work teams. American Psychologist 25, no. 2, 120-133.
In 1992, Honeywell’s defense avionics division in Albuquerque reorganized their entire 1800 person organization into multifunctional teams. Division management searched among their supervisors for people who could facilitate loyalty, communication and decision making within a group and completed the change in six months. According to the division’s general manager senior management "took a ‘burn the bridge’ approach because we wanted people to know we were serious. If we hadn’t made a big fuss, this would have died a natural death." One of the successful teams developed a data storage systems for the Northrop Grumman’s B-2 bomber. The team leader managed the group by taking actions that created team loyalty and focused their effort on the Air Force’s needs. The leader saw his job as helping the team "feel as if they owned the project by getting whatever information, financial or otherwise, they needed. I knew that if we could all charge the hill together, we would be successful" (Caminiti 1995).
Honeywell’s strategy can be instructive in developing work teams. Senior management essentially bet the farm by ushering in a complete organizational transformation within 6 months. They wanted people to know they were serious. Next they diligently searched for employees who had the skills to work in teams. Senior management didn’t organize teams and then wish for success. They carefully identified employees who would maximize the chances that their teams would be successful. Finally, team leaders reinforced a strong sense of members who possessed a sense of ownership about their project and loyalty.
Team members can also be expected to demonstrate two types of loyalty and identification: (1) loyalty to other team members and identification with the group for effective group interaction; and (2) loyalty to the organization and identification with organizational objectives for effective task accomplishment. Recent research in teams and task groups suggest that these outcomes are the product of two coincident group processes.
LOYALTY TO TEAM MEMBERS AND IDENTIFICATION WITH THE GROUP. The interpersonal processes among team members culminating in loyalty and group identification are normal to group development. Connie Gersick’s research on a variety of task groups and teams is an example of recent research findings. She found that the orientation groups took toward completing a task was established in the group’s first meeting. Gersick reported:
...lasting patterns can appear as early as the first few seconds of a group’s life...The sheer speed with which recurring patterns appear suggest that they’re influenced by material established before the group convenes. Such material includes members’ expectations about the task, each other, and the context, and their repertoire of behavior routines and performance strategies (Gersick 1988).
Only later, at the midpoint of the group’s lifespan, did strategic reorientation to norms and task accomplishment take place. Gersick’s research reveals that from the opening moments of a group’s existence its members are simultaneously developing strategies for task accomplishment and developing the structure and processes for interpersonal relationships.
Gersick’s findings also suggest that leaders need to create immediately the conditions for team members to generate team identity and loyalty such as: establishing open communication, developing trust, and generating a sense of camaraderie. Trust, loyalty, open communication and camaraderie are the group characteristics that we typically associate with successful teams’ efforts in sports and in combat units. Team efforts are the synthesis of two processes; one part interpersonal (among team members and groups external to the team) and the other part, task directed. Consequently, leaders’ creation of conditions that facilitate positive interpersonal processes will also facilitate the task directed decision making process.
To reap the benefits of teamwork, one must actually build a team. Calling a set of people a team or exhorting them to work together is insufficient. Instead, explicit action must be taken to establish a team’s boundaries, to define the task as one for which members are collectively responsible and accountable, and to give members the authority to manage both their internal processes and the team’s relations with external entities such as clients and co-workers (Hackman).
THE OTHER SIDE OF THE COIN: THE TEAM’S LOYALTY TO THE ORGANIZATION AND ITS IDENTIFICATION WITH ORGANIZATIONAL OBJECTIVES. The team’s loyalty to the organization and identification with organizational objectives are essential. Without loyalty to the organization, the team will fragment as team members pursue their individual interests. Also, teams that lack identification with their organization’s objectives are not likely to produce outcomes of value.
Team loyalty to the organization is a consequence of the rewards leaders use to manage individual performance in the organization:
(1) Visibly and verbally reward productivity and innovation
(2) Downplay status differences between management and non-management employees
(3) Consistently demonstrate how organizational membership is instrumental to employees achieving their own goals.
How are you going to implement these techniques in your organization, and can you practice your strategy? Ideology must be translated into action on a daily basis so that members of the organization have solid evidence that they are partners whose efforts are recognized as instrumental to the organization’s success. Daily actions that exemplify the core values of trust and interdependence are critical for laying a solid foundation for employees to develop allegiance to their organization. Roger Hallowell’s research on Southwest Airlines illustrates how this firm turns concepts into action.
Southwest Airlines has demonstrated its superior comprehensive strategy by (1) being the only major United States airline to earn a profit throughout the early 1990’s, (2) having one of the most successful airline stocks, and (3) being the only airline to win the industry’s "triple crown" measures of customer satisfaction . . . Southwest’s success may be due largely to its unusual focus on creating value for employees. "LUV" and "FUN," the cornerstones of Southwest’s employee-relations approach, represent concern and respect for the individual, as well as the consensus creation of the environment that encourages all employees to have fun on the job . . . LUV refers to one of the company’s core values involving the way individuals treat each other. LUV includes respect for individuality and genuine caring for others . . . FUN is exactly what its name suggests . . . FUN occurs throughout the company through jokes, parties, and generally entertaining behavior. A front-line manager notes, "We’re kind of a big family here, and family members have fun better. Herb Kelleher sums up FUN at Southwest in saying "We demonstrate by example that you don’t have to be uptight to be successful . . . LUV and FUN are embedded into the Southwest culture and reflected in the company’s operating policies . . . FUN and LUV produce commitment that changes employees’ perception of their relationship with the airline (Hallowell 1996).
Southwest Airlines’ practices for developing loyalty provide some substance to the ideas that are circulating about transforming organizational culture. Would Southwest’s techniques work in the federal government? The bottom line is that if you want to insure team success in your organization you have to think hard about the ways you can reinforce or transform your organizational culture so that it communicates an ideology of partnership and collective gain to employees.
The effort of leading teams to identify with the organization’s objectives is as challenging as efforts to develop team loyalty. When teams identify with the organization’s objectives, members’ conceptualization of problems and their solutions have a better chance of being consistent with the strategic objectives of the senior decision makers. This is a matter of a team members actually understanding the top management’s strategic frame of reference.
Senior decision makers can reveal their frame of reference for organizational issues when they imbed answers to "why" questions in their assignments to their teams. Answers to "why" questions create clarity. With clarity of purpose there is a better chance for team members to develop a common understanding of issues, and to adopt unified approaches to solutions. Researchers Carl Larson and Frank LaFasto, who interviewed members of mountain expedition teams, executive management teams, GAO and Congressional investigation teams, provide insight to team clarity:
Examples of goal clarity are literally everywhere in our interviews with leaders and members of effective teams....Captain William Bauman, a staff writer for the [Challenger disaster] investigation team, identified goal clarity as one of the primary explanations for the success of the team, one of the most effective Presidential Commissions in recent history. The mission of the Rogers Commission was to investigate the Challenger disaster and determine the cause within 120 days. . . . The team was under considerable pressure from the public and media to assess blame. . . . But what was needed immediately following the disaster was a clear determination of cause. What caused the disaster? What were the major contributing factors? And what specific recommendations would grow from these determinations? The report of the Rogers Commission never deviates from the question of what happened and why. The mission was clear and concrete, and the team was able to execute it effectively (Larson and LaFasto 1989).
Their interviews also revealed that clear communication of the team’s purpose lead to successful team outcomes in mergers and acquisitions. Another interviewee, Anthony Rucci, one of the leaders of the team that implemented the largest merger of the health care industry, provided the following insights::
The first and most important step is to define the objective clearly. In fact Rucci believes it is important to be able to visualize the result and describe what that result will look like once it is accomplished. For Rucci, the vision includes imagining what excellence would look like in achieving the result. "It’s getting the results in a way that hasn’t been done before. It’s achieving the results in a way that set a standard, a higher standard for how you can get something done"(Larson and LaFasto 1989).
Each of these examples reinforces the earlier points made about ways leaders can develop a team’s loyalty to organizational objectives. If team members know why the specific issues that the team is to address are important to senior management then they can see how their efforts will be integrated into the organization’s strategy.
THE CHARACTERISTICS OF HIGH-PERFORMANCE TEAMS
High-performance teams may be appealing to think about because they conjure images of organizational teams operating with the precision of a drill platoon, the efficiency of an Indy race car pit crew, or the effectiveness of a police SWAT team; images synonymous with capability and productivity. These images are useful for picturing how teams could operate, but leaders need more insight about high-performance teams if they are going to create them.
Jon Katzenbach and Douglas Smith provide a description of high-performance teams based upon their research on teams in a wide variety of organizations:
Strong interpersonal commitments drive a number of aspects that distinguish high-performance teams. Fueled by interpersonal commitments, team purposes become even nobler, team performance goals are more urgent, and team approach more powerful. The notion, for example, that "if one of us fails, we all fail" pervades high-performance teams. In addition, mutual concern for each other’s personal growth enable high-performance teams to develop interchangeable skills and hence greater flexibility. High-performance teams also share leadership within the team more than other teams. And, not significantly, high-performance teams seem to have a better developed sense of humor and more fun (Katzenbach 1993).
High-performance teams seem to possess the characteristics of other organizational teams. However, this type of team also displays: (1) higher levels of camaraderie; (2) increased levels of interdependence; (3) greater collective learning and adaptive capabilities; and, (4) closer identification with team outcomes than the average team. Are high-performance teams a chance occurrence? It will appear that way if you only look at a team’s output. The success-failure records of teams, especially those operating in highly competitive environments, will fluctuate over time. How many sports teams can be considered dynasties?
At the core of a high-performance team’s capability is the team members’ ability to use interpersonal relations to facilitate team learning and performance. Team members forge and maintain high levels of camaraderie and appear to leverage these personal processes to: (1) accelerate members’ ability to learn from each other and from their collective experiences; and, (2) efficiently focus members’ efforts on accomplishing their objectives. Descriptions of high-performance teams consistently mention team members’ emphasis and maintenance of strong team identity. This team also vigilantly minimizes internal politics by agreeing to place high value on the team’s collective goals.
How do leaders encourage collective action?
• Leaders need to establish a set of fundamental standards: individual commitment, motivation, and self-esteem.
• Leaders must establish team norms that require team members to be accountable to the group for their performance.
• Leaders must require the team to exert pressure on itself to constantly monitor its performance against goal achievement and to adjust their team processes when warranted.
CREATING AND MANAGING TEAMS AT THE STRATEGIC LEVEL OF ORGANIZATIONS
Whether they are used in employee involvement groups, assembly teams, maintenance crews, or research groups, many organizations have benefited from the higher quality output of teams. In the early 1990’s Motorola’s CEO and Prudential Insurance Company’s CEO offered the following perspectives on top management teams:
In my mind, there is a definite parallel between the self-managing worker teams we are trying to develop across the baseline of the organization and our top management group. We are really trying to create the same behaviors of openness, collective problem solving, multiple leadership, and mutual trust and respect in both situations. So there are important parallels. But somehow it is still different and more difficult at the top.
George Fisher, CEO Motorola
I know teams work. But I’m still not convinced it is worth the time and effort to push further in the direction of making our executive office into a team....The essence of the issue is defining a set of team goals for ourselves as a group beyond dealing with the broad strategic and leadership issues of the corporation. And so far, it is not evident to me what those would be. I must admit, however, I am intrigued by the possibility.
Robert Winters, CEO,
The Prudential Insurance Company of America
Why is it so difficult to create or even visualize a top management team? Part of the answer lies with the job demands of senior executives. Senior executives are paid to confront the VUCA environment. Under complex conditions they generate ideas for the organization’s future and translate them into initiatives, often resolving policy conflicts through negotiation. Other aspects of the strategic leaders’ responsibilities include conceptual tasks such as solving short term problems for which answers are derived through staff analysis or team consensus.
Strategic leaders make the greatest contributions to their organizations by generating decisions on issues for which there are no right answers. Here, top management teams can be of great assistance, because their members can reduce the uncertainty surrounding strategic issues by incorporating additional sources and types of information in all deliberations. Executive team members can also reduce complexity surrounding strategic issues by offering interpretations that are based on different frames of reference that can stimulate sophisticated analyses, and provide more comprehensive solutions.
Executive level decisions are also guided by multi-agency teams, comprising either strategic level executives themselves or senior staff representatives from organizations that have a stake in the issue. The Department of Defense is increasingly engaged in interagency operations. "Deep VUCA" issues ranging from drug interdiction policies, to peace keeping operations, to nuclear weapons control policies are all viewed from a multi-agency perspective. A benefit with multi-agency teams is that decision outcomes will be endorsed by those organizations that have a stake in the issue.
Can teams be organized at the strategic level to achieve gains discussed earlier? Yes, but only if challenges to developing team consensus about long term issues are overcome. The strengths of top management team members also create multi-agency liabilities in the form of each executive’s perceptual filters (Starbuck and Milliken 1988). Different terms pertain to each executive’s personalized model for interpreting VUCA issues, and these personalized models can be based on organizational culture, professional norms, individual preferences, or personal life experience. Regardless of the basis of executives’ approaches to interpretation, the success of team processes will depend on how the team manages conflict during their attempt to reach consensus.
Executive team interactions that contain too much conflict result in polarization or fragmentation within the team. Donald Hambrick, a researcher on executive teams from Columbia University conducted in-depth interviews with 23 chief executives from major corporations in the United States and Europe (Hambrick 1995). Among his findings were examples of how fragmentation occurs:
In our zeal to give autonomy, we’ve created a bunch of fiefdoms. Everyone’s pursuing their own objectives. Right now, there’s very little natural, informal communication or collaboration among these folks. We’re facing some new marketplace shifts which affect the whole company, and unless we can get our act together, we will be passed by.
We’re not running on all cylinders. Communication is slow and spotty. As a result, we’ve had things drop between the cracks. I’m trying to figure out whether this is a matter of group "chemistry", group process, or what.
Team? How do you define a team? When I think of a team, I think of interaction, give and take, and shared purpose. Here we’re a collection of strong players but hardly a "team". We rarely meet as a team-rarely see each other, in fact. We don’t particularly share the same views. I wouldn’t say we actually work at cross purposes, but a lot of self-centered behavior occurs. Where’s the "team" in all this?
These kinds of problems are not restricted to corporate teams. There are numerous examples of how excessive, dysfunctional conflict among the military services, and between the military and other government agencies, have led to suboptimal results. Richard Gabriel analyzed military operations such as the Sontay Prison raid, the Mayaguez rescue mission, the Iranian hostage rescue attempt and the Grenada invasion. Gabriel links many of these failures to breakdowns in interservice decision making at the executive level.:
A number of the key decisions seem to have been made on the basis of interservice rivalry, bureaucratic consensus, and political criteria rather than operational requirements. There seems to have been a bureaucratic imperative to give each service a role, regardless of whether it could best contribute to the success of the mission. In some instances, this imperative ruled even when a course of action seemed to work against the chances of success.
PRODUCTIVE CONFLICT
There is a third category of interaction, productive conflict, that seems best suited to the goal of strategic decision making teams. L. D. Brown describes productive conflict as follows:
Productive conflict at agency or cultural interfaces involves perceiving and explicitly recognizing cultural differences, encouraging communication about those differences, when relevant, and encouraging representatives to resolve differences without escalation.
Leaders must initiate and manage productive conflict in executive teams in two ways: through the techniques they use to unify team members’ commitment to strategic objectives; and through the rules of operation they establish for their teams. Jon Katzenbach and Douglas, in their book, The Wisdom of Teams, provide a set of guidelines that leaders can follow when establishing rules of operation for executive teams. They include:
• Carve out teams assignments that tackle specific issues. Team members will be able to connect their efforts in the top management team with a stream of tasks that can be linked to organizational change.
• Assign tasks to one or more individuals for later integration by the entire team in subsequent working sessions. This technique causes members to do real work together beyond full team meetings, allowing team involvement and accountability to grow outside the context of team meetings.
• Determine team memberships based on skill not position. Skill based membership relieves the difficult constraint of hierarchically imposed membership that also bring a political dimension to team meetings. This approach allows the option of multiple smaller teams, constituted to address particular issues.
• Require all members to do equivalent amounts of real work. Each member’s sweat equity in the work product will insure that they have first hand knowledge of the output.
• Break down hierarchical patterns of interaction. Work assignments and the contributions to be made should not be only related to hierarchical position. Without a consistent flow of contributions that go beyond hierarchical roles, each person is deprived of the opportunity to do real work on behalf of the team.
• Set and follow rules of behavior similar to those used by other teams. Senior management teams can facilitate a greater degree of mutual accountability by setting and following the same rule of conduct that help teams at all levels of the organization provide focus, avoid, and promote openness, and trust.
CONCLUDING COMMENTS ABOUT TEAMS
This chapter has presented a discussion about work teams that provides you with the tools to analyze how teams operate in a variety of contexts. Ordinary work teams can be configured to produce different outcomes and it is up to organizational leaders to match the right kind of team with the desired output. High-performance teams are not found in ordinary organizational contexts. Instead, they embody a team capability that is necessary for success in highly demanding, nonroutine tasks. Executive level teams confront VUCA issues. But they can be hampered by the challenge of trying to develop team consensus among different individuals who may interpret strategic issues differently.
Effective teams do not exist because leaders hope they will exist. They exist because leaders possess the ability to analyze accurately when teams can be effective in the organization, and because leaders know how to manage team processes to produce high-quality results.


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Source: http://www.articletrader.com ]]> http://www.articletrader.com/business/management/teams-and-decision-making-in-the.html http://www.articletrader.com/business/management/teams-and-decision-making-in-the.html Sat, 09 Dec 2006 00:00:00 -0600 The U.S. defense industry helped win the Cold War. Now it is engaged in another tremendous challenge: winning the peace. Every U.S. citizen has a stake in the future of the industry, which has played a vital role in modern life. It helped create the global village by inventing jetliner travel and space-based telecommunications, it spurred the development of digital computers, and it revolutionized access to space with the space shuttle and scientific probes to other planets (Augustine 1997).
INTRODUCTION
The U.S. defense industry is a conglomerate of companies working in a global environment to supply the Defense Department with the vast range of materials and products, from shoe strings to stealth aircraft, needed for national security. It is an organization of organizations, a system of systems, that under a single, fragile term gathers corporations and firms of all sizes and focuses them on the security interests of the U.S.
Great, far-reaching, exemplary, and revolutionary progress might begin in the minds of individuals, but accomplishment is often the result of the convergence of other resources, people and money best represented by the term organization.
BACKGROUND
Earlier chapters described the environment where public servants, or private entrepreneurs and managers, operate. Characterized as a context of "permanent white water," or as an environment that is volatile, uncertain, complex, and ambiguous, it levies special demands on strategic leaders who must operate successfully, and master tricky and precipitous currents.
The qualities most useful in transitioning from an operational stratum to one with higher challenges and demands are: the ability to function conceptually at a high level, to form and work with teams, and to lead in a process of consensus decision making. These qualities are identified in the literature of Stratified Systems Theory, in the results of the Strategic Leader Development Inventory, in individual assessment feedback, in personal commitments to development, and in understanding consensus decision making. A strategic leader, committed to utilizing a high performing team as a way of successfully coming to grips with the policy and operational environment, is well on the way to advancing to more senior levels of responsibility.
WHAT ARE ORGANIZATIONS?
Organizations are fundamentally social structures where an individual in association with others has the potential to reach certain levels of fulfillment that might otherwise be unattainable. Organizations supply both a condition and a context for dealing with our various environments. Man is by nature gregarious, and seeks to join with others to achieve common purposes. An individual with an interest in a military career as a soldier, becomes a member of an army. Organizations represent a culmination of a social order that links the individual to a collective body that in turn provides certain goods to the individual, while it simultaneously serves society.
A school is a learning organization; our community is a governing and service-providing organization; and the line of work we ultimately enter may be a business organization, a
service organization, an industry or production organization, or a professional organization. In other words, "organizations are social inventions or tools developed by men to accomplish things otherwise not possible. They are social inventions that take a variety of people, knowledge, and usually, materials of some sort and give them structure and system to become an integrated whole" (Litterer 1973).
It is the character of organizations to gather the interests, needs, and desires of people into an entity that represents what it is that they want. Thus, a school gathers together the teachers and people of a society and transmits its culture and mores to the people. A hospital gathers together its physicians and other health care providers and its technology for the diagnosis and treatment of those who are ill. A government gathers together the range of citizen services-police and fire protection, economic development, the provision of roads, sewers, and other public works that also may be consistent with the basic needs of the governed-to express a certain quality of life for them.
Organizations wax and wane with the needs of a society. At times, a society might need to have the protection of large military forces, or of "big" government, or of directed education, or health care, or of specific voluntary societies and organizations that protect the wetlands, and certain threatened species. At other times, society might be able to dispense with some of those organizations, and allow more freedom, or simply the opportunity to organize in different ways. Thus, a conscript army might become voluntary; education, after a certain level of required schooling, might also become voluntary. Large medical centers might give way to decentralized clinics that are more accessible to people. In short, organizations have a kind of life that responds to the vagaries of the environment.
CHARACTERISTICS OF ORGANIZATIONS
STRUCTURAL FRAME. Virtually any text or treatment about organizations provide some taxonomy of attributes or qualities that can be derived from organizations. In Reframing Organizations, Bolman and Deal use the device of the "structural frame" to identify the parts and components of an organization, and of their relationship to each other, both internally and externally.
SIZE. An organization could also be characterized in terms of its size, and in some instances size alone will be a factor in the strategic environment. The Boeing Company, the world's leading commercial jetliner manufacturer, announced that it will buy McDonnell Douglas, the top builder of military aircraft. The new company will be the world's largest aerospace enterprise with assets of nearly $44 billion dollars, and a workforce of nearly 210,000 employees. This consolidation creates a firm that will have instant impact on domestic and international issues associated with the aircraft industry. Size matters! Similar organizations, the Department of Defense, The International Red Cross, Greenpeace, Nike, and Reebok reflect size as a factor.
INTERNAL PROPERTIES. But there are also internal properties. In Reframing Organizations: Artistry, Choice, and Leadership, Bolman and Deal cite four "properties" of organizations:
1. Organizations are complex, because of the work, the variety of people, internal divisions (e.g., offices, branches, directorates), and relations with other components outside the organization. This follows from the notion described by VUCA. It is the very mix of task and work, people, communication, problem solving and decision making, and their permutations and combinations that produce both causal and accidental effects in any given circumstance.
2. Organizations are surprising, in that any prediction of the impact of plans considered in reaching a decision are not fully reliable. The actions of a leader can be misinterpreted by others, or as sometime happens, interpreted to fit a particular model held by one of the participants. The Iran-Contra scandal seemed to be caused in part by the interpretations of some members of the national security council staff as to the exact intentions of the President. Alexander George, writing in his book, Presidential Decisionmaking, discusses what he calls impediments to decision making in organizations, including tendencies to be narrow and parochial in identifying problems or in protecting the interests of one's own organization. Overstating the severity of problems, early dependence on proposed solutions, manipulation, and the use of procedural routines may be flaws and have negative effects on policies that are adopted.
3. Organizations are deceptive, in that structure, culture and practice frequently mask things that may really be occurring. The locker room of some professional or collegiate sports teams may be a better index of the true character of the team than the playing field itself. Ralph Nader exposed evidence that indicated that General Motors was producing a model of automobile that was "unsafe at any speed". Physicians, clergy, teachers, attorneys, jurists, and members of other respected professional organizations have sometimes concealed and withheld information from the public. Many organizations have hidden certain kinds of information that would be scandalous and harmful to the organization.
4. Organizations are ambiguous. Trying to figure out what really happens is complicated by such things as the quality and reliability of information, or the ability to properly identify the problem, or the size of the organization. It is not easy to know what might really be going on in an organization, and how the leader may be influencing its members.
OTHER WAYS TO CHARACTERIZE ORGANIZATIONS
MECHANICAL MODEL. There are still other ways to characterize organizations. One way is to see them in terms of a mechanical model which visualizes an organization in terms of inputs, processes, and outputs. In such a view, an organization is very much like a machine which might take a piece of metal or plastic, subject it to heat and pressure and other forces, and produce a component of an automobile. However, even in the mechanical view, and especially in terms of strategic decision making in government, the simple model becomes complex.
A simple input-output model describes inputs in terms of a set of information, options, and recommendations that are processed by the decision maker, and describes outputs as a complementary set of decisions, or actions for implementation. The process, comparable to a series of computerized machines on the factory floor, consists of a series of stages that inputs and outputs pass through. These stages are characterized by a cadre of people--gatekeepers, special assistants, counselors, secretaries, and confidants--whose perceived task is to help the decision maker understand the environment, and the sets of problems that emerge from it. A danger is that the problem may be so influenced by ministers and counselors that the decision maker may not see pure inputs; similarly, an executive decision might be distorted or even not acted upon by the bureaucracy or organization. In fact, at times, some agent acting on behalf of an executive might short circuit the process (Alexander George).
BIOLOGICAL MODEL. So, even in the mechanical model, rational and logical in its problem solving, there is the influence of living beings in organizations. That leads to still another view of an organization as a biological model; in this view, an organization passes through stages of birth, growth, maturity, aging, and death. In reality, most organizations could be viewed in that frame. An organization is born out of a need; it grows and reaches a level of survivability; it exists for a period of time in a stable, maturing, and developing condition--profits are up, students are graduating, people are healing from surgeries, détente and peace is achieved; it ages gracefully, or not, perhaps evolving, changing form-consolidating, downsizing, expanding-and ultimately reaching a stage where its product, or its service, or its role is no longer necessary or relevant.
For example, emergency management in the last half century in the United States has moved from a concentration on protection of citizens from nuclear attack to protection from hurricanes, earthquakes, and floods; from an office in the White House to disaggregated offices in several federal agencies to re-organization as an independent agency. Its programs have often been declared irrelevant, and the Congress has seemed to announce its death more than once without shedding a tear. Yet, it survives. Businesses come and go. CEOs move from one corporation to another, often with a mandate to "heal" a sick patient on some form of life support system. Organizations grow and change in reaction to the stimulus of the environment and what it demands at any point in time.
Each of these models, the mechanical and the biological, might be used as analogies, or frames when attempting to analyze the condition of an organization. But, despite the notion of a frame, many organizations do not seem to have boundaries. They are made up of multiple constituencies, their resources are drawn from disparate sectors of the economy, government, or the private sector, and the impact they have is experienced in widely separate quarters. A company that mines coal, for example, is connected to commercial power companies, to regulators of the federal Department of Energy, to other regulators in the Environmental Protection Agency, to OSHA, to unions, lobbyists, investors, utilities, local and state jurisdictions, the media, and other energy sources.
CONCLUSION
People affiliate with organizations to pursue some purposeful activity of benefit to them at a particular time. Organizations can arise from a variety of sources-economic, recreational, educational, artistic-and can be either mechanistic, or biologic; in the latter case, organizations sometimes seem to take on a life of their own and a specific life-cycle can be discerned. However an organization is structured, it holds great potential to enable its members to achieve a level of success they might not otherwise attain. On the other hand, an organization can become self-serving, and ignore or otherwise limit opportunities for its members.
Most strategic leaders carry out their role in an organization, however it is cast and molded. The Chief of Naval Operations, the Speaker of the House of Representatives, the Secretary of the Department of Transportation, and the CEO of IBM are all strategic leaders in different environments, all volatile, uncertain, complex, and ambiguous. Even those who seem to set off on a singular quest (one thinks of Ralph Nader) and burn with the zeal of reform, often end up having to establish, and/or work with organizations whose influence, assets, and other resources can be leveraged against formidable, stable, and powerful organizations.
ORGANIZATIONS AS SYSTEMS
Organizations represent a complex mix of the following: vision, goals, objectives, and purposes; routines and practices; people; machines; and both an internal (culture, values, ethics) and external relationship (other organizations, interest groups, and the environment). Knowing an organization's purpose, what it does, and how it does it seldom tells a leader all that needs to be known: the more complex parts of an organization are its vision, values, power, and how these elements affect the people in the organization.
Some of the complexities and interrelationships between and among the CEO and different levels of employees, and a concern for the environment, are seen in the following excerpt describing a corporate organization:
In the second story of a wooden lodge overlooking a meadow and pond veiled by mist, Tom Chappell, the CEO and co-founder of Tom's of Maine, exhorts his 75 employees to contemplate nature. Normally these workers would be churning out fennel toothpaste, calendula deodorant, honeysuckle shampoo and other aromatic aids to personal hygienics. But on this overcast Tuesday morning, the company' executives, salesmen, toothpaste mixers and warehouse workers are gathered at an off-site location to discuss the company's commitment to the environment as articulated in its "mission statement." Attendance at the meeting is mandatory; Chappell has shut down the company's plant, at a cost of more than $100,000 to insure that everyone is present.
Chappell kicks off the morning program with a brief homily that traces his own environmentalism back to a childhood spent among idyllic river valleys and mountain ranges near Pittsfield, Mass., and on the coastal islands of Maine. . . he suggests that everyone turn to their neighbor and briefly describe their own relationship to nature, which they all proceed, self-consciously, to do.
Next, the employees participate in a 90-minute game that uses a computer model to simulate a local fishing industry. Competing in teams for imaginary ships, cash and troves of fish, they plunder and inevitably destroy the fragile ecosystem. In the aftermath of their collective remorse, they are asked to discuss, in small groups, ways to improve their environmental stewardship, then to present their ideas...to the entire gathering. The morning concludes with a poem. As the meeting adjourns, everyone strolls outside for a company picnic, set beside a hillock of evergreens beneath a luminous gray sky (Barasch 1997).
Four areas in this chapter, elaborated on in following chapters, are vision; values and ethics; culture; and power. All organizations implicitly have these "areas", though their strength and influence is not always recognized nor easily acknowledged.
VISION
GM Vision Statement...
World Leader in transportation products and related services. We will earn our customer's enthusiasm through continuous improvement, driven by the integrity, teamwork, and innovation of GM people.
For a strategic leader, the first priority may be the conception and articulation of what it is that the organization can do and be, and the way to get there. In their book, Leaders, Warren Bennis and Burt Nanus say: "Leaders articulate and define what has previously remained implicit or unsaid; then they invent images, metaphors, and models that provide a focus for new attention. By so doing, they consolidate or challenge prevailing wisdom." This task, conceptual at first, but communicative at a later time, seems to be central to finding an appropriate niche for an organization, one that is differentiated enough to attract members and focused enough to bring together their power and influence on some critical task.
Typically we expect a leader to be several things. The President of the United States is simultaneously the head of state, the commander-in-chief of the Armed Forces, the head of the executive branch of the government, the principal ambassador for foreign policy. The CEO of a major cooperation is expected to have similarly broad roles, including an economic one, in leading his or her corporation. Annually at the State of the Union address to the nation, or at the stockholder meeting, the leader expresses his or her vision of what the organization is about and what it brings to its citizens or shareholders. "One of the things about leadership is that you cannot be a moderate, balanced, thoughtful, careful articulator of policy. You"ve got to be on the lunatic fringe." GE's Jack Welch sees the role of a strategic leader as someone who takes time to see beyond the stars.
Beyond the techniques and processes of developing and articulating a vision, a strategic leader needs to do two things. First, there is the notion of gathering information about the total environment, both internal and external. If broadly conceived as an ongoing process, a leader can gather information from clients, constituents, competitors, allies, friends and foes; in short, from a range of people with interests in issues germane to the organization. Second, if this gathering stage is followed by continuous processing and analysis of the information, the leader, in concert with others, can begin to "make sense" of the environment, and can begin to shape and communicate the vision that would provide the focus for the organization.
This two-step process seems to be a necessary part of strategic leadership, and seems to emerge directly from the attributes of strategic leaders described in the SLDI (conceptual flexibility, consensus decision making, and team development). While a vision may be derived in a rational way, we can also recall that in classical terms, in the Bible or in epics like the Odyssey, the heroes were mindful of dreams and other non-rational inspiration to help them visualize situations and deliver the people from an enemy, or solve some other threatening problem. A strategic leader has to be tuned to both the rational and the irrational, the linear and the circular, the scientific and the artistic.
Many organizations are led through implicit visions of members of the organization. That may be sufficient during early stages of the life of the organization where the momentum and enthusiasm of its members propel it to a position of initial stability. But, at other times, when the organization is enmeshed in a fight for institutional survival (the downsizing of components of the Army, for example, or an airline going out of business), leaders can gather information and begin to reformulate the vision of that particular organization so that it emerges from the crisis better focused on its possible futures.
The role of the strategic leader is to move the organization forward toward some objective; it can be as diverse as implementing some program of government, or directing the stewardship of a nation's religious beliefs. The articulation of a vision is part of the complex role for a strategic leader.
VALUES AND ETHICS
An organization must have a set of values from which ethical practices logically flow; organizations might also use the term philosophy. NASA's vision (ad astra per aspera) creates an image of an organization whose values revolve around rigorous science and engineering and the indomitable spirit of man. The Coast Guard describes its core values as honor, respect, and devotion to duty. The values of organizations like the Boy Scouts are set out in oath and motto. Private corporations and businesses also express their values with slogans.
That organizations would have a set of core values should not be so surprising. Members influence the organization, and an organization often draws people with common interests, values and ethical codes; the organization then simply externalizes the private values of its individual members. A church, for example, espouses a set of values in itself; in turn, the congregation solidifies the values of the organization while privately practicing those beliefs. An environmental organization attracts people interested in preserving natural aspects of things; these values are subscribed to by its members who promote those precepts as members of the organization. This symbiotic relationship between the organization and its members is critical to organizational survival.
Beyond the question of personal integrity that suggests a set of commonly held moral beliefs and practices, a strategic leader must espouse a set of values for the organization. A strategic leader must serve as an exemplar to other members of the organization in a responsible way, by faithfully serving the interests of the organization. Such a view calls for strategic leaders not to abuse their roles and positions of power.
The larger task for the strategic leader is to engender in the organization a sense of responsibility for both the internal and external environments. For a public official, that means following democratic authority, participating in public policy determination, and considering fully the impacts of such decisions on the whole of society. Exercise of a public office carries with it the obligation to object to policies that might be harmful or discriminatory to certain segments of society. For a private sector official, it may mean appropriate responsiveness to a board of directors, and to consideration of the impacts of a strategic decision on the environment. The role of the strategic leader is to foster and maintain a climate of values and ethical practice within the organization through which it can fulfill its public and private responsibilities.
CULTURE
An organization that adopts an ethical and value-oriented environment has taken the first step toward establishing a culture that promotes the aims of the institution. The subject of culture itself will be treated more fully later in this text. Our interest here is in the role of the strategic leader in understanding and shaping the culture of an organization.
Every organization, and every block or component within any organization has a way of doing things. Some of them are trivial, though they would include: how long you take for lunch; whether you pay attention to the boss; if not, who really does count; what reports are important; and whom to have coffee with. At a more important level, culture includes an ethical climate, a sense of stewardship for the resources of the organization and for its members, and a sense of civic and public responsibility. Organizations, for example, might adopt a school and serve as mentors for children there; or support environmental issues, or advocate equal opportunity.
To some extent culture can be developed and implemented in much the same way that other changes are introduced in the organization. Such an initiative might well lead to a breath of fresh air in the organization. Pope John XXIII allowed many changes to flow from a world-wide meeting of the bishops of the Catholic Church in the early 1960s; a cultural shift in certain practices in the church. Discontinuing the use of Latin for ceremonies was a significant change.
In most instances, culture develops unnoticed. A leader can become aware quite suddenly and dramatically, as is the case with unwanted news, that there is a "cancer in the White House", or there is "malaise" in the nation, or that something is rotten in Denmark. Culture expresses itself in featured news stories about Texaco and gender discrimination, about Aberdeen and sexual harassment, about Tailhook, and other pernicious events. In those instances, the culture of particular organizations obscured any sense of otherwise ethical behavior.
Culture also is often expressed positively in non-verbal terms, by symbols, representations, colors, logos, songs and anthems. It is the nature of symbols to express what is often difficult to express verbally. The President of the United States is by virtue of his office a symbol. Images of the President standing at attention at Dover Air Force Base; or, signing a bill; or, delivering the State of the Union address, are rooted in our culture of respect for the office of the President.
The task of the strategic leader is to notice what is really happening in the organization beyond the wiring diagram, beneath the glossy reports, and behind what he hears. The same diligence that the leader might use in discerning and gathering information prior to establishing a vision for an organization might well serve in determining its culture.
POWER
We've mentioned previously that it is part of the nature of an organization to gather and consolidate power. It is through power, and its surrogate politics, that an organization accomplishes its purposes and fulfills its mandates whether it comes from legislation, or the policies of a board of directors, or from the inherent and critical nature of the organization. Such power not only defines the essential purposes of the organization, but also provides the means to achieve its objectives.
And it is precisely in its consolidation of power that an organization can dare to be great and can gain those goals that fulfill the aspirations of its members. Thus, a firm that makes automobiles and that seeks to be a world class manufacturer in that industrial segment will use its economic, technical, and artistic power to design, engineer, manufacture, and sell enough vehicles to gain a sizable market share.
The role of the strategic leader is to use the power inherent in the organization to leverage that power through alliances, both formal and informal, with the power in other organizations. The strategic leader also needs to be conscious of the corruption that sometimes lies with the exercise of power.
PEOPLE
Project Focus: Hope*
Recognizing the dignity and beauty of every person,
we pledge intelligent and practical action
to overcome racism, poverty and injustice.
And to build a metropolitan community where all people
may live in freedom, harmony, trust and affection.
Black and white, yellow, brown and red
from Detroit and its suburbs
of every economic status,
national origin and religious persuasion
we join in this covenant.
Ideally, organizations provide opportunities for individuals to reach the highest levels of achievement. Individuals join an organization to pursue a career, to earn a living, to engage in professional activity, and to associate with others who may have the same goals. An organization offers the fulfillment of dreams or aspirations.
If the fit between the individual and the organization is sound, the association between them might last a lifetime. People join a particular religion and never leave it; others become lifelong employees of a corporation. In those instances, the organization meets the needs of the individual, and the individual contributes to the good of the institution. Each gets a level of satisfaction that is sufficient for continued association.
Conversely, if the fit between the individual and the organization is unsound, the association might be temporary, and disappointing. A recruit may enter one of the military services, and find the discipline and rigor do not provide the satisfaction necessary for continued membership. A student may enter a college and find that the requirements and other aspects of academic life are not satisfying.
One of the phenomena associated with large organizations is a certain impersonality. Even after working "together" in the same place for years, some people realize that they don't really know a particular person. And the larger, more diverse and geographically dispersed an organization may be, the more complex is the communication about things critical and essential to the organization. The "front" office becomes impersonalized as "them", usually in a pejorative way. In turn, the front office sees its employees as lacking the attitudes and skills that are critical for continued success. Thus, an uneasy climate of suspicion and tamped-down hostility may begin to affect an organization. People begin to feel unimportant, uninvolved, even unloved.
One of the critical tasks of the strategic leader is to recognize and provide for the needs of the members of the organization. Many organizations, recognizing the value and importance of employees have begun to take significant actions to improve the conditions that would allow employees to satisfy their human needs, and thus contribute more substantially to the good of the organization. In other words, they have begun to examine the characteristics of human resources and provide a better fit between the individual and the organization.
Conditions where employees were largely regimented, perceived to be replaceable parts in a large enterprise, such as an assembly line, or working in a bureaucracy, or as a member of the armed forces, have changed to accommodate more of the human resource dimensions. Flexibility has replaced rigidity. Hours of work have been adjusted in some cases, and telecommuting, flex time and other accommodations have been introduced to keep pace with the larger environment. The work force itself reflects a diversity in gender, ethnicity race, age, interests, and skills. Jobs are rotated so that people do not become bored. Recognition of a commonality of interests is leading to more win-win solutions.
The radical idea of sharing power with more and more members of organizations seems to fall under the broad category of empowering. The proverbial suggestion box has given way to allowing workers to suggest changes without recourse to someone's approval. Based on the premise that people want to contribute and can do so in a meaningful way, the strategic leader will find the balance between the "inmates running the asylum" and responsible contributions; in the end, it may simply be an application of the maxim offered by management consultant, Tom Peters: "Involve everyone all the time" (Peters, 1987).
A strategic leader can enhance the culture of an organization through the approaches that he or she takes toward people; how they are recruited, trained, and brought into the organization; how they are rewarded and counseled while they are in the organization; the opportunity they have to contribute to the organization; the measure of independence and trust as part of self-managing teams; in short, the extent to which the culture of the organization provides for their recreational, social, and professional development.
CONCLUSION
The task of strategic leadership in VUCA environments is critical. Organizations--nations, large elements of government, multi-national corporations, and national associations carry within their cultures, values, vision, political aspects, and the lives of people. It is a complexity that corporate and other strategic leaders might recognize in this series of statements posed by McCaskey:
We are not sure what the problem is.
We are not sure what is really happening.
We are not sure what we want.
We do not have the resources that we need.
We are not sure who is supposed to do what.
We are not sure how to get what we want.
We are not sure how to determine if we have succeeded.
In spite of these uncertainties, strategic leaders still must be effective decision makers. Understanding more about subtle qualities in organizations-vision, values and ethics, culture, and power-about the relationship of people who are members of the organization, and about managing and leading during transitional periods-may make you a better leader, able to act with increased wisdom, purpose, and prudence.


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Source: http://www.articletrader.com ]]> http://www.articletrader.com/business/stock-investing-part-3.html http://www.articletrader.com/business/stock-investing-part-3.html Wed, 06 Dec 2006 00:00:00 -0600
Relative valuation is a simple way to unearth low-priced companies with strong fundamentals. As such, investors use comparative multiples like price-earnings ratio (P/E), enterprise multiple (EV/EBITDA) and price-to-book ratio all the time to assess the relative worth and performance of companies and to identify buy and sell opportunities. The trouble is that while relative valuation is quick and easy to use, it can be a trap for investors.
Quick and Easy
The concept behind relative valuation is simple and easy to understand: the value of a company is determined in relation to how similar companies are priced in the market. Here is how to do a relative valuation on a publicly listed company:
• Create a list of comparable companies, often industry peers and obtain their market values.
• Convert these market values into comparable trading multiples, such as P/E, price-to-book, enterprise-value-to-sales and EV/EBITDA multiples.
• Compare the company's multiples with those of its peers to assess whether the firm is over or undervalued.
No wonder relative valuation is so widespread. Key data - including industry metrics and multiples - is readily available from investor services like Multex, Reuters and Bloomberg for a small fee, if not free of charge. In addition, the calculations can be performed with fewer assumptions and less effort than fancy valuation models like discounted cash flow analysis (DCF). (See, Taking Stock Of Discounted Cash Flow.)

Relative Value Trap
Relative valuation is quick and easy, perhaps. But because it's based on nothing more than casual observations of multiples, it can easily go awry.

Consider this: a well-known company surprises the market with exceedingly strong earnings. Its share price deservedly takes a big leap. In fact, the firm's valuation goes up so much that its shares are soon trading at P/E multiples dramatically higher than those of other industry players. Soon investors ask themselves whether the multiples of other industry players look cheap against those of the first company. After all, these firms are in the same industry, aren't they? If the first company is now selling for so many times more than its earnings, then other companies should trade at comparable levels, right?

Not necessarily. Companies can trade on multiples lower than those of their peers for all kinds of reasons. Sure, sometimes it's because the market has yet to spot the company's true value, which means the firm represents a buying opportunity. Other times, however, investors are better off staying away. How often does an investor identify a company that seems really cheap, only to discover that the company and its business is teetering on the verge of collapse?

In 1998, when Kmart's share price was downtrodden, it became a favorite of some investors. They couldn't help but think how downright cheap the shares of the retail giant looked against those of higher-valued peers Walmart and Target. Those Kmart investors failed to see that the business's model was fundamentally flawed. The company's earnings continued to fall and, overburdened with debt, Kmart filed for bankruptcy in 2002.

Investors need to be cautious of stocks that are proclaimed to be "inexpensive". More often than not, the argument for buying a supposed undervalued stock isn't that the company has a strong balance sheet, excellent products or a competitive advantage. Trouble is, the company might look undervalued because it's trading in an overvalued sector. Or, like Kmart, the company might have intrinsic shortcomings that justify a lower multiple.

Multiples are based on the possibility that the market may presently be making a comparative analysis error, whether overvaluation or undervaluation. A relative value trap is a company that looks like a bargain compared to its peers, but is not. Investors can get so caught up on multiples that they fail to spot fundamental problems with the balance sheet, historical valuations and most importantly, the business plan.

Do Your Homework
The key to keeping free from relative value traps is extra homework. The challenge for investors is to spot the difference between companies and figure out whether a company deserves a higher or lower multiple than its peers.

For starters, investors should be extra careful when picking comparable companies. It is not enough simply to pick companies in the same industry or businesses. Investors need also to identify companies that have similar underlying fundamentals.

Aswath Damadoran, author of the "The Dark Side Of Valuation" (2001), argues that any fundamental differences between comparable firms that might affect the firms' multiples need to be thoroughly analyzed in relative valuation. All companies, even those in the same industries, contain unique variables - such as growth, risk and cash flow patterns - that determine the multiple. Kmart investors, for instance, would have benefited from examining how fundamentals like earnings growth and bankruptcy risk translated into trading-multiple discounts.

Next, investors will do well to examine how the multiple is formulated. It is imperative that the multiple be defined consistently across the firms being compared. Remember, even well-known multiples can vary in their meaning and use.

For example, let's say a company looks expensive relative to peers based on the well used P/E multiple. The numerator - share price - is loosely defined. While the current share price is typically used in the numerator, there are investors and analysts who use the average price over the previous year. There are also plenty of variants on the denominator. Earnings can be those from the most recent annual statement, the last reported quarter, or forecasted earnings for the next year. Earnings can be calculated with shares outstanding, or it can be fully diluted, and it can also include or exclude extraordinary items. We've seen in the past that reported earnings leave companies with plenty of room for creative accounting and manipulation. Investors must discern on a company-by-company basis what the multiple means.

Conclusion
Investors need all the tools they can get their hands on to come up with reasonable assessments of company value. Full of traps and pitfalls, relative valuation needs to be used in conjunction with other tools like DCF for a more accurate gauge of how much a firm's shares are really worth.


How to Read Footnotes - Part 3: Evaluating the Board of Directors

You'd be surprised at what you can learn from looking at the disclosures made about a company's board of directors. All it takes is a little time and a little knowledge. In the third part of our series on how to read footnotes we will look at some guidelines that will help you read between the lines and spot the red flags on a company's board of directors.


Overview
In theory, the board is responsible to the shareholders and is supposed to govern a company's management. In reality, the board has become a servant of the CEO, who is typically also the chairman of the board. But the role of the board of directors has come under scrutiny in light of the excesses of Enron, WorldCom, Healthsouth and their ilk. Since the passage of the Sarbanes-Oxley Act increased the risk of litigation and criminal charges, boards have become more concerned about their roles and composition.

The Checklist
There is a checklist that investors can use to evaluate the objectivity and effectiveness of a board. This list was developed from a study done by the Corporate Library ("the study") and was reported in the Oct 27, 2003, edition of the Wall Street Journal (page R7).

1. Size of the Board
A large board is a sign that membership is a payback of some kind, a "thank you" for good service or for getting the CEO on another board. On the other hand, a small board could be just as ineffective if it is stacked with sycophants. According to the Corporate Library's study, the average board size is 9.2 members, ranging from 3 to 31 members.

As an analyst, I think the ideal size is seven, and here is why. There are two critical board committees that must be comprised of independent members: the compensation committee and the audit committee. Based upon our research, the minimum number for each committee is three. This means a minimum of six board members is needed so that no one is on more than one committee - having members doing double duty may compromise the important wall between audit and compensation, which should help avoid any conflicts of interest. Furthermore, if members are serving on a number of other boards it may increase the risk that the members cannot devote adequate time to their responsibilities.

Rounding out the ideal board is the seventh member, the chairperson of the board. It's the responsibility of the chairperson to make sure the board is functioning properly and the CEO is fulfilling his or her duty and following the directives of the board. Obviously, if the CEO is also the chairperson of the board, a conflict of interest is created.

Two or three additional people may be necessary to staff any additional committees, such as nominating or governance, but more than nine members makes the board too big to function effectively.

2. Insider/Outsider (Degree of Independence)
A key attribute of an effective board is that it is comprised of independent outsiders. An outsider is someone who has never worked at the company, is not related to any of the key employees and does not/did not work for a major supplier or customer. The WSJ study found that independent outsiders comprised 66% of all boards and 72% of S&P boards.

While this definition of independent outsiders seems clear enough, you'd be surprised at the number of times it is misapplied. Too often, the 'outsider' label is given to the retired CEO or a relative, when they are in fact insiders with material conflicts of interest.

3. Committees
There are three important committees that each board should have: audit, compensation and nominating. There may be more committees depending on corporate philosophy (which is determined by an ethics committee) or if the company wants to combat current negative headlines. Let's take a closer look at the three main committees:
The Audit Committee
The audit committee is charged with working with the auditors to make sure that the books are correct and that there are no conflicts of interest between the auditors and the other consulting firms employed by the company. Ideally, the chair of the audit committee is a CPA. But too often there is not a CPA anywhere on the audit committee, let alone on the board. The NYSE requires that the audit committee include a financial expert, but this qualification is typically met by a retired banker, even though that person's ability to catch fraud may be questionable. The audit committee should meet at least four times a year in order to review the most recent audit. An additional meeting should be held if there are other issues that need to be addressed.

The Compensation Committee
The compensation committee is responsible for setting the pay of top executives. While it seems obvious that the CEO (or other people with conflicts of interest) should not be on this committee, you'd be surprised at the number of companies that allow just that. Because of the 'I'll scratch your back if you scratch mine' conflict of interest, it is important to check to see if the members of the compensation board are also on the compensation committees of other firms. Also, the compensation committee should meet at least twice a year: one meeting is a sign that the committee meets just to approve a pay package that was created by the CEO or a consultant without much debate.

The Nominating Committee
This committee is responsible for nominating people to the board. The nomination process should aim to bring on people with independence and a skill set currently lacking on the board.

4. Other Commitments/Time Constraints
A key consideration in determining the effectiveness of a board member is the number of other boards and committees they are on.

The following chart from the survey shows the time commitments of board members of the 1,700 largest U.S. public companies. This indicates that the majority of board members sit on no more than three boards. What this data does not indicate is the number of committees that these people are on.






You'll often find that the key board members (the independent ones) serve on both the audit and the compensation committees and are also on three or more other boards. You have to wonder how much time a board member can devote to a company's business if he or she is on multiple boards. This situation also raises questions about the supply of independent outside directors. Are these people pulling double duty because there's a lack of qualified outsiders?
5. Paybacks
The apparent shortage of independent outsiders also makes one wonder if a board seat is not a form of corporate welfare for retired CEOs - especially when you consider that the board member usually gets paid for each meeting and may receive an annual salary as well as stock options. You have to question the rationale of having a board composed of CEOs of other companies and 70 year olds who are also on several other boards.

6. Related Transactions
Companies must disclose any transactions with executives and directors in a footnote entitled "Related Transactions". This can prove to be very enlightening reading because it discloses some actions that cause conflicts of interest, such as doing business with a director's company or having the CEO's wife on the payroll.

Conclusion - the Bottom Line
The composition of the board of directors says a lot about corporate management and governance. A company loses credibility if its board is stacked with insiders that rubber stamp accounting and compensation issues that were decided by the CEO.

Value by the Book

What price should you pay for a company's shares? If the goal is to unearth high-growth companies selling at low-growth prices, the price-to-book ratio offers investors a handy, albeit fairly crude, approach to finding undervalued companies. It is, however, important to understand exactly what the ratio can tell you and when it may not be an appropriate measurement tool.


Difficulties of Determining Value
Let's say you identify a company with strong profits and solid growth prospects. How much should you be prepared to pay for it? To answer this question you might try using a fancy tool like discounted cash flow analysis to provide a fair value. But DCF can be tricky to get right, even if you can manage the math. It requires an accurate estimate of future cash flows, but it can be awfully hard to look more than a year or two into the future. DCF also demands the return required by investors on a given stock, another number that is difficult to produce accurately.

What Is P/B?
There is an easier way to gauge value. Price-to-book value (P/B) is the ratio of market price of a company's shares (share price) over its book value of equity. The book value of equity, in turn, is the value of a company's assets expressed on the balance sheet. This number is defined as the difference between the book value of assets and the book value of liabilities.

Assume a company has $100 million in assets on the balance sheet and $75 million in liabilities. The book value of that company would be $25 million. If there are 10 million shares outstanding, each share would represent $2.50 of book value. If each share sells on the market at $5, then the P/B ratio would be 2 (5/2.50).

What Does P/B Tell Us?
For value investors, P/B remains a tried and tested method for finding low price stocks that the market has neglected. If a company is trading for less than its book value (or has a P/B less than 1), it normally tells investors one of two things: either the market believes the asset value is overstated, or the company is earning a very poor (even negative) return on its assets.

If the former is true, then investors are well advised to steer clear of the company's shares because there is a chance that asset value will face a downward correction by the market, leaving investors with negative returns. If the latter is true, there is a chance that new management or new business conditions will prompt a turnaround in prospects and give strong positive returns. Even if this doesn't happen, a company trading at less than book value can be broken up for its asset value, earning shareholders a profit.

A company with a very high share price relative to its asset value, on the other hand, is likely to be one that has been earning a very high return on its assets. Any additional good news may already be accounted for in the price.

Best of all, P/B provides a valuable reality check for investors seeking growth at a reasonable price. Large discrepancies between P/B and ROE, a key growth indicator, can sometimes send up a red flag on companies. Overvalued growth stocks frequently show a combination of low ROE and high P/B ratios. If a company's ROE is growing, its P/B ratio should be doing the same.

No Magic Bullet
Despite its simplicity, P/B doesn't do magic. First of all, the ratio is really only useful when you are looking at capital-intensive businesses or financial businesses with plenty of assets on the books. Thanks to conservative accounting rules, book value completely ignores intangible assets like brand name, goodwill, patents and other intellectual property created by a company. Book value doesn't carry much meaning for service-based firms with few tangible assets. Think of software giant Microsoft, whose bulk asset value is determined by intellectual property rather than physical property; its shares have rarely sold for less than ten times book value. In other words, Microsoft's share value bears little relation to its book value.

Book value doesn't really offer insight into companies that carry high debt levels or sustained losses. Debt can boost a company's liabilities to the point where they wipe out much of the book value of its hard assets, creating artificially high P/B values. Highly leveraged companies - like those involved in, say, cable and wireless telecommunications - have P/B ratios that understate their assets. For companies with a string of losses, book value can be negative and hence meaningless.




Behind-the-scenes, non-operating issues can impact book value so much that it no longer reflects the real value of assets. For starters, the book value of an asset reflects its original cost, which doesn't really help when assets are aging. Secondly, their value might deviate significantly from market value if the earnings power of the assets has increased or declined since they were acquired. Inflation alone may well ensure that book value of assets is less than the current market value.

At the same time, companies can boost or lower their cash reserves, which in effect changes book value, but with no change in operations. For example, if a company chooses to take cash off the balance sheet, placing it in reserves to fund a pension plan, its book value will drop. Share buybacks also distort the ratio by reducing the capital on a company's balance sheet.

Conclusion
Admittedly, the P/B ratio has shortcomings that investors need to recognize. But it offers an easy-to-use tool for identifying clearly under or overvalued companies. For this reason, the relationship between share price and book value will always attract the attention of investors.
The "True" Cost of Stock Options




How to value employee stock options (ESO)? This is possibly the central issue in the debate on whether these options should be expensed. According to basic accounting rules, if a value can be placed on this form of compensation, it should be expensed.

Proponents of expensing employee stock options say there are many models that can be used to place a value on options. Opponents argue these models are not applicable to employee stock options. This article will take a look at the argument of the opponents and then explore the possibility of a different approach to determining the cost of employee stock options.


The Arguments Against
Several models have been developed to value options that are traded on the exchanges, such as puts and calls. The models use assumptions and market data to estimate the value of the option at any point in time. Perhaps the most widely known is the Black-Scholes Model, which is the one most companies use when they discuss employee options in the footnotes to their SEC filings.

There are two main drawbacks to using these types of valuation models:
1. Assumptions - Like any model, the output (or value) is only as good as the data/assumptions that are used. If the assumptions are faulty, you will get faulty valuations regardless of how good the model is. The key assumptions in valuing employee stock options are the risk-free rate, stock volatility, dividends (if any) and life of the option. These are hard things to estimate because of the many underlying variables involved. More importantly, they can be manipulated: by adjusting any one or a combination of these assumptions, management can lower the value of the stock options and thus minimize the options' adverse impact on earnings.
2. Applicability - Another argument against using an option-pricing model for employee stock options is that the models were not created to value these types of options. The Black-Scholes model was created for valuing exchange-traded options on financial instruments (such as stocks and bonds) and commodities. The data used in these options are based on the expected future price of the underlying asset (a stock or commodity) that is to be set in the marketplace by buyers and sellers. Employee stock options, however, cannot be traded on any exchange, and option-pricing models were created because the ability to trade an option is valuable.
An Alternative Viewpoint
Outside of these theoretical debates, there is a real hard-dollar cost to employee stocks options and it is already disclosed in the financial statements. The real cost of employee options is the stock buyback program, used to manage dilution.

Companies use stock buyback programs to reduce and therefore manage the number of shares outstanding: a reduction in shares outstanding increases earnings per share. Generally, companies say they implement buybacks when they feel their stock is undervalued.


Most companies that have large employee stock option programs have stock buyback programs so that, as employees exercise their options, the number of shares outstanding remains relatively constant, or undiluted. If you assume that the main reason for a buyback program is to avoid earnings dilution, the cost of the buyback is a cost of having an employee stock option program, which can be expensed on the income statement.

If a company does not have a stock buyback program, then earnings will be reduced by both the cost of the options issued and dilution.

Conclusion - The Bottom Line
Stock options are used in lieu of cash wages, period. As such, they should be expensed in the period they are awarded. The cost of a stock repurchase program can be used as a way to value those options because in most cases management uses a repurchase program to prevent EPS from declining.

Even if a company does not have a share repurchase program, you can use the average annual share price times the number of shares underlying the options (net of shares expected to be un-exercised or expired) to derive an annual cost.

Show and Tell: The Importance of Transparency

Ask investors what kind of financial information they want companies to publish and you'll probably hear two words: more and better. Quality financial reports allow for effective, informative fundamental analysis.

But let's face it, the financial statements of some firms are designed to hide rather than reveal information. Investors should steer clear of companies that lack transparency in their business operations, financial statements or strategies. Companies with inscrutable financials and complex business structures are riskier and less valuable investments.


Transparency Is Assurance
The word "transparent" can be used to describe high-quality financial statements. The term has quickly become a part of business vocabulary. Dictionaries offer many definitions for the word, but those synonyms relevant to financial reporting are "easily understood", "very clear", "frank", and "candid".

Consider two companies with the same market capitalization, same overall market-risk exposure, and the same financial leverage. Assume that both also have the same earnings, earnings growth rate and similar returns on capital. The difference is that Company A is a single-business company with easy-to-understand financial statements. Company B, by contrast, has numerous businesses and subsidiaries with complex financials.

Which one will have more value? Odds are good the market will value Company A more highly. Because of its complex and opaque financial statements, Company B's value will be discounted.

The reason is simple: less information means less certainty for investors. When financial statements are not transparent, investors can never be sure about a company's real fundamentals and true risk. For instance, a firm's growth prospects are related to how it invests. It's difficult if not impossible to evaluate a company's investment performance if its investments are funneled through holding companies, making them hidden from view. Lack of transparency may also obscure the company's level of debt. If a company hides its debt, investors can't estimate their exposure to bankruptcy risk.

High-profile cases of financial shenanigans, such as those at Enron and Tyco, showed everyone that managers employ fuzzy financials and complex business structures to hide unpleasant news. Lack of transparency can mean nasty surprises to come.

Blurry Vision
The reasons for inaccurate financial reporting are varied: a small but dangerous minority of companies actively intends to defraud investors; other companies may release information that is misleading but technically conforms to legal standards.

The rise of stock option compensation has increased the incentives for companies to misreport key information. Companies have increased their reliance on pro forma earnings and similar techniques, which can include hypothetical transactions. Then again, many companies just find it difficult to present financial information that complies with fuzzy and evolving accounting standards.

Furthermore, some firms are simply more complex than others. Many operate in multiple businesses that often have little in common. For example, analyzing General Electric - an enormous conglomerate with dozens of businesses, from GE Plastics to NBC - is more challenging than examining the financials of a firm like Amazon.com, a pure play online retailer.

When firms enter new markets or businesses, the way they structure these new businesses can result in greater complexity and less transparency. For instance, a firm that keeps each business separate will be easier to value than one that squeezes all the businesses into a single entity. Meanwhile, the increasing use of derivatives, forward sales, off-balance-sheet financing, complex contractual arrangements and new tax vehicles can befuddle investors.

The cause of poor transparency, however, is less important than its effect on a company's ability to give investors the critical information they need to value their investments. If investors neither believe nor understand financial statements, the performance and fundamental value of that company remains either irrelevant or distorted.


Transparency Pays
Mounting evidence suggests that the market gives a higher value to firms that are upfront with investors and analysts. Transparency pays, according to Robert Eccles, author of "Building Public Trust – The Value Reporting Revolution". Eccles shows that companies with fuller disclosure win more trust from investors. Relevant and reliable information means less risk to investors and thus a lower cost of capital, which naturally translates into higher valuations. The key finding is that companies that share the key metrics and performance indicators that investors consider important are more valuable than those companies that keep information to themselves.

Of course, there are two ways to interpret this evidence. One is that the market rewards more transparent companies with higher valuations because the risk of unpleasant surprises is believed to be lower. The other interpretation is that companies with good results usually release their earnings earlier. Companies that are doing well have nothing to hide and are eager to publicize their good performance as widely as possible. It is in their interest to be transparent and forthcoming with information, so that the market can upgrade their fair value.

Further evidence suggests that the tendency among investors to mark down complexity explains the conglomerate discount. Relative to single-market or pure play firms, conglomerates are discounted by as much as 20%. The positive reaction associated with spin-offs and divestment can be viewed as evidence that the market rewards transparency.

Naturally, there could be other reasons for the conglomerate discount. It could be the lack of focus of these companies and the inefficiencies that follow. Or it could be that the absence of market prices for the separate businesses makes it harder for investors to assess value.

It's worth noting that, even if a company's financial statements are totally transparent, investors may still not understand them. If biotech specialist Amgen and semiconductor maker Intel were totally forthcoming about their R&D spending, investors might still lack the knowledge to properly value these companies.

Conclusion
Investors should seek disclosure and simplicity. The more companies say about where they are making money and how they are spending their resources, the more confident investors can be about the companies' fundamentals.

It's even better when financial reports provide a line-of-sight view into the company's growth drivers. Transparency makes analysis easier and thus lowers an investor's risk when investing in stocks. That way you, the investor, are less likely to face unpleasant surprises.

Why There Are Few Sell Ratings on Wall Street

Why are there so few sell recommendations on Wall Street? This has been a matter of much debate in the media, and with good reason. Read on and discover the answer to this popular question - you may be surprised!


Bull Market Explanation
The current view is that analysts tend to be wildly optimistic and possibly criminal in how they rate stocks during a bull market. Researchers have published data showing that, during the late 1990s, sell ratings were as scarce as value investors. And while the ratio of sell ratings to other ratings has increased since then, the sells remain in the minority.

Research Requires Compensation
The reason there are so few sells is that it is not economical to follow a stock with a sell rating. Providing research coverage requires a large investment of time and money. In order to remain profitable and cover the cost of providing research, brokerage firms need to be able to make money on transactions made by customers trading the stock or get investment banking business. A stock that is going up has the potential to generate profit for researchers because investors may buy the stock many times and will need more information throughout the time they own the stock. A sell rating results in just one trade.

Historically, it was a very rare occurrence to find research initiated on a company with a sell or hold rating because the cost of initiating coverage is not justified by the potential revenue of that research coverage. Coverage is usually initiated and maintained on companies that have the potential to be long-term winners, thereby generating income for a longer period than it took the brokerage to initiate coverage. Of course, investors want to buy stocks that are expected to rise, sometimes several times, which generates fee income that (hopefully) more than offsets the brokerage's cost of providing that research.

When Sell Ratings Are Issued
Sell ratings are issued if a company's profitability starts to falter or if it has issues that indicate that its stock is no longer a good investment. When a company reaches such a point, its stock may be placed on a monitor status, at which time fewer reports are issued, if any. Indeed, the brokerage is more likely to quietly drop the stock and publish no further research.

However, in post-Spitzer Wall Street, there is a new game in town and it's called a quota system. Brokerage firms are now required to have a certain percentage of sell ratings. While this is meant to prevent future abuses, it actually increases the operating costs of brokerage firms and, possibly more damaging, regretful research on firms that previously had no coverage.




Regretful research is the result of analysts trying to increase their number of sells (to keep up with their quota) by finding some small/micro-cap firm and doing a brief report on why it is not a good investment. The method and motivation behind this research is regretful because it may not be in depth, stemming from a desire to meet the quota rather than a commitment to providing investment information. The unlucky company used to fulfill the sell quota could be in the early stages of improving profitability and may be a great long-term investment, but the superficial sell rating assigned to it will taint it and keep investors away because it is likely to be the only research on that company.

Conclusion - The Bottom Line
Investors want to know more about stocks that can go up and not so much about stocks that might go down. To meet this demand, analysts spend more time looking for stocks that will go up than analyzing stocks that may or will go down. This market dynamic can be summed up by two classic Wall Street sayings:
• An analyst is only as good as their last idea.
• A stock can be bought many times but sold only once.
The quota system may do more harm than good because it encourages research that, regretfully, may not present an accurate analysis of a company's investment potential.

Evaluating Retained Earnings: What Gets Kept Counts

When sizing up a company's fundamentals, investors need to look at how much capital is kept from shareholders. Making profits for shareholders ought to be the main objective for a listed company and, as such, investors tend to pay most attention to reported profits. Sure, profits are important. But what the company does with that money is equally important.

Typically, a portion of the profit is distributed to shareholders in the form of a dividend. What gets left over is called retained earnings or retained capital. Savvy investors should look closely at how a company puts retained capital to use and generates a return on it.


The Job of Retained Earnings
In broad terms, capital retained is used to maintain existing operations or to increase sales and profits by growing the business.

Life can be hard for some companies - such as those in manufacturing - that have to spend a large chunk of profits on new plants and equipment just to maintain existing operations. Decent returns for even the most patient investors can be elusive. For those forced to constantly repair and replace costly machinery, retained capital tends to be slim.

Some companies need large amounts of new capital just to keep running. Others, however, can use the capital to grow. When you invest in a company, you should make it your priority to know how much capital the company appears to need and whether management has a track record of providing shareholders with a good return on that capital.

Retained Earnings for Growth
If it has any chance of growing, a company must be able to retain earnings and invest them in business ventures that, in turn, can generate more earnings. In other words, a company that aims to grow must be able to put its money to work, just like any investor. Say you earn $10,000 each year and put it away in a cookie jar on top of your refrigerator. You will have $100,000 after 10 years. However, if you earn $10,000 and invest it in a stock earning 10% compounded annually, then you will have $159,000 after 10 years.

Retained earnings should boost company value and, in turn, boost the value of the amount of money you invest into it. The trouble is that most companies use their retained earnings for maintaining the status quo. If a company can use its retained earnings to produce above-average returns, then it is better off keeping those earnings instead of paying them out to shareholders.

Determining the Return on Retained Earnings
Fortunately, for companies with at least several years of historical performance, there is a fairly simple way to gauge how well management employs retained capital. Simply compare the total amount of profit per share retained by a company over a given period of time against the change in profit per share over that same period of time.

For example, if Company A earns 25 cents a share in 1993 and $1.35 a share in 2003, then per-share earnings rose by $1.10. From 1993 through 2003, Company A earned a total of $7.50 per share. Of the $7.50, Company A paid out $2 in dividends, and therefore had a retained earnings of $5.50 a share. Since the company's earnings per share in 2003 is $1.35, we know the $5.50 in retained earnings produced $1.10 in additional income for 2003. Company A's management earned a return of 20% ($1.10 divided by $5.50) in 2003 on the $5.50 a share in retained earnings.

When evaluating the return on retained earnings, you need to determine whether it's worth it for a company to keep its profits. If a company reinvests retained capital and doesn't enjoy significant growth, investors would probably be better served if the board of directors declared a dividend.

Evaluating Retained Earnings by Market Value
Another way to evaluate the effectiveness of management in its use of retained capital is to measure how much market value has been added by the company's retention of capital. Suppose shares of Company A were trading at $10 in 1993, and in 2003 they traded at $20. Thus, $5.50 cents per share of retained capital produced $10 per share of increased market value. In other words, for every $1 retained by management, $1.82 ($10 divided by $5.50) of market value was created. Impressive market value gains mean that investors can trust management to extract value from capital retained by the business.

Conclusion
For stable companies with long operating histories, measuring the ability of management to employ retained capital profitably is relatively straightforward. Before buying, investors need to ask themselves not only whether a company can make profits, but whether management can be trusted to generate growth with those profits.

Can You Count On Goodwill?


Goodwill is hard to count on because its value can come from abstract and often unreliable things, like ideas and people, neither of which are guaranteed to work for a company forever. Determining goodwill also involves some time to work around accounting conventions. When analyzing company fundamentals, investors should try hard to get a sense of where the value of a company's goodwill is coming from and where it might be going.

What Is Goodwill?
Given its hazy nature, goodwill is designated as an intangible asset. It is a blanket term that represents, in one lump sum, the value of brand names, patents, customer base loyalty, competitive position, R&D and other hard-to-price assets a company might own. It encompasses all the factors above and beyond book value that make investors willing to buy a business.

Hazards of Goodwill in M & A
Investors need to worry about goodwill when a company buys another company and pays more than the fair market value of net assets. Let's say you invest in Thunder Inc. The company has $100 million in cash with no other assets or liabilities, and therefore a book value of $100 million. Now, imagine that Thunder Inc. buys Lightning Inc. for $100. Lightning Inc. has a whole host of different assets with a fair market value of $100 million, liabilities of $50 million and a book value of $50.

Before the deal, Thunderbolt's book value amounted to $100 million. Post-purchase, Thunderbolt emerges with $100 million in assets and $50 million in liabilities, which means its book value (assets minus liabilities) is just $50 million. Here is where the goodwill accounting convention makes its appearance. Goodwill is the amount over and above the fair market value of Lightning's net assets. To account for the purchase price of $100 million, a total of $50 million worth of goodwill will be tacked onto Thunderbolt's balance sheet.
The Equity Risk Premium - Part 1


In theory, stocks should provide a greater return than safe investments like Treasury bonds. The difference is called the equity risk premium: it is the excess return that you can expect from the overall market above a risk-free return. There is vigorous debate among experts about the method employed to calculate the equity premium and, of course, the resulting answer. In this article, we take a look at these methods - particularly the popular supply-side model - and the debates surrounding equity premium estimates.

Why Does it Matter?
The equity premium helps to set portfolio return expectations and determine asset allocation policy. A higher premium, for instance, implies that you would invest a greater share of your portfolio into stocks. Also, the capital asset pricing relates a stock's expected return to the equity premium: a stock that is riskier than the market - as measured by its beta - should offer excess return above the equity premium.


Greater Expectations
Compared to bonds, we expect extra return from stocks due to the following risks:
1. Dividends can fluctuate, unlike predictable bond coupon payments.
2. When it comes to corporate earnings, bond holders have a prior claim while common stock holders have a residual claim.
3. Stock returns tend to be more volatile (although this is less true the longer the holding period).
And history validates theory. If you are willing to consider holding periods of at least 10 or 15 years, U.S. stocks have outperformed treasuries over any such interval in the last 200 years.

But history is one thing, and what we really want to know is tomorrow's equity premium. Specifically, how much extra above a safe investment should we expect for the stock market going forward? Academic studies tend to arrive at lower equity risk premium estimations - in the neighborhood of 2-3%, or even lower! Later in this article, we'll explain why this is always the conclusion of an academic study, whereas money managers often point to recent history and arrive at higher estimations of premiums.

Getting at the Premium
Here are the four ways to estimate the future equity risk premium:



What a range of outcomes! Opinion surveys naturally produce optimistic estimates, as do extrapolations of recent market returns. But extrapolation is a dangerous business: first, it depends on the time horizon selected, and second, we cannot know that history will repeat itself. Professor William Goetzmann of Yale has cautioned, "History, after all, is a series of accidents; the existence of the time series since 1926 might itself be an accident." For example, one widely accepted historical accident concerns the abnormally low long-term returns to bondholders that started right after World War II (and subsequently low bond returns increased the observed equity premium); bond returns were low in part because bond buyers in the 1940s and 1950s - misunderstanding government monetary policy - clearly did not anticipate inflation.

Building a Supply Side Model
Let's review the most popular approach, which is to build a supply-side model. There are three steps:
1. Estimate the expected total return on stocks.
2. Estimate the expected risk-free return (bond).
3. Find the difference: expected return on stocks minus risk-free return equals the equity risk premium.
We'll keep it simple and sidestep a few technical issues. Specifically, we are looking at expected returns that are long-term, real, compound and pre-tax. By long-term, we mean something like 10 years, as short horizons raise questions of market timing. (That is, it is understood that markets will be over or under-valued in the short run.) By 'real', we mean net of inflation. Even if we estimated the stock and bond returns in nominal terms, inflation would fall out of the subtraction anyhow. And by 'compound', we mean to ignore the ancient question of whether forecasted returns ought to be calculated as arithmetic or geometric (time-weighed) averages.

Finally, although it is convenient to refer to pre-tax returns as do virtually all academic studies, individual investors should care about after-tax returns. Taxes make a difference. Let's say the risk-free rate is 3% and the expected equity premium is 4%; we therefore expect equity returns of 7%. Say we earn the risk-free rate entirely in bond coupons taxed at ordinary income tax rates of 35%, whereas equities may be deferred entirely into a capital gains rate of 15% (i.e., no dividends). The after-tax picture in this case makes equities look even better.


Step One: Estimate the Expected Total Return on Stocks
Dividend-Based Approach
The two leading supply-side approaches start with either dividends or earnings. The dividend-based approach says that returns are a function of dividends and their future growth. Consider an example with a single stock that today is priced at $100, pays a constant 3% dividend yield (dividend per share divided by stock price), but for which we also expect the dividend - in dollar terms - to grow at 5% per year.





In this example, you can see that if we grow the dividend at 5% per year and insist on a constant dividend yield, the stock price must go up 5% per year too. The key assumption is that the stock price is fixed as multiple of the dividend. If you like to think in terms of P/E ratios, it is the equivalent to assuming that 5% earnings growth and a fixed P/E multiple must push the stock price up 5% per year. At the end of five years, our 3% dividend yield naturally gives us a 3% return ($19.14 if the dividends are reinvested). And the growth in dividends has pushed the stock price to $127.63, which gives us an additional 5% return. Together, we get a total return of 8%.

That's the idea behind the dividend-based approach: the dividend yield (%) plus the expected growth in dividends (%) equals the expected total return (%). In formulaic terms, it is just a re-working of the Gordon Growth Model, which says that the fair price of a stock (P) is a function of the dividend per share (D), growth in the dividend (g) and the required or expected rate of return (k):



Earnings-Based Approach
Another approach looks at the price-to-earnings (P/E) ratio and its reciprocal: the earnings yield (earnings per share ÷ stock price). The idea is that the market's expected long-run real return is equal to the current earnings yield. For example, at the end of 2003, the P/E for the S&P 500 was almost 25. This theory says that the expected return is equal to the earnings yield of 4% (1 ÷ 25 = 4%). If that seems low, remember it's a real return. Add a rate of inflation to get a nominal return.

Here is the math that gets you the earnings-based approach:




Whereas the dividend-based approach explicitly adds a growth factor, growth is implicit to the earnings model. It assumes the P/E multiple already impounds future growth. For example, if a company has a 4% earnings yield but doesn't pay dividends, then the model assumes the earnings are profitably reinvested at 4%.

Even experts disagree here. Some "rev up" the earnings model on the idea that, at higher P/E multiples, companies can use high-priced equity to make progressively more profitable investments. Arnott and Bernstein - authors of perhaps the definitive study - prefer the dividend approach precisely for the opposite reason. They show that, as companies grow, the retained earnings they often opt to reinvest result in only sub-par returns - in other words, the retained earnings should have instead been distributed as dividends.
Handle with Care
Let's remember that the equity premium refers to a long-term estimate for the entire market of publicly-traded stocks. Lately several studies have cautioned that we should expect a fairly conservative premium in the future. There are two reasons why academic studies, regardless of when they are conducted, are certain to produce low equity risk premiums. The first is that they make an assumption that the market is correctly valued. In both the dividend-based approach and earnings-based approach, the dividend yield and earnings yield have reciprocal valuation multiples:



Both models assume that the valuation multiples - the price-to-dividend and P/E ratio - are correct in the present and will not change going forward. This is understandable, for what else can these models do? It is notoriously difficult to predict an expansion or contraction of the market's valuation multiple. The earnings model might forecast 4% based on a P/E ratio of 25. And earnings may grow at 4%, but if the P/E multiple expands to, say, 30 in the next year, then the total market return will be 25%, where multiple expansion alone contributes 20%! (30/25 -1 = +20%)

The second reason low equity premiums tend to characterize academic estimates is that the total market growth is limited over the long-term. You'll recall that we have a factor for dividend growth in the dividend-based approach. Academic studies assume that dividend growth for the overall market - and, for that matter, earnings or EPS growth - cannot exceed the total economy's growth over the long term. If the economy - as measured by gross domestic product (GDP) or national income - grows at 4%, then studies assume that markets cannot collectively outpace this growth rate. Therefore, if you start with an assumption that the market's current valuation is approximately correct and you set the economy's growth as a limit on long-term dividend growth (or earnings or earnings per share growth), a real equity premium of 4 or 5% is pretty much impossible to exceed.

Conclusion
Now that we have explored the risk premium models and their challenges, it is time to look at them with actual data. This we do in the second part of this series. The first step is to find a reasonable range of expected equity returns; step two is to deduct a risk-free rate of return and; and step three is to try to arrive at a reasonable equity risk premium.
ROA on the Way


Sure, it's interesting to know the size of a company. Each year Fortune Magazine publishes a list of the 500 biggest companies by asset base. But ranking companies by the size of their assets is rather meaningless unless one knows how well those assets are put to work for investors.


As the name implies, return on assets (ROA) gauges how efficiently a company can squeeze profit from its assets, regardless of size. A high ROA is a telltale sign of solid financial and operational performance.

Calculating ROA
The simplest way to determine ROA is to take net income reported for a period and divide that by total assets. To get total assets, calculate the average of the beginning and ending asset values for the same time period.
ROA = Net Income/Total Assets

Some analysts take earnings before interest and taxation, and divide over total assets:
ROA = EBIT/Total Assets

This is a pure measure of the efficiency of a company in generating returns from its assets, without being affected by management financing decisions.

Either way, the result is reported as a percentage rate of return. An ROA of, say, 20% means that the company produces $1.00 of profit for every $5.00 it has invested in its assets. You can see that ROA gives a quick indication of whether the business is continuing to earn an increasing profit on each dollar of investment. Investors expect that good management will strive to increase the ROA - to extract greater profit from every dollar of assets at its disposal.

A falling ROA is a sure sign of trouble around the corner, especially for growth companies. Striving for sales growth often means major upfront investments in assets, including accounts receivables, inventories, production equipment and facilities. A decline in demand can leave an organization high and dry, and overinvested in assets it cannot sell to pay its bills. The result can be financial disaster.

ROA Hurdles
Expressed as a percentage, ROA identifies the rate of return needed to determine whether investing in a company makes sense. Measured against common hurdle rates like the interest rate on debt and cost of capital, ROA tells investors whether the company's performance stacks up.

Compare ROA to the interest rates companies pay on their debts: if a company is squeezing out less from its investments than what it's paying to finance those investments, that's not a positive sign. By contrast, an ROA that is better than the cost of debt means that the company is pocketing the difference.

Similarly, investors can weigh ROA against the company's cost of capital to get a sense of realized returns on the company's growth plans. A company that embarks on expansions or acquisitions that create shareholder value should achieve an ROA that exceeds the costs of capital; otherwise, those projects are likely not worth pursuing. Moreover, it's important that investors ask how a company's ROA compares to those of its competitors and to the industry average.

Getting Behind ROA
There is another, much more informative way to calculate ROA. If we treat ROA as a ratio of net profits over total assets, then two telling factors determine the final figure: net profit margin (net income divided by revenue) and asset turnover (revenues divided by average total assets).

If return on assets is increasing, then either net income is increasing or average total assets are decreasing.
ROA = (Net Income/Revenue) X (Revenues/Average Total Assets)
A company can arrive at a high ROA either by boosting its profit margin or, more efficiently, by using its assets to increase sales. Say a company has an ROA of 24%. Investors can determine whether that ROA is driven by, say, a profit margin of 6% and asset turnover of 4 times, or a profit margin of 12% and an asset turnover of 2 times. By knowing what's typical in the company's industry, investors can determine whether or not a company is performing up to par.



This also helps clarify the different strategic paths companies may pursue - whether a low-margin, high-volume producer or a high-margin, low-volume competitor.

ROA also resolves a major shortcoming of return on equity (ROE). ROE is arguably the most widely used profitability metric, but many investors quickly recognize that it doesn't tell you if a company has excessive debt or is using debt to drive returns. Investors can get around that conundrum by using ROA instead. The ROA denominator - total assets - includes liabilities like debt (remember total assets = liabilities + shareholder equity). Consequently, everything else being equal, the lower the debt, the higher the ROA.

A Couple of Things to Watch For
Still, ROA is far from being the ideal investment evaluation tool. There are a couple of reasons why it can't always be trusted. For starters, the 'return' numerator of net income is suspect (as always), given the deficiencies of accrual-based earnings and the use of managed earnings.

Also, since the assets in question are the sort that are valued on the balance sheet - namely, fixed assets and not intangible assets like people or ideas - ROA is not always useful for comparing one company against another. Some companies are 'lighter', having their value based on things such as trademarks, brand names and patents, which accounting rules don't recognize as assets. A software maker, for instance, will have far fewer assets on the balance sheet than a car maker. As a result, the software company's assets will be understated, and its ROA may get a questionable boost.

Conclusion
ROA gives investors a reliable picture of management's ability to pull profits from the assets and projects into which it chooses to invest. The metric also provides a good line of sight into net margins and asset turnover - two key performance drivers. ROA makes the job of fundamental analysis easier, helping investors recognize good stock opportunities and minimizing the likelihood of unpleasant surprises.

Z Marks the End

How do you know when a company is at risk of corporate collapse? To detect any signs of looming bankruptcy, investors calculate and analyze all kinds of financial ratios: working capital, profitability, debt levels and liquidity. The trouble is, each ratio is unique and tells a different story about a firm's financial health. At times they can even appear to contradict each other. Having to rely on a bunch of individual ratios, the investor may find it confusing and difficult to know when a stock is going to the wall.

In a bid to resolve this conundrum, NYU Professor Edward Altman introduced the Z-score formula in the late 1960s. Rather than search for a single best ratio, Altman built a model that distills five key performance ratios into a single score. As it turns out, the Z-score gives investors a pretty good snapshot of corporate financial health.


The Z-score Formula
Here is the formula (for manufacturing firms), which is built out of the five weighted financial ratios:
Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:
Z = score
A = Working Capital/Total Assets
B = Retained Earnings/Total Assets
C = Earnings Before Interest & Tax/Total Assets
D = Market Value of Equity/Total Liabilities
E = Sales/Total Assets
Strictly speaking, the lower the score, the higher are the odds of bankruptcy. A Z-score of lower than 1.8 indicates that the company is heading for bankruptcy. Companies with scores above 3 are unlikely to enter bankruptcy. scores in between 1.8 and 3 lie in a gray area.

Breaking Down the Z
Now that we know the formula, it's helpful to examine why these particular ratios are included. Let's take a look at the significance of each one:
• Working capital/total assets (WC/TA) is a ratio that is a good test for corporate distress. A firm with negative working capital is likely to experience problems meeting its short-term obligations - because there are simply not enough current assets to cover them. By contrast, a firm with significantly positive working capital rarely has trouble paying its bills.
• Retained earnings/total assets (RE/TA) measures the amount of reinvested earnings or losses, which reflects the extent of the company's leverage. Companies with low RE/TA are financing capital expenditure through borrowings rather than through retained earnings. Companies with high RE/TA suggest a history of profitability and the ability to stand up to a bad year of losses.
• Earnings before interest and tax/total assets (EBIT/TA ) is a version of return on assets (ROA), an effective way of assessing a firm's ability to squeeze profits from its assets before factors like interest and tax are deducted.
• Market value of equity/total liabilities (ME/TL) is a ratio that shows - if a firm were to become insolvent - how much the company's market value would decline before liabilities exceed assets on the financial statements. This ratio adds a market value dimension to the model that isn't based on pure fundamentals. In other words, a durable market capitalization can be interpreted as the market's confidence in the company's solid financial position.
• Sales/total assets (S/TA) tells investors how well management handles competition and how efficiently the firm uses assets to generate sales. Failure to grow market share translates into a low or falling S/TA.



WorldCom Test
To demonstrate the power of the Z-score, let's look at how it holds up with a tricky test case. Consider the infamous collapse of telecommunications giant WorldCom. Declared bankrupt in July 2002, WorldCom lost investors more than $100 billion in value after management falsely recorded billions of dollars as capital expenditures rather than operating costs.

Here we calculate Z-scores for WorldCom using annual 10-K financial reports for years ending December 31 1999, 2000 and 2001. Indeed, WorldCom's Z-score suffered a sharp fall. Also note that the Z-score moved from the gray area into the danger zone in 2000 and 2001, before declaring bankruptcy in 2002.
Input Financial Ratio 1999 2000 2001
X1 Working capital/ Total Assets -0.09 -0.08 0
X2 Retained earnings/Total Assets -0.02 0.03 0.04
X3 EBIT/Total Assets .09 .08 .02
X4 Market Value/Total Liabilities 3.7 1.2 .50
X5 Sales/Total Assets 0.51 0.42 0.3
Z-score 2.5 1.4 .85

But WorldCom management cooked the books, inflating the company's earnings and assets in the financial statements. What impact do these shenanigans have on the Z-score? Overstated earnings likely increase the EBIT/total assets ratio in the Z-score model, but overstated assets would actually shrink three of the other ratios with total assets in the denominator. So the overall impact of the false accounting on the company's Z-score is likely to be downward.

Where Z Falls Short
Alas, the Z-score is not perfect and needs to be calculated and interpreted with care. For starters, the Z-score is not immune to false accounting practices. As WorldCom demonstrates, companies in trouble may be tempted to misrepresent financials. The Z-score is only as accurate as the data that goes into it.

The Z-score also isn't much use for new companies with little or no earnings. These companies, regardless of their financial health, will score low. Moreover, the Z-score doesn't address the issue of cash flows directly, only hinting at it through the use of the net working capital-to-asset ratio. After all, it takes cash to pay the bills.

Finally, Z-scores can swing from quarter to quarter when a company records one-time write-offs. These can change the final score, suggesting that a company that's really not at risk is on the brink of bankruptcy.

Conclusion
To keep an eye on their investments, investors should consider checking their companies' Z-score on a regular basis. A deteriorating Z-score can signal trouble ahead and provide a simpler conclusion than the mass of ratios. Given its shortcomings, the Z is probably better used as a gauge of relative financial health rather than as a predictor. Arguably, it's best to use the model as a quick check of financial health, but if the score indicates a problem, it's a good idea to conduct a more detailed analysis.


Retirement Plan Tax Forms You May Need to File - Part 1


In most cases, the only way to receive the proper tax treatment for your income, including income you receive as a distribution from your retirement plan or education savings account (ESA), is by filing the proper forms. In fact, failure to file the appropriate form could result in you paying more taxes than you owe or owing the IRS an excise penalty. In this two-part series we give an overview of some important forms you should know about.

IRS Form 5329
Form 5329, entit

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Source: http://www.articletrader.com ]]> http://www.articletrader.com/business/topics-on-stock-trading-part-3.html http://www.articletrader.com/business/topics-on-stock-trading-part-3.html Wed, 06 Dec 2006 00:00:00 -0600

EPS manipulation might be the second oldest profession, but there is a relatively easy way for investors to protect themselves. This article will show you how to evaluate the quality of any kind of EPS, whether it's GAAP, pro forma, or otherwise.

Overview
The evaluation of earnings per share should be a relatively straightforward process, but thanks to the magic of accounting, it has become a game of smoke and mirrors, accompanied by constantly mutating versions that seem to have come out of Alice in Wonderland. Instead of Tweedle-dee and Tweedle-dum we have pro forma EPS and EBITDA. And, despite rumors to the contrary, the whisper number - the cheshire cat of Wall Street - continues to exist as guidance.

To be fair, this situation cannot be totally blamed on management. Wall Street deserves as much blame due to its myopic focus on the near-term and knee-jerk reactions to one-cent misses. A forecast is always only a guess - nothing more, nothing less - but Wall Street often forgets this. This, however, does create opportunities for investors who can evaluate the quality of earnings over the long run and take advantage of market overreactions.


EPS Quality
High-quality EPS means that the number is a relatively true representation of what the company actually earned (i.e. cash generated). I use the word 'relatively' because while evaluating EPS cuts through a lot of the accounting gimmicks, it does not totally eliminate the risk that the financial statements are misrepresented. While it is becoming harder to manipulate the statement of cash flows, it can still be done.

A low-quality EPS number does not accurately portray what the company earned. GAAP EPS (earnings reported according to generally accepted accounting principals) may meet the letter of the law but may not truly reflect the earnings of the company. Sometimes GAAP requirements may be to blame for this discrepancy; other times it is due to choices made by management. In either case, a reported number that does not portray the real earnings of the company can mislead investors into making bad investment decisions.

How to Evaluate the Quality of EPS
The best way to evaluate quality is to compare operating cash flow per share to reported EPS. While this is an easy calculation to make, the required information is often not provided until months after results are announced, when the company files its 10-K or 10-Q with the SEC.

To determine earnings quality, I rely on operating cash flow. The company can show a positive earnings on the income statement while also bearing a negative cash flow. This is not a good situation to be in for a long time, because it means that the company has to borrow money to keep operating. And at some point, the bank will stop lending and want to be repaid. A negative cash flow also indicates that there is a fundamental operating problem: either inventory is not selling or receivables are not getting collected. 'Cash is king' is one of the few real truisms on Wall Street, and companies that don't generate cash are not around for long. Want proof? Just look at how many of the dotcom wonders survived!

If operating cash flow per share (operating cash flow divided by the number of shares used to calculate EPS) is greater than reported EPS, earnings are of a high quality because the company is generating more cash than is reported on the income statement. Reported (GAAP) earnings, therefore, understate the profitability of the company.

If operating cash flow per share is less than reported EPS, it means that the company is generating less cash than is represented by reported EPS. In this case, EPS is of low quality because it does not reflect the negative operating results of the company and overstates what I feel are the true (cash) operating results.

An Example
Let's say that Behemoth Software (BS for short) reported that its GAAP EPS was $1.00. Assume that this number was derived by following GAAP and that management did not fudge its books. And assume further that this number indicates an impressive growth rate of 20%. In most markets, investors would buy this stock.

However, if BS's operating cash flow per share were a negative $0.50, it would indicate that the company really lost $0.50 of cash per share versus the reported $1.00. This means that there was a gap of $1.50 between the GAAP EPS and actual cash per share generated by operations. A red flag should alert investors that they need to do more research to determine the cause and duration of the shortfall. The $0.50 negative cash flow per share would have to be financed in some way, such as borrowing from a bank, issuing stock, or selling assets. These activities would be reflected in another section of the cash flow statement.

If BS's operating cash flow per share were $1.50, this would indicate that reported EPS was of high quality because actual cash that BS generated was $0.50 more than was reported under GAAP. A company that can consistently generate growing operating cash flows that are greater than GAAP earnings may be a rarity, but it is generally a very good investment.




Trends Are Also Important
Because a negative cash flow may not necessarily be illegitimate, investors should analyze the trend of both reported EPS and operating cash flow per share (or net income and operating cash flow) in relation to industry trends. It is possible that an entire industry may generate negative operating cash flow due to cyclical causes. Operating cash flows may be negative also because of the company's need to invest in marketing, information systems and R&D. In these cases, the company is sacrificing near-term profitability for longer-term growth.

Evaluating trends will also help you spot the worst case scenario, which occurs when a company reports increasingly negative operating cash flow and increasing GAAP EPS. As discussed above, there may be legitimate reasons for this discrepancy (economic cycles, need to invest for future growth), but if the company is to survive, the discrepancy cannot last long. The appearance of growing GAAP EPS even thought the company is actually losing money can mislead investors. This is why investors should evaluate the legitimacy of a growing GAAP by analyzing the trend in debt levels, times interest earned, days sales outstanding and inventory turnover.

The Bottom Line
Without question, cash is king on Wall Street, and companies that generate a growing stream of operating cash flow per share are better investments than companies that post increased GAAP EPS growth and negative operating cash flow per share. The ideal situation occurs when operating cash flow per share exceeds GAAP EPS. The worst situation occurs when a company is constantly using cash (causing a negative operating cash flow) while showing positive GAAP EPS. Luckily, it is relatively easy for investors to evaluate the situation.

Cyclical Versus Non-Cyclical Stocks


Investors cannot control the cycles of the economy, but they can adjust their investing practices with its ebbs and flows. Adjusting to economic transitions requires an understanding of how industries are characterized by their relationship to the economy. It's important for you to know the fundamental difference between cyclical and non-cyclical companies so that you can distinguish between sectors that are affected by economic changes and those that are more immune. Here we look at the industries that reside within these categories, and identify where it's best to put your money when the economy starts to decline.


What Does Cyclical and Non-Cyclical Mean?
These terms, cyclical and non-cyclical, refer to how highly correlated a company's share price is to economic fluctuations. Non-cyclical stocks repeatedly outperform the market when economic growth slows, while cyclical companies are highly correlated to the economy. The non-cyclical securities, also called defensive stocks, experience profit regardless of economic gyrations because they produce or distribute goods and services we always need: food, power, water and gas. The sales of companies with cyclical stocks, on the other hand, depend on whether or not the economy is strong; sales will thrive when people have extra income to spend on luxuries, and they'll decline when the economy slumps.

The Concept
The difference between cyclical and non-cyclical industries is simply the difference between necessity and luxury. There are certain items we can't live without and won't likely cut back on even when times are tough. The stocks of companies producing these things are non-cyclical and are "defended" against the effects of economic downturn, providing great places to invest when the economic outlook is sour. For example, household non-durable goods - a fancy term for the things you use up quickly around the house - such as toothpaste, soap, shampoo and dish detergent may not seem like essentials, but you can't really sacrifice them. Most people don't feel they can wait until next year to lather up with soap in the shower.

Contrast this to the new car you've had your eye on. Although it's more exciting to buy a new car than soap, you are more likely to postpone the car for a year or two if your finances feel the effects of an economic slump. Another good example of a cyclical industry is fine dining. When things are good people are more inclined to take the family out for an expensive meal; macaroni and cheese, on the other hand, has to suffice when finances are depressed. Other examples of cyclical industries are manufacturing, the steel industry, travel and construction - the sectors that produce things we can live without when money is tight. These are exactly the types of industries you want to avoid when the economy turns sour.

Charting a Cyclical vs. Non-Cyclical Company
Below is a chart showing the performance of a highly cyclical company, the Ford Motor Co. (blue line), and a classic non-cyclical company, Florida Public Utilities Co. (red line). This chart clearly demonstrates how each company's share price reacts to downturns in the economy.




Notice that the downturn in the economy from 2000 to 2002 drastically reduced Ford's share price, whereas the growth of Florida Public Utilities' share price hardly batted an eye at the slowdown.





Non-Cyclical Industries - Safety in Turbulent Times
Let's look more closely at examples of non-cyclical industries so that you know where to start looking when a recession is on the horizon.
Utilities
An excellent example of a non-cyclical industry is utilities, which can help investors avoid losses when highly cyclical companies are suffering. For instance, selling your Caterpillar stock and buying a share in, say, Minnesota Power Inc. is a type of maneuver that investors have used for years during economic downturns. If times become tough, there's not much money for building projects, so construction companies are less likely to purchase heavy machinery. But, no matter what, people's top priority will always be to have power and heat for themselves and their families. By providing a service that is consistently used, utility companies grow conservatively and do not fluctuate dramatically - these companies provide safety, but this also means they are not going to skyrocket when the economy experiences growth.

Household Non-Durables
As we mentioned before, people will always need certain essentials around the house. From deodorant to bleach, we can't really sacrifice the things that keep us and our living spaces clean. For this reason, companies such as Procter & Gamble, Colgate-Palmolive and the Gillette Co. are all attractive investment choices when the economy is in the dumps.

Tobacco
It is easy to see why tobacco companies are considered non-cyclical: it's hard for smokers to stop smoking, even during a recession. So a company such as British American Tobacco will exhibit more stability during these times. Even though tobacco is considered a "sin" industry and may be unethical for some investors, it does have the characteristics of a non-cyclical sector.

Conclusion
Learning how to predict economic cycles is not within the scope of this article, but simply realizing that different industries respond differently to economic fluctuations can help keep your money safe. When the economy cools off, the cyclical companies will be hit the hardest, so seek out stable companies that produce things you can't live without.
Move over P/E, Make Way for the PEG


It is common practice for investors to use the price-to-earnings ratio (P/E ratio) to determine if a company is over or undervalued. There are, however, many extreme cases of stocks trading at 10,000 or more times their earnings - these kinds of situations affect the ratio's accuracy for assessing a company. The companies with a high P/E ratio are typically startup companies with little or no revenues; however, a high P/E does not necessarily mean the stock isn't a good buy for the long term.


Let's take a closer look at what the P/E ratio tells us:
P/E Ratio = Market Value per Share



Earnings per Share (EPS)


There are two primary components here, the market value (price) of the stock and the earnings of the company.

Earnings are very important to consider. After all, earnings represent profits, for what every business strives. Earnings are calculated by taking the hard figures into account: revenue, cost of goods sold (COGS), salaries, rent, etc. These are all important to the livelihood of a company. If the company isn't using its resources effectively it will not have positive earnings, and problems will eventually arise.

Besides earnings, there are other factors that affect the value of a stock. For example:
• Brand - The name of a product or company has value. Brands such as McDonald's, Microsoft and General Motors are worth billions.
• Human Capital - Now more than ever, a company's employees and their expertise are thought to add value to the company. It's about time!
• Expectations - The stock market is forward looking. You buy a stock because of high expectations for strong profits, not because of past achievements.
• Barriers To Entry - For a company to be successful in the long run, it must have strategies to keep competitors from entering the industry. Coca-Cola, for example, has built a very extensive distribution channel--anybody can make pop, but getting that product to the market like Coke does, is very costly.

All these factors will affect a company's earnings growth rate. Because the P/E ratio uses past earnings, it gives a less accurate reflection of these growth potentials.

The relationship between the price/earnings ratio and earnings growth tells a much more complete story than the P/E on its own. This is called the PEG ratio and is formulated as:
PEG Ratio = Price/Earnings Ratio


Annual EPS Growth*


*The number used for annual growth rate can vary. It can be forward (predicted growth) or trailing, and either a one- to five-year time span. Check with the source providing the PEG ratio to see what kind of number they use.


Looking at the value of PEG of companies is just like looking at the P/E ratio: a lower PEG means that the stock is more undervalued.

Let's demonstrate the PEG ratio with an example. Say you are interested in buying stock in one of two companies. The first is a networking company with 50% annual growth in net income and a P/E ratio of 100. The second company is in the beer business. It has lower earnings growth at 24% and its P/E ratio is also relatively low at 12.



Many justify the stock valuations of tech companies by relying on the assumption that these companies have enormous growth potential. Can we do the same in our example?

Networking Company:
P/E ratio (100) divided by the annual earnings growth rate (50) = PEG ratio of 2

Beer Company:
P/E ratio (12) divided by the annual earnings growth rate (24) = PEG ratio of .5

The PEG ratio shows us the sexier high-tech company, compared to the beer company, doesn't have the growth rate to justify its higher P/E.

Take Microsoft as another example. At time of writing it had a P/E of 37 and an expected earnings growth next year of 9.6%, this gives us a PEG 3.86. The S&P 500 has a P/E of 24 and an earnings growth of 14%, this produces a PEG of 1.71. Judging by the PEG ratio, Microsoft is significantly pricier than the S&P 500.

Investors are getting pickier. Many have abandoned the P/E ratio, not because it is worthless, but because they desire more information about a stock's potential. We've realized that the P/E doesn't tell us everything we need to know. Using the P/E along with current growth rates produces the more informative PEG ratio, a great indicator of a stock's potential value.
The Importance of a Profit/Loss Plan




Who needs a profit/loss plan? Isn't investing only about buying low and selling high? It would be nice to always buy at the bottom and sell at the top, but it is nearly impossible to do so consistently. Furthermore, investors are only human: emotions that sway our judgment it is in our nature to hate losing. Taking a loss on a stock, therefore, is not only detrimental to our pocketbooks, but it also hurts our egos. Time and time again investors take profits by selling an investment that has appreciated, but hold onto declining stocks in the hope of a rebound; oftentimes these investments shrivels to a fraction of their previous worth. So how can an investor avoid this type of outcome? One solution is to learn to be a disciplined investor and to adopt a profit/loss plan. In this article, we'll go over this strategy and show you how to use it to stay in the black.


What Is a Profit/Loss Plan?
This plan is a step that many retail investors (and professionals) often overlook. The profit/loss plan is a set of limits that determines the maximum loss or gain an investor will take on a stock. Containing losses is a very important part of a investing, so the profit/loss plan is crucial to a sound strategy.

We all make stock-picking mistakes and most of us have lost money in the stock market - what sets the great investors apart is their ability to recognize their bad choices and use what they've learned to make up for them later. A profit/loss plan helps you recognize your mistakes by allowing you to separate your emotions from investing. If you aren't too zealous about your gains and you see them purely as a means of increasing your cash flows (rather than your ego), you will have a much easier time letting go of your losses and, therefore, controlling them.

Devising Your Plan
Devising a plan may be more difficult than you'd expect. First, you'll need to set the maximum gain you will accept and the maximum loss you will tolerate for your investments, but these maximums and minimums shouldn't necessarily be the same for every stock. For example, a blue chip stock is more unlikely to rise or fall by 10% within any given year as compared to a small-cap growth stock, which will exhibit more volatility. In other words, you must analyze each stock individually to estimate how much it is likely to move in either direction.

Some investors use technical or fundamental analysis or a combination of both to determine appropriate limits for gains and losses. (For an introduction to "technimental analysis", see the article Charting Your Way to Better Returns.) Another way to devise your limits is by modeling your plan on the performance of a designated benchmark such as an index or even on the past performance of your own portfolio.

Another factor you must consider when devising your profit/loss plan is your risk tolerance, which depends on many factors such as your personality, your time frame and your available capital. Typically, people who are risk averse will have tighter boundaries than those of people who don't mind risk. Risk lovers will try to profit as much as possible from a rising stock, but a more conservative investor may sell the stock early on in its rise to eliminate the risk of losses, which would occur if the stock took a quick downward dive. If you prefer to shy away from risks, a profit/loss plan of 10% each way may not be suitable or even realistic for you. On the other hand, if you are willing to take on the added risks associated with potential profits, then a 10% profit/loss might be more appropriate.

Carrying Out Your Plan
Once you've decided on your numbers, whether conservative or aggressive, you have to put the plan into action with as few hitches as possible. Remember, this plan has a double requirement: you have to sell your stocks (1) if they fall to a certain level and (2) if they rise to a certain level.

Now, brokers will not let you enter two different sell orders for the same security so you need to figure out which one you'd rather enter first. It may be wisest to enter orders that first protect your downside: many wise investors use the stop-loss order, which instructs your broker to buy or sell a stock once it has reached a certain price. The stop loss ensures that you won't get burned on a down market, especially if you aren't able to watch it every second. When you enter in your order with your broker, set the stop price at your maximum loss percentage and then sit and wait. If the price ends up appreciating to your upper boundary, just change the price of your stop loss order, which will then activate the immediate sale of your stock.

Staying Disciplined
Once you have your profit/loss strategy in place, you will have to remember that the whole idea of the plan is to establish strict guidelines for when to sell. Sure, it hurts to see a stock continue to rise once you have sold it, but it is often better to sell on the way up than to wait until you have to dump the stock while the price is collapsing after its peak. Jack Kennedy once said, "Only a fool holds out for the top dollar."



Conclusion
Keep in mind that our example figures are generalizations. Devising your plan requires detailed research, analysis, self-assessment and a realistic outlook. Setting a profit limit at 100% (double your money) doesn't make sense if you invest in low-risk companies that grow steadily at 15% per year.

Here are some things to remember:
• A stock that declines 50% means you will need to double your money to get back to even. Controlling losses is the key to sound investing.
• Making mistakes is human nature. Once you realize this, you will find it easier to move on.
• Buying a stock and holding onto it for a very long time doesn't mean you will make money. A buy and hold strategy will work only if you pick the right companies.

The most important part of devising a profit/loss plan is sticking to it!
What Is the "Chinese Wall"?

The term "Chinese Wall" has been used in headlines, but why and what does it mean? This article will define that term, give a little history about it, and discuss why it appears in the news.


The question of analyst objectivity is a big issue, especially in regards to how analysts treat their firm's investment-banking clients and individual ("retail") investors. In other words, if an analyst's employer has a commitment to bring a stock to the market, how objective can that analyst be? Won't they tend to promote the stock in order to get the big bucks?

These are good questions, but the issue is not new. Following the crash of 1929, the government sought to provide a separation between investment bankers and brokerage firms in order to avoid the conflict of interest between objective analysis and the desire to have a successful stock offering. These regulations became known as the "Chinese Wall" because they were meant to create a barrier as effective as the Great Wall of China between the two operations. Most investment/brokerage firms even re-located departments to different floors. This issue received more attention in the wake of dotcom fallout perhaps as people were seeking a scapegoat.

Historically, Wall Street analysts have been paid a combination of a base salary, a percentage based upon trading volume in the stocks that they cover, and a percentage of any investment banking deals with which they are involved. These packages are generally structured to reward good stock picking; however, the potential for ethical conflict is greatest in investment-banking deals.

Ideally, investment bankers involve the firm's analyst early in the process in order to get their opinion of the deal. The analyst will have a better understanding of the client company's industry and is generally better able to determine the viability of the deal. If the analyst does not think that the client company has the fundamental strength to be public, the bankers should drop the deal and move on. If the analyst thinks that the client company has a good business plan and profit potential, the company should go to the Street to raise funds to grow and contribute to the economy.

Generally speaking, we analysts (Reg FD Disclosure: I am a practicing analyst) try to find good investment ideas because we can only succeed if we build a reputation as a good stock picker and forecaster. The cliché that "analysts are only as good as their last idea" is very true. I call this the "invisible hand theory of research" because the desire for long-term success in this industry guides the analyst to focus on finding good stocks rather than to promote the stock du jour.

Henry Blodgett and Mary Meeker typify the dotcom market, and they were involved in the largest deals and got the most airtime. In their defense, I think they tried to rationalize an irrational market. They saw that the market was paying for "new paradigm" stocks and tried to find a way to apply rational valuation techniques to irrational prices.




Were they wrong in what they did? One could argue the following:
• Based on "normal" markets and analytical thought, many of the dotcoms should never have gone public.
• The Street is to blame because they were the ones who "sold" us those bad stocks.
• They should be punished.
But this is based on 20/20 hindsight and ignores the fact that many of us were constantly challenging the "new paradigm" consensus and knew it would just be a matter of time. But we did not get on CNBC as much as the other talking heads because our story was not as "newsworthy."


Despite periodic excesses, the system works. Analysts perform a very crucial role in the markets: transforming data into information for investors to use in their decision making process. We like reading footnotes in company filings and asking management "Colombo-style" questions. We relish in the challenge of finding the next big stock and hope to be paid fairly for our efforts. We know that we are only as good as our last idea and will not consciously jeopardize our reputations.

As in most sectors of life, however, the system functions within the parameters of the current environment, and environments change with time. Excesses do occur, but are generally not recognized as such until after the fact.

I think the current debate is healthy and will be productive if for no other reason than to increase the awareness of the individual investor. "Caveat investor" will be the buzzword for 2001.
Types Of EPS




Gertrude Stein said, "A rose is a rose is a rose," but the same cannot be said about earnings per share (EPS).

While the math may be simple, there are many varieties of EPS being used these days, and investors must understand what each one represents if they're to make informed investment decisions. For example, the EPS announced by the company may differ significantly from what is reported in the financial statements and in the headlines. As a result, a stock may appear over- or undervalued depending on the EPS being used. This article will define some of the varieties of EPS and discuss their pros and cons.

By definition, EPS is net income divided by the number of shares outstanding; however, both the numerator and denominator can change depending on how you define "earnings" and "shares outstanding". Because there are so many ways to define earnings, we will first tackle shares outstanding.


Shares Outstanding
Shares outstanding can be classified as either primary (primary EPS) or fully diluted (diluted EPS).

Primary EPS is calculated using the number of shares that have been issued and held by investors. These are the shares that are currently in the market and can be traded.

Diluted EPS entails a complex calculation that determines how many shares would be outstanding if all exercisable warrants, options, etc. were converted into shares at a point in time, generally the end of a quarter. We prefer diluted EPS because it is a more conservative number that calculates EPS as if all possible shares were issued and outstanding. The number of diluted shares can change as share prices fluctuate (as options fall into/out of the money), but generally the Street assumes the number is fixed as stated in the 10-Q or 10-K.

Companies report both primary and diluted EPS, and the focus is generally on diluted EPS, but investors should not assume this is always the case. Sometimes, diluted and primary EPS are the same because the company does not have any "in-the-money" options, warrants or convertible bonds outstanding. Companies can discuss either, so investors need to be sure which is being used.
Earnings
As has been evident in recent headlines, EPS can be whatever the company wants it to be, depending on assumptions and accounting policies. Corporate spin-doctors focus media attention on the number the company wants in the news, which may or may not be the EPS reported in documents filed with the Securities & Exchange Commission (SEC). Based on a set of assumptions, a company can report a high EPS, which reduces the P/E multiple and makes the stock look undervalued. The EPS reported in the 10Q, however, can result in a much lower EPS and an overvalued stock on a P/E basis. This is why it is critical for investors to read carefully and know what type of earnings is being used in the EPS calculation.

We will focus on five types of EPS and define them in the context of the type of "earnings" being used.

Reported EPS (or GAAP EPS)
We define reported EPS as the number derived from generally accepted accounting principles (GAAP), which are reported in SEC filings. The company derives these earnings according to the accounting guidelines used. (Note: A discussion of how a company can manipulate EPS under GAAP is beyond the scope of this article, but investors should remember that it is possible. Our focus is on how earnings can be distorted even if there is no intent to manipulate results.)

A company's reported earnings can be distorted by GAAP. For example, a one-time gain from the sale of machinery or a subsidiary could be considered as operating income under GAAP and cause EPS to spike. Also, a company could classify a large lump of normal operating expenses as an "unusual charge" which can boost EPS because the "unusual charge" is excluded from calculations. Investors need to read the footnotes in order to decide what factors should be included in "normal" earnings and make adjustments in their own calculations.

Ongoing EPS
This EPS is calculated based upon normalized or ongoing net income and excludes anything that is an unusual one-time event. The goal is to find the stream of earnings from core operations which can be used to forecast future EPS. This can mean excluding a large one-time gain from the sale of equipment as well as an unusual expense. Attempts to determine an EPS using this methodology is also called "pro forma" EPS.

Pro Forma EPS
The words "pro forma" indicate that assumptions were used to derive whatever number is being discussed. Different from reported EPS, pro forma EPS generally excludes some expenses/income that were used in calculating reported earnings. For example, if a company sold a large division, it could, in reporting historical results, exclude the expenses and revenues associated with that unit. This allows for more of an "apples-to-apples" comparison.

Another example of pro forma is a company choosing to exclude some expenses because management feels that the expenses are non-recurring and distort the company's "true" earnings. Non-recurring expenses, however, seem to appear with increasing regularity these days. This raises questions as to whether management knows what it is doing or is trying to build a "rainy day fund" to smooth EPS.

Headline EPS
The headline EPS is the EPS number that is highlighted in the company's press release and picked up in the media. Sometimes it is the pro forma number, but it could also be an EPS number that has been calculated by the analyst/pundit that is discussing the company. Generally, soundbites do not provide enough information to determine which EPS number is being used.

Cash EPS
Cash EPS is operating cash flow (not EBITDA) divided by diluted shares outstanding. We think cash EPS is more important than other EPS numbers because it is a "purer" number. Cash EPS is better because operating cash flow cannot be manipulated as easily as net income and represents real cash earned, calculated by including changes in key asset categories such as receivables and inventories. For example, a company with reported EPS of $0.50 and cash EPS of $1.00 is preferable to a firm with reported EPS of $1.00 and cash EPS of $0.50. Although there are many factors to consider in evaluating these two hypothetical stocks, the company with cash is generally in better financial shape.

Other EPS numbers have overshadowed cash EPS, but we expect it to get more attention because of the new GAAP rule (FAS 142), which allows companies to stop amortizing goodwill. Companies may start talking about "cash EPS" in order to differentiate between pre-FAS 142 and post-FAS 142 results; however, this version of "cash EPS" is more like EBITDA per share and does not factor-in changes in receivables and inventory. Consequently, I think it is not as good as operating-cash-flow EPS, but is better in certain cases than other forms of EPS.

The Bottom Line
Caveat investor (investor beware)! There are many types of EPS being used, and investors need to know what the EPS represents and determine if it is a valid representation of the company's earnings. A stock may look like a great value because it has a low P/E, but that ratio may be based on assumptions with which you may not agree.
The Media as a Lagging Indicator

Have you ever noticed how often today's headlines are really yesterday's news? By the time an event reaches the national consciousness through the media filter, it's almost over. For example:
• In 1987, the movie Wall Street, starring Michael Douglas and Charlie Sheen, was a hit just months before the crash.
• 1987 was never called a "crash" until late 1988, after the market had already started to rally.
• Jeff Bezos was Time's "Man of the Year" in December 1999 - the following year, the dotcom bubble burst.
• The , a short-lived TV show about a baby-boomer brokerage firm, aired November to December 2000 - just before the 2001 meltdown.
Why Is This Important?
In the next few weeks, the media will be filled with so-called news about the recession. Regardless of the fact that this economy has been in a recession since August, the data to "prove" it will not be released until October. While this is old news to the people who have been laid off, it will mark the turning point. Once the media finally uses the "R" word, the economy will probably already be on the mend, so investors should act on buying opportunities.

Another interesting aspect of the media as a lagging indicator is that once a company is featured on the cover of a magazine or in a book, it is time to sell - even though there are exceptions, this is often the case. For example, most of the companies highlighted in In Search of Excellence subsequently under-perform. Al Dunlap and Donald Trump had their day in the spotlight, but they had subsequent challenges.

What This Means for Investors
It also means that to be a successful investor, you need to look for investment ideas where others are not, and you need to buy when others are not. While there is a risk in being first, there is also a risk in being a follower. Being early may mean you have to wait longer than expected for the market to "discover" your stock, but if you have done your homework, value investors just need to wait. Momentum investors like to jump on the bandwagon after it's already started, but their ride may be short, and the momentum may carry them over the cliff.

There are many stocks with solid fundamentals and great investment potential, but the challenge is to find them. Wall Street remains focused on the mega-cap stocks that are mostly yesterday's news and have little left to offer. Luckily, investors can use the Internet to do their own research instead of blindly following Wall Street's recommendations. Thanks to Reg FD, conference calls and other information are now available to individual investors. But investors must learn how to differentiate between hype and analysis and steer clear of misinformation and outright fraud.

Helpful Resources
Fortunately, there are many websites that not only educate investors, but also offer helpful information and analysis. Here are some of my favorites (besides Investopedia, of course):
• researchstock.com (*) - Provides in-depth research on small-cap stocks that are not being followed by Wall Street.
• charthelp - Provides information on technical analysis.
• bigcharts - Current news, charts and decent info on analyst coverage.
• multex - Wall Street research reports (pay per view).
• sec.gov - EDGAR provides access to financial statements.
• AIMR.org - Provides information on analyst objectivity and the rules/regulations that Chartered Financial Analysts follow.
• Nasdaq - Lots of data

New Accounting Rules Could Roil The Markets


FAS 142 is the accounting rule introduced in 2001 that changed how companies treat goodwill. To avoid making bad investment decisions, investors must be aware of this rule's impact on reported earnings. This accounting rule change impacts earnings in two major ways, both of which could give uninformed investors a wrong signal:


1. It generates a one-time boost to EPS that could fool the market into thinking it represents a change in the fundamentals.

2. It provides an incentive to write-off goodwill during the next few quarters, which will further depress weak earnings.

Previously, companies were required to amortize goodwill over a long time (40 years), and this non-cash expense reduced reported (GAAP) EPS. FAS 142 eliminates amortization and institutes an annual impairment test. This article will briefly review the potential impact of these changes on reported earnings. We expect the changes to start impacting earnings by the end of 2001.

EPS Impact: A Potential False Positive
The new accounting change will provide a one-time boost to a company's EPS, which may be misinterpreted by the market as an improvement in the long-term earnings potential of the company, causing the market to move the stock higher. There is also the possibility that the market may react like it does when a company announces a stock split, bidding the shares higher although no change occurs in the fundamental earning power of the company. One Wall Street analyst recently estimated that this change could boost software firms' EPS by 114%.

In reality, however, a company's fundamentals, real earnings potential and cash flows remain unchanged regardless of the new rules. FAS 142 can be viewed as a rule change that occurs in the middle of the game. But because companies are not required to restate historical results, the change will potentially result in significant EPS growth in the first quarter after adoption of the rule. During the next three quarters, while EPS growth will be exaggerated when it is compared to the same quarter of the prior year, sequential EPS growth will fall back to lower ("normal") levels.

After the dismal earnings reported in this year, this sudden acceleration of EPS growth may generate a knee-jerk reaction in the market, causing these shares to rise. Under this scenario, uninformed investors may get caught up in the excitement and could lose money as they chase what they think is strong earnings growth.

Ironically, the companies that may experience the greatest EPS "growth" from this change are the old dotcom darlings. Internet and telco companies whose earnings have evaporated could post significant EPS growth as they eliminate the amortization of the huge amounts of goodwill they accumulated during the heady days when all-stock mergers were done at outrageous multiples. Hopefully these companies will resist the temptation to use this as an opportunity to generate renewed interest in their tired shares.

Impairment Hell: Another Blow to Already Weak Earnings
The one-time charge offs that may be forthcoming during the next two quarters will further depress already weak earnings. FAS 142 requires companies to evaluate goodwill annually in light of expected value (an impairment test). It also requires companies to charge off goodwill if it is impaired (i.e. the appraised value is less than the value recorded on the books).

Companies have a year after adoption of FAS 142 to perform the impairment test and charge off impaired goodwill, but the rule provides incentives to bite the bullet during the first fiscal quarter after adoption:
• If the charge is made in the company's first fiscal quarter, no restatement is required and the charge is treated as an extraordinary item (does not impact net income because it is recorded below the net income line).
• Charge-offs made after the first quarter of the fiscal year will require restatement of preceding financial statements.
• Charges made after the first year will be treated as operating expenses and will reduce net income.
Consequently, it behooves a company to bite the bullet and take the charge in their first quarter in an attempt to avoid a hit to earnings and the cost of restatements.

Another factor that could accelerate impairment charge-offs is that current market valuations are significantly below the prices paid for the acquisitions a few years ago. The opportunity to "clean house" at the start of the new year, as well as complying with the new rules, could result in very large charge-offs.

A current example of this impairment risk is Enron. In its 10Q filing on 11/19/01, Enron disclosed that it "might be forced to take a $700 million pre-tax charge to earnings…due to a drop in the value of some of its assets" (The Wall Street Journal, Nov 21, 2001, page A4). While FAS 142 is not specifically cited as the sole reason for the write-off, and we have not been able to contact management for a clarification, this does sound like an "impairment event".





How the market will react to this additional bad news is unknown, but we see two possible outcomes. On one hand, the combination of dismal economic data, weak earnings and FAS 142 charge-offs could result in a grand sell-off as investors perform their year-end tax selling. On the other hand, the news that companies are cleaning house may provide some good news for bulls in a very bearish market.

The Impact of FAS 142 Should Be Felt During the Next Earnings Season
The impact of FAS 142 should be revealed as companies report year-end results next spring. While most of the larger companies have fiscal years that are calendar years, there are a number of companies with non-calendar fiscal years that will report FAS 142 results later this year and early 2002. This should provide a good indication of how FAS 142 will impact results and how the market will react.

The Bottom Line
Artificially inflated earnings growth and large asset charge-offs could negate each other as well as cause stock volatility. In any event, investors will need to dig even deeper into financial statements to fully understand a stock's long-term earning potential. Investors should also guard themselves against being fooled by an inefficient market and those companies that will do whatever it takes to generate spin for their shares.
Theme Investing: Mega-Trends and Market Psychology

Investing has always been a little like surfing. Successful investors spot key investment themes (waves) and ride them to profits. Sometimes the waves are shorter and smaller than we had expected. Other times the wave takes on a mind of its own and falls under its own weight. The hardest but most profitable thing to do is to be the lone rider of a wave that others have abandoned for the "next best thing", and then wait for them to catch up. The key is to know when to get on and when to get off. Previous examples of trend investing include defense stocks during the second World War, oil stocks in the '70s, and of course, the dotcoms.


Spotting the Trends
How do you spot the next wave? You need to step back from the daily noise of the market and look at the long term - we're talking years, not weeks. You need to look for the long-term forces that will propel some stocks and draw money from other sectors. In the early- and mid-1990s the focus was on demographic trends and the graying of the baby boomers. In the second half of the 1990s, it was the Internet.

Demographics and the Internet also illustrate how long-term trends fall in and out of favor. Both seemed to peter out eventually. The profit potential of investing in companies that benefit from the graying of the baby boomers was the focus of many investors at one time, but it was overshadowed by the Internet, obscured by market psychology that tends to focus on the current hot theme.

The events of September 11th, for example, caused a major reallocation of money into sectors that benefit from rebuilding our infrastructure and making our society safer from attack. Prior to September 11th, the market was focused on telco inventory corrections and old dotcom names; the market lacked any new ideas to sell to investors. After the attacks, the spotlight turned to security and defense stocks. While many of these previously unnoticed stocks had potential, many did not have any. A blind rush to buy any stock with a "security theme" could have resulted in another bubble.

Funds moved out of the old favorites into new hot sectors. These significant changes in investment policy represented a reaction to a key event, much like the reallocation that occurred in mid-1990 as investors were drawn to the promise of Internet stocks. The demand for increased security represented a long-term structural and psychological change that provided a potential boost for stocks in that sector. The effects on insurance, airlines and brokerages reflected near-term concerns for profits as institutional investors raised cash to reallocate funds to security stocks. Other long-term trends remained intact, but market psychology tends to focus the Street's attention on one or two sectors at any one time.



There are three key things to remember:

1. Differentiate between knee-jerk reactions and fundamental structural changes.

2. Don't sell to avoid short-term losses. If you have decided that a sector/stock is a good long-term buy, don't try to avoid a short-term loss with panic selling. If a sector is falling, individual investors will not get the best prices, so it is better to stay put. You have a better chance of getting the stock cheap by buying when everyone else is selling.

3. Stick with your game plan, but be vigilant for major structural changes. Demographic stocks may be a better buy today because we are all six years older, but a smarter investment would be airport security stocks with solid fundamentals. You, of course, need to do your homework before investing.

The Great Gap

Wall Street is myopically focused on a minority of large-cap stocks, leaving the majority of stocks under-followed and undervalued. Wall Street is focused on the big caps because that's where the investment banking (and big profits) are. Small/micro/nano-cap stocks (however you want to classify them) with solid fundamentals and great investment potential have been left to languish without a way to get their story to individual investors. Our research indicates that stocks in this under-followed sector are undervalued by 20-40%. The challenge for investors is to find reliable sources of information on these "undiscovered" stocks.

Why Is Wall Street Focused on a Small Number of Big-Cap Stocks?
Wall Street has become focused on a very small number of big-cap stocks because that's where the money is and because mergers eliminated independent regional brokerage firms that used to support small-cap stocks. Investment banking now drives profitability, and the bigger deals have the biggest margins. At one time, trading desks generated reasonable profits, but regulatory changes and competition narrowed spreads to miniscule levels. As a consequence, brokerages make a market in only the most liquid stocks (which are also big-cap names) in order to generate enough volume to justify their existence. With every investment banker vying for the same deal, research coverage has become a lemmings' market with everybody following the same stocks.

Merger activity eliminated small regional brokerage firms that provided financial support to small-cap stocks. These regional brokerage houses provided investment banking, market-making, and research coverage to companies in their market area. This provided small-cap firms with access to capital and a growing shareholder base. As larger brokerage houses and banks acquired these smaller firms, however, their activities were redirected to the large-cap sector. Companies that do not meet a specific market cap or do not have the potential to yield a sizable investment banking deal are being dropped from coverage lists.

To prove this, we analyzed the Baseline database to compare market cap and analyst coverage (all data is as of Jan 5, 2001). Baseline has almost 10,400 stocks in its database and contains the stocks in all the major indexes as well as ones suggested by the Baseline subscribers who are analysts and portfolio managers. Because part of the database consists of stocks recommended by individual input, it also provides a perspective on what is deemed interesting by the users.

As shown in Figure 1, an average of less than two analysts cover each of the 4,890 stocks with less than $500 million in market cap. In contrast, an average of 25 analysts cover each of the 10 companies with a market cap of $200 billion or more.


Figure 1

More noteworthy is the fact that of the 4,890 companies with under $500 million in market cap, 32% (1,558) are not followed by anybody. Figure 2 shows how the lack of attention declines as market cap increases.




Figure 2

Here is one final fact about the dearth of attention paid to micro/nano-cap stocks (under $1 billion in market cap): of the 5,578 stocks with $1 billion or less in market cap (about 54% of the total database), an amazing 53% have zero to one analysts following the stock.


Figure 3

Believe it or not, the figures in this analysis are overstated, meaning that coverage is even less than presented. This overstatement is caused by situations in which an analyst maintains coverage but changes firms (duplicating analyst coverage) and/or assistants are included in the data (multiple analysts from one firm).

Why Look at Small/Micro Cap Stocks?
If the pros are focusing on the big caps, why should you look elsewhere? The reason is value. Granted, some of the companies at this end of the food chain may not warrant any attention. But we have found many companies with solid fundamentals that are undervalued simply because investors are not aware of them. The table below contains a few examples of "undiscovered" stocks that were found to be extremely undervalued by the acquiring company.



This is the bottom line: there are numerous stocks that are undervalued just because they do not receive research coverage, but other companies are finding them and paying significant premiums for the stock.

To summarize, Wall Street is focused on a small number of stocks for the following reasons:
1. Trading margins have shrunk, forcing firms to trade only the more liquid (big-cap) stocks.

2. Investment banking drives profitability and the biggest profits lie with the biggest deals.

3. Mergers and acquisitions have eliminated small regional firms that used to support stocks as they grew from micro-cap to mid-cap.

This created an information gap between investors and the large number of good companies without research coverage. Bridging this gap are firms that provide fee-based research; however, there are also other players who are attempting to manipulate stocks by using promotional pieces disguised as professional research. Investors need to know how to differentiate between the good, the bad and the ugly.



What Investors Need to Know
Investors must differentiate between substance and hype. Here, listed in order of importance, are some questions to ask to ensure you are reading professional fee-based research:
1. What is the nature of the relationship between the company and the analyst?
The nature of the relationship should be clearly disclosed in the report. A disclosure statement is required by SEC regulations and is usually found at the end of the report (and in small type). Information as to what, if anything, has been paid for the report is usually placed in the middle or end of the small type. If you cannot find a disclosure statement, beware. If the nature of the payment is not disclosed, and the report has not come from a known brokerage or investment-banking firm, beware.

Compensation Structure
A fixed-fee relationship is preferable to one in which the analyst is paid in some form of equity (stock, warrants or stock options) and/or contains a bonus if the stock appreciates. The absence of an "equity kicker" significantly decreases the risk that the writer is hyping the stock to maximize his or her income. A fixed-fee relationship also indicates that the information source should be a more reliable source of information for the investor, at least during the term of the engagement. Generally, a fixed-fee relationship will require the research firm to cover at least a one year period and call for the issuance of quarterly reports on a timely basis. In contrast, "pump and dump" shops will write on a company only as long as it will take to achieve their schemes.

Does Compensation Adversely Impact the Analyst's Objectivity?
Generally speaking, professional analysts are only as good as their last idea. To be successful, analysts must build their credibility one good stock at a time. This "invisible hand" forces professional analysts to focus their efforts on finding and promoting the best investment ideas and developing a reputation as being a source of good information.

Wall Street research used to be viewed as objective because there were no fees paid by the company being researched; however, now there is increasing debate as to how objective a Wall Street analyst can be. The reason for this is that analyst compensation packages generally consist of a base salary, a percentage of the investment banking deals in which they are involved, and a percentage of the trading volume generated by their research coverage. With this arrangement, it is no wonder that investors are beginning to question Wall Street's objectivity.

So now this question emerges: how objective can fee-based research be when they are being paid directly by the company being analyzed? Our research has found that many users (buy-side, sell-side and individual investors) feel that fee-based research is more objective because the compensation is fixed and not dependent upon investment banking deals or stock trades.

Our conclusion is that the best determination of objectivity is the quality of the research.

2. What is the Quality of the Research?
Readers need to judge the tone and content of a research report. A "report" that is full of promotional language and sparse on details is a hype piece and should not be used in making investment decisions. This is a type of fiction that talks about how the stock will "rocket" to new highs and how the author "guarantees" a huge return on your investment.

Beware if the word "guarantee" is used anywhere in a report - nothing is ever guaranteed.

What an Objective Research Report Should Contain
A professional research report provides a balanced view by discussing a firm's competitive advantages, providing an overview of the prospects/challenges facing the company and the industry, analyzing operating results against a relevant peer group, and providing earnings estimates based upon clearly-stated assumptions. The "G" word (guarantee) is never used. The report does deal with assumptions and expectations with which the reader may disagree, but they are presented for consideration.

Continuous Coverage
Due to the significant amount of time and effort required to initiate research coverage on a stock, the analyst is making a long-term commitment to following the company and the industry. Consequently, professional objective coverage usually means that the writer has a long-term commitment and will therefore be a reliable source of information for a long time. This is in contrast to others who will issue "reports" until they have achieved their pump and dump goals.

3. What Are the Author's Credentials?
The report should indicate the author's experience and background. A professional research report clearly identifies the writer and his or her contact information so that you can investigate the author and his/her firm. If not, beware.

Credentials may not always determine who is a better analyst, but they do indicate a person's desire to reach a certain level of competency. An analyst who has 20 years of experience but does not have an MBA could be a better stock picker than a newly minted MBA. But having an MBA or CFA generally indicates that the analyst has attained a certain level of knowledge.

The Chartered Financial Analyst, or CFA, designation is a key credential. The Charter is issued by CFA Institute, which is an international society of financial professionals. To achieve the designation, one must pass a series of three six-hour exams (held once a year) that tests your knowledge of ethics, government regulations, economics, accounting, stock and bond analysis, and portfolio management. Not having a CFA does not necessarily mean that the writer is not a competent analyst, and having a CFA does not necessarily make one an expert stock picker. But it does signify that the person has passed a series of difficult and demanding tests and has proven a mastery over a body of financial knowledge. More importantly, however, the CFA charter indicates its holder has a commitment to a high standard of ethical and professional standards.



Summary
Fee-based research is a useful way to bridge the gap between companies and investors looking for new ideas and undervalued stocks; however, both parties must be aware of the differences between an objective research report and a hype piece designed to manipulate a stock's price. Likewise, under-followed companies need to find reputable independent research firms to reach the growing number of individual investors who are making their own investment decisions.
What Is A Small Cap?


The meanings of "big cap" and "small cap" are generally understood by their names: big-cap stocks are shares of larger companies and small-cap stocks are shares of smaller companies. Labels like these, however, are often misleading. If you don't realize how big "small-cap" stocks have become, you'll miss some good investment opportunities.

Small-cap stocks are often cited as good investments due to their low valuations and potential to grow into big-cap stocks, but the definition of small cap has changed over time. What was considered a big-cap stock in 1980 is a small-cap stock today. This article will define the "caps" and provide additional information that will help investors understand terms that are often taken for granted.


First, we need to define "cap", which refers to market capitalization and is calculated by multiplying the price of a stock by the number of shares outstanding. Generally speaking, this represents the market's estimate of the "value" of the company; however, it should be noted that while this is the common conception of market capitalization, to calculate the total market value of a company, you actually need to add the market value of any of the company's publicly traded bonds.

Big-cap stocks refer to the largest publicly traded companies like General Electric (NYSE: GE) and IBM (NYSE: IBM). These are also called the blue chip stocks. "Big" has also been believed to have less risk while "small" has implied more risk, but, as evidenced by Enron (NYSE: ENE), this is not a good assumption to make. It is true, however, that the bigger they are, the harder they fall.

The definition of big/large cap and small cap differ slightly between the brokerage houses and have changed over time. The differences between the brokerage definitions are relatively superficial and only matter for the companies that lie on the edges. The classification is important for borderline companies because mutual funds use it to determine which stocks to buy.

The current approximate definitions are as follows:

Big Cap - Market cap of $10 billion and greater
Mid Cap - $2 billion to $10 billion
Small Cap - $300 million to $2 billion
Micro Cap - $50 million to $300 million
Nano Cap - Under $50 million

These categories have increased over time along with the market indexes. In the early 1980s, a big-cap stock had a market cap of $1 billion. Today that size is viewed as small. It remains to be seen if these definitions also deflate when the market does.
The big-cap stocks get most of Wall Street's attention because that is where the lucrative investment banking business is. These, however, represent a very small minority of publicly traded stocks. The majority of stocks are found in the smaller classifications, and this is where the values are. To prove this we examined Baseline's database of 10,721 stocks and found that 88% of the stocks were in the smaller classifications. Note the new category that shows how big "big" has become.
Mega Cap: 10 0.1% (over $200 billion)
Big Cap: 374 3.5%
Mid Cap: 794 7.4%
Small Cap: 1888 17.6%
Micro Cap: 2015 18.8%
Nano Cap: 1699 15.8%




The big and small labels are also attached to the major stock exchanges and indexes, which also leads to confusion. The Dow Jones Industrial Index is viewed as consisting of only big-cap stocks while the Nasdaq is often viewed as being comprised of small-cap stocks. These perceptions were generally true prior to 1990, but have since changed. Since the tech boom, the market caps of the stock exchanges and indexes vary and overlap. The average market cap for the Dow, however, remains much larger than the average market cap for the Nasdaq 100.

Conclusion
Here are some main points to keep in mind:
• Labels such as big and small are subjective, relative and change over time.
• Big does not always mean less risky, but the big caps are the stocks most closely followed by Wall Street analysts.
• This attention, however, generally means that there are no value plays in the big-cap arena.
EBITDA: The Good, the Bad, and the Ugly



EBI

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Source: http://www.articletrader.com ]]> http://www.articletrader.com/business/stocks-part-3.html http://www.articletrader.com/business/stocks-part-3.html Wed, 06 Dec 2006 00:00:00 -0600
There are some very important phrases that investors need to recognize as major red flags. Filings made to the Securities & Exchange Commission (SEC) and legal boilerplates often do more to obscure than disclose, but, by being able to recognize a few key phrases, the casual reader will be alert to some very important information that will help him or her avoid investment mistakes. One of these key phrases is "material adverse effect".


Material Adverse Effect Defined
A material adverse effect (MAE) statement is very important because it is a clear signal to investors that there is something very wrong. This phrase usually signals a severe decline in profitability and/or the possibility that the company may not be able to remain in business. In other words, the Grim Reaper is in the building and the FBI is probably not far behind.

For example, let's say Industrial Blowdart Inc. has a major customer that represents 75% of annual sales. If that client took its business elsewhere, the decision would have a material adverse impact on Blowdart's sales, profitability and ability to stay in business. The company's MAE might read as follows:

"One customer accounts for over 70% of our annual sales. If we lost this customer's business, the loss would have a material adverse effect on Blowdart's profits and ability to remain in business."

Another example would be if Blowdart has a critical line of credit that it uses to finance working capital (i.e. inventory or accounts receivable). If the bank refuses to renew the line of credit, the inability to find another lender would have a material adverse impact on Blowdart's ability to stay in business because the company would run out of money.

While most of this sounds like common sense, what is defined as "material" and what constitutes "adverse" are in the eye of the beholder. Generally accepted accounting principles allow flexibility in determining what must be defined and disclosed as a material adverse event. Despite SEC action in 1999 and the increased scrutiny that companies are currently under, many continue to use their own definitions in order to manage earnings.

Materiality: If It Matters, It's Material
A piece of information is material if it is reasonable to expect that disclosure of that information will impact the company's stock price. Or, if you prefer the legalistic definition, information is material if "it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item" (source: Financial Accounting Standards Board).


Despite the fact that common sense would determine materiality, companies and their accountants continue to find many ways to manage earnings by coming up with their own definitions of materiality. Generally, this involves establishing a numerical threshold, say 5%, and deciding that anything that has less than 5% impact on the bottom line is immaterial and thus does not require discussion. There are also cases where companies, in order to hide their mistakes, netted items against each other to keep below their numerical threshold. The reason for this subterfuge is, of course, earnings management.

For example, from 1991 to 1995, WR Grace used a $60 million "reserve" of supposedly immaterial items to smooth earnings, and the company's outside auditors knew about it (according to the SEC). They used the numerical threshold to stay within GAAP's gaps.

Many companies today continue to net so-called immaterial items in order to hit earnings targets. While we won't mention any names (AMZN), the netting takes place in the Other Income/Expense line of the income statement. Items that are used to net are gains/losses on investments and restructuring reserves.

In 1999, the SEC attempted to prevent companies from hiding material items by establishing the following rules:
• An intentional misstatement, even if it involves an immaterial amount, is material because of the intent to mislead.
• Numerical thresholds alone are unacceptable.
• Management must also weigh qualitative matters if the misstatement will hide a change in earnings or concerns a key business segment.
• The company cannot net items netting results in a misstatement of the company's financial statement.

Not Usually an Early Warning Signal
MAEs are not early warning signals, but rather signs that a situation has already deteriorated to a very bad stage. Usually they're the result of an accumulation of events over time that compound to a point where a critical limit is crossed. Closely following a company's operating results over time will alert investors to potential MAEs, but this kind of awareness requires a great deal of effort, time and experience.

Assume, for example, that as the result of the 2001-2002 recession, Blowdart's financial condition has deteriorated to the point where it is in default of its loan covenants. This is a typical material adverse event because it means that, if the company and the bank cannot agree on how to restructure the loan, Blowdart could go out of business.

If you followed Blowdart stock, you would know that it was having problems. But, you would have also had to dig through the SEC filings to find the loan agreements and then read those boring things in order to find the key operating ratios.

It is very possible that Blowdart and their bankers can restructure the loans and get the company through the difficult times. After all, that's what bankers are supposed to do, right? On the other hand, if the bank wants to exit the relationship, Blowdart needs to find another lender, which may not be easy to do because of the company's recent operating history and/or current economic conditions.

In this hypothetical situation, investors would need to review this stock in light of their own risk aversion profile (which determines the degree to which owning this stock keep you up at night). While the outcome might even be 60/40 in favor of a successful loan renegotiation, you may not want to deal with the added risk. If so, sell the stock. But you may have studied the company and industry closely and feel that there are some strong fundamental reasons for owning the stock for the long term.

Where to Look for MAE Statements
The MAE phrase can be found in several places because government regulations require companies to disclose material events:
• In the footnotes to SEC filings (10Qs and 10Ks) relating to the issue that could cause the MAE. This is the most likely place to look (and another reason to read the footnotes first). In the first example noted above, the MAE statement would appear in Blowdart's footnote that discusses accounts receivables or customer concentration. In the second example it would be found in the footnote related to financing and loans payable.
• Press releases sometimes also contain an MAE phrase if the release deals with financing issues or if the company is announcing a material event.
• Management's Discussion and Analysis (MD&A) should contain some reference to the MAE, but generally it does not. Companies put the MD&A upfront to highlight the good stuff and hide the bad stuff in the footnotes.
Conclusion
It is unreasonable to require companies to discuss every business detail in the financial statements. Heck, those things are too long and hard to read already. There is a need to find a balance between required disclosures and onerous reporting burdens. Perhaps the best advice that corporations should use is that more information is always better. Erring on the side of "over disclosure" - something that investors should value more than the illusion of steady earnings - will enhance corporate credibility

When Insiders Buy, Should Investors Join Them?

Tips for beating the market tend to come and go quickly, but one has held up extremely well: if executives, directors or others with inside knowledge of a public company are buying or selling shares, investors should consider doing the same thing. Indeed, much research shows that insider trading activity is a valuable barometer of broad shifts in market and sector sentiment. But, before chasing each insider move, outsiders need to consider the factors that dictate the timing of trades and the factors that conceal the motivations.


Reasons to Follow
The argument for shadowing insiders makes a lot of sense. Executives and directors have the most up-to-date information on their company's prospects. Intimately acquainted with cyclical trends, order flow, supply and production bottlenecks, costs and other key ingredients of business success, these insiders are way ahead of analysts and portfolio managers, not to mention individual investors. Insiders' decisions - legal or not - to trade in their own company's stock are certainly worth examining.

Research supports the view that insider information works best in the aggregate. Independent research firm Market Profile Theorem (MPT) showed that insider trading trends signal an up-and-coming shift in market sentiment. To identify trends, MPT analysts employ the Brooks Ratio, which divides total insider sales of a company by total insider trades (purchases and sales) and then averages this ratio for 2,500 stocks. If the average Brooks Ratio is less than 40%, the market outlook is bullish; above 60% signals a bearish outlook.

University of Michigan finance professor Nejat Seyhun, author of "Investment Intelligence from Insider Trading", offers a similar story. Stock prices rise more after insiders' net purchases than after net sales. On the whole, insiders do earn profits from their legal trading activities, and their returns are greater than those of the overall market.

The Stories behind the Signals
Surges in insider trading appear to divine an upcoming switch in the market's direction. But outside investors have to be awfully careful about reading positive messages into every insider buy they see. Nor should investors treat individual sales as signals to unload their own holdings. Admittedly, one big insider buy or sell order might offer investors a hint of things to come, but it hardly translates into a sure-fire pointer for outperforming the market.

More companies require newly appointed executives and directors to own shares. As market indicators, these required purchases are irrelevant to outside investors. Other companies encourage ownership by providing stock loans to executives for half the purchase price. These are examples of the company taking steps to align the interests of management and shareholders. While certainly commendable, these transactions do not provide reason for outsiders to buy stock.

Sometimes an insider will announce a stock buy just to get Wall Street's attention, but announcing is not the same as doing. Healtheon founder Jim Clark once proclaimed that he intended to buy as much as $100 million worth of the company stock. Healtheon shares surged the day of the announcement, but Clark didn't buy anywhere near as much as he had suggested. The stock quickly declined, and those who followed his lead got burned.

Although they may buy their company's stock because they expect good things to come, insiders do not sell simply because they think their company shares are about to sink in value. Insiders sell for all kinds of reasons. They might want to diversity their holdings, distribute stock to investors, pay for a divorce or take a well-earned trip to Mustique.

Another big problem with using insider data on specific companies is that executives sometimes misread company prospects. Some insiders may buy even as share prices collapse. Far from being the first to jump ship, Nortel Network executives and directors bought Nortel stock several times since before the stock plunged by 90%. When insiders do correctly assess their companies' share, it can be a matter of luck as much as anything else.



Employee stock options, which compose an ever-larger portion of executives' compensation, can make analysis tricky. Remember this: if the insider is exercising stock options by buying the stock, it is not very meaningful if the options were granted at rock-bottom prices. At the same time, when buying through the exercise of their options, executives do not have to disclose this. Outsiders can really only guess how much "real" buying is taking place.

Tips for Using Insider Data
Investors should consider the following guidelines when analyzing specific insider trading situations:
• Some insiders are better than others - Directors know less about a company's outlook than executives. Key executives are the CEO and CFO. People running the company know the most about where it is heading.
• A lot of trading is better than a little - One or two insiders at a big corporation do not make a trend. Three or more provide a better indication that something is happening. Generally speaking, solitary trades are unreliable.
• People at small companies know more - At small and mid-sized companies, virtually all insiders are privy to company financials. At big corporations, information is more dispersed and typically only the core management team has the big picture.
• Stay the course - Evidence suggests that insiders tend to act far in advance of expected news. They do this in part to avoid the appearance of illegal insider trading. A study by academics at Pennsylvania State and Michigan State contends that insider activity precedes specific company news by as long as two years before the disclosure of the news.

Conclusion
Here is the upshot: insider tracking is not easy, and it is hardly a guarantee of big returns. A pattern of trades might offer a cue for upcoming market shifts, and it is certainly reassuring to buy or sell a stock knowing that an insider is doing the same thing. Following the lead of insiders, however, will never replace diligent research

"Widow And Orphan Stocks": Do They Still Exist?


In the past, the term "widows and orphans" was used to describe stocks with a relatively high degree of safety and dividend income. Because they had relatively minimal risk and provided income to feed the family, these kinds of stocks were literally thought to be the only investments suitable for widows and orphans. The term is noteworthy because it was generally used during market bottoms, but today it means something different.


A widow-and-orphan stock was the blue chip stock of its day: the stock of a large well-known firm that was thought to have an unassailable market leadership position and that paid a "good" dividend. This term was generally applied to utility stocks (electric, gas and telephones). Utilities are often referred to as widow-and-orphan stocks because of their monopoly (or, if you prefer, government-mandated market leadership) and dividend yield. Banks were excluded from this class as the result of their involvement in the bubble and crash of 1929. It was not until several years after the government-instituted regulations like the Glass-Steagall Act, which separated investment banking and "regular" commercial banking, that "widows and orphans" was again applied to commercial banks. Depending on the business cycle, the term was also applied to railroad and auto stocks.

While the need for safety and income of widows and orphans has not changed, the market and companies did. Stocks that were once viewed as a safe haven for very risk-averse investors changed either because the company's business strategy changed or the market changed. A good example is AT&T.

Despite many challenges, AT&T remained an archetypal widow-and-orphan stock for a long time. To use current terminology, it was the first to market and dominate its competitors until it became a de-facto monopoly. But times changed, and in the 1970s the government forced AT&T to break itself up into the Baby Bells. The breakup created competition, but AT&T continued to be viewed as a widow-and-orphan stock because, based upon its market position and dividend, it was perceived as a relatively safe investment.

In the late 1990s, AT&T changed and was no longer a widow-and-orphan stock, although many did not realize this. The change was wrought by the combination of a significant market transformation and a modification in the company's strategy. In the dotcom market, "telephone" and "telecommunications" became "telcos" as the phone companies morphed into new-age Internet stocks. The combination of government deregulation and technological advances increased competition, and the number of LECs, CLECs and telcos increased as entrepreneurs entered the market to provide commodity communication services. All of this threatened AT&T's dominant position.

In response to the change in the marketplace, AT&T changed. Management decided that it had to modify its strategy for the company to survive. They made acquisitions that altered the basic nature of the company, most notably the acquisition of Telecommunications Inc. (TCI). The acquisition of TCI can be viewed as the beginning of the end because it signaled that AT&T was no longer "your father's phone company" but an Internet firm focusing on the convergence of telco and cable services.

This change, if noted, went largely unreported. After all, who wanted safety in the late 1990s? Investors wanted dotcoms, not widow-and-orphan stocks, because all stocks rose at 20% per year, and AT&T was no exception. Despite the change from a safe utility to a highly-risky dotcom, AT&T was still viewed as a safe stock by many long-time holders. But today, in the wake of the dotcom bust, few would call AT&T a widow-and-orphan stock.

Usage of the term "widows and orphans" seems to mirror the market. Ignored during bull markets and resurfacing in bear markets, the term regained usage during the 1970s, following the "Nifty 50" bull market of the 1960s. While these blue-chip stocks may have suffered from the economic downturn, their reliable dividend was enough to earn them the title of widow-and-orphan stock. Investors could, despite the business risk, find some degree of safety in the dividend income.


But this time may be different. Historically, widow-and-orphan stocks provided investors a safe harbor from business risk. Today investors seek refuge from an additional menace: credibility risk. This risk results from the frequent reported occurrences of corporate executives using creative accounting to cook the books, a technique these executives use to achieve profit goals and "earn" their big bonuses. Even if there are companies that seem to have credibility, can an investor ever be sure? Many of the respected big-cap stocks of the late 1990s are now discredited in retrospect, and their restated operating results almost make it seem like the economic boom was really a result of creative accounting. How can any stock be called safe enough for widows and orphans if there is the risk that the books are being cooked?

Perhaps it is time to redefine the terms "widows" and "orphans". Individual investors have been "widowed" by Wall Street, which, by following only big-cap, highly liquid stocks, has shifted its focus to serving the needs of institutional investors. "Orphan" stocks now are small-cap stocks (under $500 million in market capitalization) that have been abandoned by Wall Street, not because they are bad investments, but because they do not provide investment banking opportunities. Many of these orphan stocks are good investments because they have solid balance sheets, growing earnings, and sometimes a healthy dividend. But because Wall Street ignores them, investors remain unaware of these investment opportunities. A contemporary usage of widows and orphans may refer to small-cap stocks with solid fundamentals. These stocks pose relatively less credibility risk because management is more focused on the business rather than cooking the books.

We can reunite these widowed investors and orphaned stocks, but it will require new ways of thinking both on the part of investors and the companies of orphaned stocks. Investors must realize that they need to take more responsibility in doing their own research and looking at many sources of information (not just research reports) in order to make good investment decisions. In addition, the executives of orphaned stocks must take the initiative to get their information to the market of widows. These new channels of information distribution include webcasts and unbiased fee-based research.


The Hidden Value of Intangibles

What can explain the runaway success of an initial public offering from a company with no earnings history? On the other hand, why can a bit of bad news or an earnings report that just misses market expectations send a healthy company's share price into a nosedive?

When the market ignores a company's historical financial performance, the market is often responding to "information asymmetry". The asymmetry occurs because traditional financial reporting methods - audited financial reports, analyst reports, press releases and the like - disclose only a fraction of the information that is relevant to investors. The value of intangible assets - research and development (R&D), patents, copyrights, customer lists and brand equity - represents a large part of that information gap.


Any business professor will tell you that the value of companies has been shifting markedly from tangible assets, "bricks and mortar", to intangible assets like intellectual capital. These invisible assets are the key drivers of shareholder value in the knowledge economy, but accounting rules do not acknowledge this shift in the valuation of companies. Statements prepared under generally accepted accounting principles do not record these assets. Left in the dark, investors must rely largely on guesswork to judge the accuracy of a company's value.

A study comparing market value to the book value of 3,500 U.S. companies over a period of two decades shows the dramatic upward rise in intangible value. In 1978, market value and book value were pretty much matched: book value was 95% of market value. Twenty years on, book value was just 28% of market value. Lev Baruch, an accounting professor at New York University's Stern School of Business, reckons that in the late 1990s businesses invested a staggering $1 trillion per year in intangible assets.

Accounting rules have not kept pace. For instance, if the R&D efforts of a pharmaceuticals company create a new drug that passes clinical trials, the value of that development is not found in the financial statements. It doesn't show up until sales are actually made, which could be several years down the road. Or consider the value of an e-commerce retailer. Arguably, almost all of its value comes from software development and copyrights and its user base. While the market reacts immediately to clinical trial results or online retailers' customer churn, these assets slip through financial statements.

There is a serious disconnection between what happens in capital markets and what accounting systems reflect. Accounting value is based on the historical costs of equipment and inventory, whereas market value comes from expectations about a company's future cash flow, which comes in large part from intangibles such as R&D efforts, patents and good ol' workforce "know-how".

Investors' jumpiness about valuation hardly comes as a surprise. Imagine investing in a company with $2 billion market capitalization but with revenues to date of only $100 million. You would probably suspect that there is a big grey area in the valuation picture. Perhaps you would turn to analysts to supply missing information. But analysts' metrics help only so much. Rumor and innuendo, PR and the press, speculation and hype tend to fill the information space.



In order to better milk their patents and brands, many companies do measure their worth. But these numbers are rarely available for public consumption. Even when used internally, they can be troublesome. Miscalculating the future cash flows generated from a patent, say, could prompt a management team to build a factory that it cannot afford.

To be sure, investors could benefit from financial reporting that includes improved disclosure. Already a dozen or so countries, including the U.K. and France, allow recognition of brand as a balance sheet asset. The Financial Accounting Standards Board is currently involved in a study to determine whether or not it should require intangibles on the balance sheet. However, because of the enormous difficulty of actually valuing intangibles and the big risk of inaccurate measurements or surprise write-downs, investors should not expect that decision to come any time soon.

It nevertheless pays for investors to try to get a grip on intangibles. Much accounting research is devoted to coming up with ways of valuing them, and, fortunately, techniques are improving. While opinions on suitable approaches still vary sharply, it is worthwhile for investors to take a look.

Here is a place to start: try calculating the total value of a company's intangible assets. One method is calculated intangible value (CIV). This method overcomes drawbacks of the market-to-book method of valuing intangibles, which simply subtracts a company's book value from its market value and labels the difference. Because it rises and falls with market sentiment, the market-to-book figure cannot give a fixed value of intellectual capital. CIV, on the other hand, examines earnings performance and identifies the assets that produced those earnings. In many cases, CIV also points to the enormity of the unrecorded value.

Using microprocessor giant Intel as an example, CIV goes something like this:
Step 1: Calculate average pre-tax earnings for the past three years. For Intel, that's $9.5 billion.

Step 2: Go to the balance sheet and get the average year-end tangible assets for the same three years, which, in this case, is $37.6 billion.

Step 3: Calculate Intel's return on assets (ROA), by dividing earnings by assets: 25% (nice business to be making chips).

Step 4: For the same three years, find the industry's average ROA. The average for the semiconductor industry is around 11%.

Step 5: Calculate the excess ROA by multiplying the industry average ROA (11%) by the company's tangible assets ($37.6 billion). Subtract that from the pre-tax earnings in step one ($9.5 billion). For Intel, the excess is $5.36 billion. This tells you how much more than the average chip maker Intel earns from its assets.

Step 6: Pay the taxman. Calculate the three-year average income tax rate and multiply this by the excess return. Subtract the result from the excess return to come up with an after-tax number, the premium attributable to intangible assets. For Intel (average tax rate 34%), that figure is $3.53 billion.

Step 7: Calculate the net present value of the premium. Do this by dividing the premium by an appropriate discount rate, such as the company's cost of capital. Using an arbitrary discount rate of 10% yields $35.3 billion.

That's it. The calculated intangible value of Intel's intellectual capital - what doesn't appear on the balance sheet - amounts to a whopping $35.3 billion! Assets that big deserve to see the light of day.


Fee-Based Research: The Good, The Bad And The Ugly

Because it refers to something that bridges the information gap created by Wall Street, fee-based research is a term that investors need to know about. This article will define the term and discuss how to decipher the good from the bad and the ugly.


Defined
Fee-based research is research compiled by an independent research firm that is compensated by the company that is the subject of the report (also referred to as the "subject company"). This research is different from subscription-based research, whereby the reader pays for research reports on a pay-per-view basis or with an annual subscription. And like investors using subscription-based research, investors using fee-based research need to know how to tell the difference between legitimate, objective research and reports written to manipulate stock prices.

The Good
Objective fee-based research plays an increasingly important role in today's market because it provides investors with information that would otherwise not be available. To fully appreciate how important this information service is, we need to review a bit of history.

In the beginning, the research departments of brokerage firms provided research on stocks of all market capitalizations. Wall Street firms tended to follow larger-cap stocks while regional firms followed smaller-cap stocks in their backyards. This allowed small brokerage companies to have access to capital, which allowed the small caps to grow to a point at which they were "discovered" by Wall Street. And investors saw that this was good.

But things changed when deregulation resulted in smaller commissions, shrunken trading spreads and industry consolidation. These events resulted in a smaller number of larger firms, which focused only on big-cap stocks because the big-cap stocks had enough profits to fund research departments. Consequently, thousands of small and micro-cap stocks were orphaned - dropped from research coverage - because they did not provide enough profit potential to the brokerage firm. If a stock did not generate a certain level of trading volume, or if the company did not have the potential for an investment banking deal of a specific amount, the stock was dropped from coverage. This left thousands of companies in the wilderness and unable to convey their story to investors. This was bad, but investors seemed unaware of the change because they were worshipping at the bull market of the late 1990s.

Onto the scene came fee-based research with a mission to bridge the information gap and guide orphaned stocks to the promised land of investor awareness. The independent analyst spends a lot of time and expense preparing fundamental research that is free to investors. In this way, the company's information is made available to the widest possible audience.

The increased need for fee-based research has been recognized by the investment community. In Jan 2002 the National Institute of Investor Relations (NIRI) issued guidelines for the use of fee-based research.

The Bad
The bad thing is that for most of its history, fee-based research has been used to manipulate stock prices. Unscrupulous firms used this "research" and boiler-room operations to pump and dump stocks while supposedly legitimate research was done by Wall Street firms. This resulted in a stereotype that all fee-based research is illegitimate, but while there are still many cases of market manipulation, investors are taking a closer look at fee-based research.

Investors read fee-based research because things changed in 2002. Wall Street research is no longer viewed as legitimate since it has been tainted by investment banking considerations. Realizing that the Street follows a limited number of companies, investors today are more educated and are looking for other sources of information.



The Ugly
The really ugly part of all this is that there are many small-cap companies with good investment potential that remain orphaned because they do not believe that investors give any credibility to fee-based research. They continue to wander in the wilderness, expecting the Street to eventually recognize their worth and start covering their stock.

As these orphaned companies wait for the Street, their competitors are discovering that the orphaned shares are undervalued and acquire the orphan. Based upon our research, the average take-out premium for an orphaned company is about 20%. Had orphaned companies taken the initiative to reach investors by using fee-based research, they probably would not have left so much money on the table.

The Bottom Line
In this brave new world investors are more educated and are looking beyond Wall Street for their information. Legitimate fee-based research is becoming more recognized because it fills the market's need for objective information. The challenge for both investors and small-cap companies is to differentiate between the good and bad independent firms.

Fortunately, there are two good sources of information that will help investors and corporate management spot legitimate fee-based research. The first is an article entitled "Six Signs of an Objective Research Report", in which I detail how a reader can determine the objectivity of a research report.

The other source is the Research Objectivity Standards that have been proposed by the Association for Investment Management and Research (AIMR). These proposed standards detail the process required to issue an objective research report, and they provide the reader with a checklist to use in evaluating any research report. It also provides corporate management a list to use when evaluating the services of independent research firms.





Taking Stock of Discounted Cash Flow

At a time when financial statements are under close scrutiny, the choice of what metric to use for making company valuations has become increasingly important. Wall Street analysts are emphasizing cash flow-based analysis for making judgments about company performance.

A key valuation tool at analysts' disposal is discounted cash flow (DCF) analysis. Analysts use DCF to determine a company's current value according to its estimated future cash flows. Forecasted free cash flows (operating profit + depreciation + amortization of goodwill - capital expenditures - cash taxes - change in working capital) are discounted to a present value using the company's weighted average costs of capital. For investors keen on gaining insights on what drives share value, few tools can rival DCF analysis.

Recent accounting scandals and inappropriate calculation of revenues and capital expenses give DCF new importance. With heightened concerns over the quality of earnings and reliability of standard valuation metrics like P/E ratios, more investors are turning to free cash flow, which offers a more transparent metric for gauging performance than earnings. It is harder to fool the cash register. Developing a DCF model demands a lot more work than simply dividing the share price by earnings or sales. But in return for the effort, investors get a good picture of the key drivers of share value: expected growth in operating earnings, capital efficiency, balance sheet capital structure, cost of equity and debt, and expected duration of growth. An added bonus is that DCF is less likely to be manipulated by aggressive accounting practices.


DCF analysis shows that changes in long-term growth rates have the greatest impact on share valuation. Interest rate changes also make a big difference. Consider the numbers generated by a DCF model offered by Bloomberg Financial Markets. Sun Microsystems, which recently traded on the market at $3.25, is valued at almost $5.50, which makes its price of $3.25 a steal. The model assumes a long-term growth rate of 13.0%. If we cut the growth rate assumption by 25%, Sun's share valuation falls to $3.20. If we raise the growth rate variable by 25%, the shares go up to $7.50. Similarly, raising interest rates by one percentage point pushes the share value to $3.55; a one percent fall in interest rates boosts the value to about $7.70.

Investors can also use the DCF model as a reality check. Instead of trying to come up with a target share price, they can plug in the current share price and, working backwards, calculate how fast the company would need to grow to justify the valuation. The lower the implied growth rate, the better - less growth has therefore already been "priced into" the stock.

Best of all, unlike comparative metrics like P/Es and price-to-sales ratios, DCF produces a bona fide stock value. Because it does not weigh all the inputs included in a DCF model, ratio-based valuation acts more like a beauty contest: stocks are compared to each other rather than judged on intrinsic value. If the companies used as comparisons are all over-priced, the investor can end up holding a stock with a share price ready for a fall. A well-designed DCF model should, by contrast, keep investors out of stocks that look cheap only against expensive peers.

DCF models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Investors must constantly second-guess valuations; the inputs that produce these valuations are always changing and susceptible to error.


Meaningful valuations depend on the user's ability to make solid cash flow projections. While forecasting cash flows more than a few years into the future is difficult, crafting results into eternity (which is a necessary input) is near impossible. A single, unexpected event can immediately make a DCF model obsolete. By guessing at what a decade of cash flow is worth today, most analysts limit their outlook to 10 years. Investors should watch out for DCF models that are taken to ridiculous lengths. Samantha Gleave, a London-based analyst with Credit Suisse First Boston, published a DCF model for Eurotunnel that runs through 2085!

These are not the only problems. With its focus on long-range investing, the DCF model isn't suited for short-term investments. A model that shows that Sun Microsystems is worth $5.50 does not mean that it will trade for that any time soon; furthermore, over-reliance on DCF can cause investors to overlook unusual opportunities. DCF can prevent investors from buying into a market bubble. DCF can also prompt investors to sell, which might mean they miss those big share price run-ups that can be so profitable (provided the shares are sold at the peak).

Don't base your decision to buy a stock solely on discounted cash flow analysis. It is a moving target, full of challenges. If the company fails to meet financial performance expectations, if one of its big customers jumps to a competitor, or if interest rates take an unexpected turn, the model's numbers have to be re-run. Any time expectations change, the DCF-generated value is going to change.

Here is a link that can't be missed: Aswarth Damadoran, professor of finance at New York University's Stern School of Business has created an excellent web site http://pages.stern.nyu.edu/~adamodar/ devoted to valuation techniques. He offers numerous DCF models set up in Excel spreadsheets, and he gives details on the intricacies of the models.

Stock Ratings: The Good, the Bad and the Ugly

Investors have a love-hate relationship with stock ratings. On the one hand, stock ratings are loved because they succinctly convey how an analyst feels about a stock. On the other hand, they are hated because they can often be a manipulative sales tool. This article will look at the good, the bad and the ugly sides of stock ratings.


The Good: Soundbites Wanted
Today's media, and investors, demand information in soundbites because our collective attention span is measured in nanoseconds (which also is apparently how the market measures a "long-term" investment). "Buy", "sell" and "hold" ratings are effective because they quickly convey the bottom line to investors.

But the main reason why ratings are good is that they are the result of the reasoned and objective analysis of experienced professionals. It takes a lot of time and effort to analyze a company and to develop and maintain an earnings forecast. And while different analysts may arrive at different conclusions, their ratings are efficient in summarizing their efforts. However, a rating is one person's perspective, and it will not apply to every investor.

The Bad: One Size Does Not Fit All
While each rating succinctly conveys a recommendation, this rating is really a point on an investment spectrum. It is like a rainbow, in which there are many shades between the primary colors.

A stock's investment risk and an investor's risk tolerance cause the blurring between the primary recommendations. A color may be a specific point on the spectrum, but the color's specific electromagnetic arrangement can be perceived differently by different people, either because of individual characteristics (like color blindness) or perspective (like looking at the rainbow from a different direction), or both.

A stock, unlike the fixed nature of the electromagnetic spectrum (a color's place along the spectrum is fixed by physics), can move along the investment spectrum and be viewed differently by different investors. This "morphing" is the result of the preferences of individuals (individual risk tolerance), the business risk of the company and the overall market risk, which all change over time.

For example, think of a line (or rainbow) and imagine "buy", "hold" and "sell" as points at the left end, middle and right end of the line/rainbow. I will demonstrate how things change by examining the history of the shares of AT&T (NYSE:T).

First, I will examine how perspectives at one point in time matter. In the beginning (say, in the 1930s), AT&T was considered a "widow-and-orphan" stock, meaning it was a suitable investment for very risk-averse investors: the company was perceived as having little business risk because it had a product everybody needed (it was a monopoly), and it paid a dividend (income that was needed by the "widows to feed the orphans"). Consequently, AT&T stock was perceived as a safe investment, even if the risk of the overall market changed (due to depressions, recessions or war).

At the same time, a more risk-tolerant investor would have viewed AT&T as a "hold" or "sell" because, compared to other more aggressive investments, it did not offer enough potential return. The more risk-tolerant investor wants rapid capital growth, not dividend income: risk-tolerant investors feel that the potential additional return justifies the added risk (of losing capital). An older investor may agree that the riskier investment may yield a better return, but he or she does not want to make the aggressive investment (is more risk-averse) because, as an older investor, he or she cannot afford the potential loss of capital (needs the dividend income to "feed the orphans").

Now let's look at how time changes everything. A company's risk profile ("specific risk" in Street talk) changes over time as the result of internal changes (e.g.. management turnover, changing product lines, etc.), external changes (e.g.. "market risk" caused by increased competition), or both. AT&T's specific risk changed while its break-up limited its product line to long-distance services, and while competition increased and regulations changed. And its specific risk changed even more dramatically during the dotcom boom in the 1990s: it became a "tech" stock and acquired a cable company. AT&T was no longer your "father's phone company," nor was it a "widows and orphans stock." In fact, at this point the tables turned. The conservative investor who would have bought AT&T in the 1940s probably considered it a "sell" in the late 1990s. And the more risk-tolerant investor who would not have bought AT&T in the 1940s most likely rated the stock a "buy" in the 1990s.

It is also important to understand how individuals' risk preference changes over time and how this change is reflected in their portfolios. As investors age, their risk tolerance changes. Young investors (in their 20s) can invest in riskier stocks because they have more time to make up for any losses in their portfolio and still have many years of future employment (and because the young tend to be more adventurous). This is called the "life cycle theory of investing". It also explains why the older investor, despite agreeing that the riskier investment may offer a better return, cannot afford to risk his or her savings.

In 1985, for example, yuppies in their mid-30s invested in startups like AOL because these companies were the "new" new thing. And if the bets failed, the yuppies still had many (about 30) years of employment ahead of them to generate income from salary and other investments. Now almost 20 years later, those same investors cannot afford to place the same "bets" they placed when they were younger. They are nearer to the end of their workable years (10 years from retirement) and thus have less time to make up for any bad investments.


The Ugly: Ratings Are Being Used as a Substitute for Thinking
While the dilemma surrounding Wall Street ratings has been around since the first trade under the buttonwood tree on Manhattan Island, things have recently turned ugly with the revelation that some ratings did not reflect the true feelings of analysts. Investors are responding like Captain Renault in Casablanca: they are "shocked, shocked to find that" such illicit happenings could be occurring in a fine establishment like Wall Street. But ratings, like stock prices, can be manipulated by unscrupulous people, and have been throughout time. The only difference is that this time it happened to us.

But just because a few analysts were dishonest, this does not mean that all analysts are liars. Their assumptions may turn out to be wrong, but this does not mean that they did not do their best to provide investors with thorough and independent analysis.

Investors must remember two things. First, most analysts do their best to find good investments, so ratings are, for the most part, useful. Second, legitimate ratings are valuable pieces of information that investors should consider, but ratings should not be the only tool in the investment decision-making process.

The Bottom Line
A rating is one person's view based upon his or her perspective, risk tolerance and current view of the market. This perspective may not be the same as yours. The bottom line is that ratings are valuable pieces of information for investors, but they must be used with care and in combination with other information and analysis in order to make good investment decisions.


Earnings Guidance: The Good, the Bad and Good Riddance?

"Earnings guidance" is a relatively new term that describes an old practice. But new regulations have changed how this information is given to the market. Some companies are now saying they will stop giving guidance to combat the market's focus on the short-term, but could it be because of the potential liabilities the companies face? This article will provide a perspective on this age-old tradition, discuss the good and bad points, and examine why some companies are saying "no more".


Defined
Earnings guidance is defined as the comments management gives about what it expects its company will do in the future. These comments are also known as "forward-looking statements" because they focus on sales or earnings expectations in light of industry and macroeconomic trends. These comments are given so that investors can use them to evaluate the company's earnings potential.

An Age-Old Tradition
Providing forecasts is one of the oldest professions. In previous incarnations, earnings guidance was called the "whisper number". The only difference is that whisper numbers were given to selected analysts so that they could warn their big clients. Fair disclosure laws (known as Reg FD) made this illegal and companies now have to broadcast their expectations to the world, giving all investors access to this information at the same time. This has been a good development.

The Good: More Information Is Always Better
Earnings guidance serves an important role in the investment decision-making process. Under current regulations, it is the only legal way a company can communicate its expectations to the market. This perspective is important because management knows its business better than anyone else and has more information on which to base its expectations than any number of analysts. Consequently, the most efficient way to communicate management's information to the market is via guidance. In an ideal world, analysts would use this information in combination with their own research to develop earnings forecasts.

The Bad: Management Can Manipulate Expectations
The cynical view is that, because this is not an ideal world, managements use guidance to sway investors. In bull markets some companies have given optimistic forecasts when the market wants momentum stocks with fast-growing EPS. In bear markets companies have tried to lower expectations so that they can "beat the number" during earnings season. It is one of the analyst's jobs to evaluate management expectations and determine if these expectations are too optimistic or too low, which may be an attempt at setting an easier target. Unfortunately, this is something that many analysts forgot to do during the dotcom bubble.


Why Some Companies Stopped Giving Guidance
Claiming that guidance promotes the market's focus on the short term, some companies have said they will stop providing guidance in order to try to combat this obsession with the short term. While this may sound noble, they can't seriously think this will be effective.

Eliminating guidance will not change the market's fixation on the short term because the market's incentive policies cannot be dictated. Coke could stop talking to everybody, but there would still be a score of quarterly estimates on First Call. Why? Because that is what institutional investors want. The Street will remain focused on the short term because that is how it is compensated. Everyone on Wall Street is paid annually and gets paid more if he or she outperforms in that year. This focus will not change if companies don't talk to the Street.

The real reason why some companies have stopped giving guidance is probably a legal one. In this post-bubble, litigation-happy environment, eliminating guidance will avoid potential liability expenses. It will also allow management to spend more time on running the company because it won't have to answer guidance questions anymore.

The Ugly: Eliminating Guidance Will Increase Volatility
Eliminating guidance will result in more diverse estimates and missed numbers. Analysts often use guidance as a reference point from which to build their forecasts. Without this anchor, the range of analysts' estimates will be wider, producing larger variances from actual results. Misses of more than a penny may become commonplace.

An interesting question is what will the Street do if misses become bigger and more frequent? Today, if a company misses the consensus estimate by a penny, its stock could suffer or soar, depending on whether the miss was negative or positive. Bigger misses could result in bigger swings in stock prices, producing a more volatile market. On the other hand, if the market is aware that the misses are caused by the lack of guidance, it may become more forgiving. If there is an argument for stopping guidance, it is that the Street would be more forgiving of companies that miss the consensus estimate.

The Bottom Line
Guidance has a role in the market because it provides information that can be used by investors to analyze the company, evaluate management and create forecasts. Companies are foolish if they think they can alter the market's short-term focus. The Street will still do what it wants, and it will stay focused on quarterly timelines. If, however, more companies opt for no guidance, the Street may inadvertently become more rational and therefore stop whipsawing stock prices for miniscule variances that are really just SWAGs (Systematic, but We're All Guessing).


Reg AC: What Does It Mean To Investors?

The Securities & Exchange Commission (SEC) recently released a new regulation that is meant to increase the level of honesty in research reports. Many think the law will have little impact because it does not go far enough. This article will define Reg AC and discuss its potential impact on the market and investors.


Reg AC Defined
On Feb 6, 2003, the SEC issued Reg AC (the "AC" stands for analyst certification) which requires analysts to "certify the truthfulness of the views they express in research reports and public appearances, and disclose whether they have received any compensation related to the specific recommendations or views expressed in those reports and appearances." The goal is similar to the regulation that requires CEOs and CFOs to certify the truthfulness of the financial statements they publish.

What Does It Accomplish?
At the very least, Reg AC will increase disclosure and hold analysts more accountable, much like CEOs and CFOs are now more accountable for the financial statements they issue. How much of an impact Reg AC will have is open to debate. Some claim the law does not go far enough. Others feel that existing laws already provide enough protection.

I originally thought this would be a non-event because there are already regulations and policies that require disclosures. Pre-existing SEC regulations require disclosures of the nature of the relationship between the brokerage firm and the subject company. For example, the brokerage firm must disclose if it has been involved in an investment banking deal or if it has acted as an underwriter within the last three years. Independent fee-based research firms must also disclose if and how much the subject company has paid them. And if an analyst is a CFA charter holder, CFA Institute's Code of Ethics and Standards of Professional Conduct currently require the analyst to state his or her true opinions in the research report.

The new twist that Reg AC will introduce is that it requires the disclosure of whether the analyst received any compensation "related to the specific recommendation or views expressed". I interpret this to mean that analysts must report whether or not the subject company has paid for a "buy" rating ("specific recommendation") or a favorable report ("views expressed").

The Potential Impact
I think the main contribution of Reg AC will be that it requires analysts to disclose whether the subject company paid for an objective research report or a rating. In order to discuss how this will impact the market, we need to review how Wall Street has changed.

At one time, brokerage firms researched most publicly-traded companies; however, the number of companies that receive research coverage declined significantly over the last 10 years due to industry consolidation and, more recently, due to staff reductions at Wall Street firms. Today, the remaining brokerage firms cover a relatively small number of stocks. This minority consists of stocks with the largest market capitalization and highest liquidity.

The majority of publicly traded firms (about 65%, based upon our research) has been "orphaned" by Wall Street and has little or no research coverage. We have found that most of these orphaned companies have good fundamentals and represent long-term value investments. The challenge facing these companies is reaching investors who are looking for good long-term investments.

Independent research firms are attempting to bridge this information gap. As with any industry, some are more legitimate than others, and a good way to differentiate the good from the bad is to read disclosure statements. And this is where Reg AC may have its greatest impact.

Contracting for objective research coverage is very different from paying for a rating. In my opinion, legitimate fee-based research involves both parties committing to objective research coverage for at least one year. This provides investors with the ability to read about and evaluate a company's progress for four quarters. One-time reports do not help investors track a company's progress, nor do they indicate a company's commitment to providing investors with necessary information.


To provide the market with objective research for a period spanning several quarters, companies who want to maintain their credibility will contract only with legitimate independent research firms. These research firms will provide Reg AC disclosures because they want to abide by the laws and have nothing to hide.

Other times, companies will hire a firm to write a one-time favorable report with a "buy" recommendation. These types of reports will not contain the Reg AC disclosure. The absence of the disclosure should serve as a red flag to investors, who should then ignore the report.

Time Will Tell
It may take some time to determine the real impact of Reg AC, but I think the end result may be surprising. Today, not much is expected to change with the implementation of Reg AC. People had the same opinion when CEOs and CFOs were first required to certify their financial statements, but these regulations did bring about many changes. CEOs and CFOs implemented new reporting procedures and made their subordinates more accountable, which appears to have eliminated some of the abuses that were made famous by Enron and others.

What is certain is that this reiterates the importance of reading disclosure statements and gives investors another indicator of the legitimacy of a report. Investors must read disclosure statements so that they understand the nature of the relationship between the research firm and the subject company. Investors should not put much faith in reports that do not contain the Reg AC disclosure.


All about EVA


The goal of all companies is to create value for the shareholder. But how is value measured? Wouldn't it be nice if there were a simple formula to figure out whether a company is creating wealth?

A growing number of analysts and consultants think there is an answer. Like many economic formulas, the measure - Economic Value Add (EVA) - is both intriguingly clever and maddeningly deceptive. Does EVA simplify the task of finding value-generating companies or does it just muddy the waters?


What Is EVA?
It is a performance metric that calculates the creation of shareholder value. It distinguishes itself from traditional financial performance metrics such as net profit and EPS: EVA is the calculation of what profits remain after the costs of a company's capital - both debt and equity - are deducted from operating profit. The idea is simple but rigorous: true profit should account for the cost of capital.

To understand the difference between EVA and its older cousin, net income, let's use an example based on a hypothetical company, Ray's House of Crockery. Ray's earned $100,000 on a capital base of $1,000,000 thanks to big sales of stew pots. Traditional accounting metrics suggest that Ray is doing a good job. His company offers a return on capital of 10%. However, Ray's has only been operating for a year, and the market for stew pots still carries significant uncertainty and risk. Debt obligations plus the required return that investors demand for having their money locked up in an early-stage venture add up to an investment cost of capital of 13%. That means that, although Ray's is enjoying accounting profits, the company lost 3% last year for its shareholders.

Conversely , if Ray's capital is $100 million - including debt and shareholder equity - and the cost of using that capital (interest on debt and the cost of underwriting the equity) is $13 million a year, Ray will add economic value for his shareholders only when profits are more than $13 million a year. If Ray's earns $20 million, the company's EVA will be $7 million.

In other words, EVA charges the company rent for tying up investors' cash to support operations. There is a hidden opportunity cost that goes to investors to compensate them for forfeiting the use of their own cash. EVA captures this hidden cost of capital that conventional measures ignore.

Developed by the management consulting firm Stern Stewart, EVA really caught fire in the 1990s. Big corporations, including Coca-Cola, GE and AT&T, employ EVA internally to measure wealth creation performance. In turn, investors and analysts are now scrutinizing company EVA just as in the past they observed EPS and P/E ratios. Stern Stewart has gone so far as to trademark the concept.

The Calculation
There are four steps in the calculation of EVA:
1. Calculate Net Operating Profit After Tax (NOPAT)
2. Calculate Total Invested Capital (TC)
3. Determine a Cost of Capital (WACC)
4. Calculate EVA = NOPAT – WACC% * (TC)


The steps appear straightforward and simple. But looks can be deceiving. For starters, NOPAT hardly represents a reliable indicator of shareholder wealth. A firm NOPAT might show profitability according to the GAAP (generally accepted accounting principles), but standard accounting profits rarely reflect the amount of cash left at year end for shareholders. According to Stern Stewart, literally dozens of adjustments to earnings and balance sheets - in areas like R&D, inventory, costing, depreciation and amortization of goodwill - must be made before the calculation of standard accounting profit can be used to calculate EVA. To protect its trademark, Stern Stewart doesn't fully disclose the adjustments - making the job of using the metric even more difficult.

Figuring out the cost of capital (WACC) is even more thorny. WACC is a complex function of the capital structure (proportion of debt and equity on the balance sheet), the stock's volatility measured by its beta, and the market risk premium. Small changes in these inputs can result in big changes in the final WACC calculation.




That said, if carried out consistently, EVA should help us identify the best investments, that is, the companies that generate more wealth than their rivals. All other things being equal, firms with high EVAs should over time outperform others with lower or negative EVAs.

But the actual EVA level matters less than the change in the level. According to research conducted by Stern Stewart, EVA is a critical driver of a company's stock performance. If EVA is positive but is expected to become less positive, it is not giving a very good signal. Conversely, if a company suffers negative EVA but is expected to rise into a positive territory, a good buying signal is given.

Of course, Stern Stewart is hardly unbiased in its assessment. New research challenges the close relationship between rising EVA and stock price performance. Still, the growing popularity of the concept reflects the importance of EVA's basic principle: the cost of capital should not be ignored but kept at the forefront of investors' minds. Best of all, EVA gives analysts and anyone else the chance to look skeptically at EPS reports and forecasts.
The Changing Role Of Equity Research



In this interactive discussion of equity research, we will review the role of this research and how it is impacted by bull and bear markets. We will also discuss fee-based research and its growing importance. Your responses to the questions at the end of this article will be the basis for the last part of this article, where you can observe what investors think is the role of equity research in today's market.

*Editor's note: The follow-up to this article is posted here.


Research and the Stock Market
Actually, the title of this article is a bit misleading because the role of research has not changed since the first trade occurred under the Buttonwood Tree on Manhattan Island. What has changed is the environments (bull and bear markets) that influence research.

The role of research is to provide information to the market. An efficient market relies on information: a lack of information creates inefficiencies that result in stocks being misrepresented (over or under valued). Analysts use their expertise and spend a lot of time analyzing a stock, its industry and peer group to provide earnings and valuation estimates. Research is valuable because it fills information gaps so that each individual investor does not need to analyze every stock. This division of labor makes the market more efficient.

Research in Bull and Bea

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Source: http://www.articletrader.com ]]>