Friday, January 29, 2010
why banks aren't lending (the FDIC lottery for assets), making healthcare cheaper and some incredible links on behavior
Monday, January 25, 2010
Saturday, January 23, 2010
The fact that the House is considering passing the Senate bill and then adjusting it through reconciliation is absolutely absurd.
There are two problems. Firstly, the Senate bill would never have even been approved without the blatantly corrupt appointment of Kirk to Kennedy's seat. For those of you who don't follow Massachusetts politics too closely, When John Kerry was running for president, Democrats in the MA legislature didn't want Mitt Romney, the governor at the time, to appoint a Republican senator, so they changed the rules of gubernatorial appointment to the Senate to state that the governor cannot appoint a senator to a vacant seat. Instead, a special election must be held posthaste.
When Ted Kennedy was terminal, the MA legislature, recognizing that Deval Patrick, the governor, is a Democrat, went back and changed the rules to what they were beforehand.
Adjusting procedure on the basis of who is in power is extremely shady... with any sense of fairness or dignity, Kirk would not have been in the Senate, which would have meant the Senate bill would have not passed. The fact that nobody is making a big deal out of this is unbelievable.
The other problem is that reconciliation is inherently designed to combat BUDGETARY issues, and budgetary issues only. The 2003 Bush Tax Cuts mentioned in the politico article were a classic use of reconciliation, because tax cuts are budgetary. Would it have been better if they had been designed to be bipartisan? Absolutely. However, the use of reconciliation was not absurd.
Even the "budgetary" parts of the health bill are not really budgetary issues by themselves , they're part of a healthcare overhaul which was not intended for reconciliation. To use that would be to abuse the procedures of the Senate.
In November 2008, it was hard not to vote for Democrats across the board. Just a year later, it's becoming hard not to vote for Republicans across the board. As long as Huckabee and Palin aren't the nominees, it's a real thought.
Btw, for the first time since the beginning of the Obama presidency, a poll has shown that Huckabee would narrowly defeat Obama in a presidential election if it were held today. We're not talking Romney, a moderate Republican, here. We're talking about a former MINISTER. That should be a wakeup call, but everyone is ignoring it...
Friday, January 22, 2010
Thursday, January 21, 2010
Wednesday, January 20, 2010
I disagree with Nate Silver's assessment. He claims that the difference between Coakley's high water mark and her end result is the fault of her as a candidate, when a LOT changed on the national scene between those numbers (people had more time to digest healthcare, which was the key differentiator in statistics for who voted for and against Coakley).
Also, he claims Coakley was a terrible candidate. However, Scott Brown isn't exactly the next Reagan or Republican Obama. Very few people ever mention "wow, I'm inspired by Scott Brown!". Secondly, Coakley won a primary with three other strong candidates - one of whom has already been elected to the US House of Representatives by Mass residents (Capuano), one with a tremendous private sector record that would be useful in dealing with banks (Pagliuca, whose mistake was not making this apparent), and the founder of the most successful nonprofit in the country (Khazei). This was the most attention I can remember ever being given to any Democratic or Republican primary in this state (including for governor, where the primaries have actually been competitive). Maybe that's cuz it was Kennedy's seat, but it doesn't matter.
More evidence for the fact that this was a national referendum can be seen in NJ and VA's results. Three's a trend, and when you have the uninspiring likes of Bob McDonnell, Chris Christie and Scott Brown engineering massive voting turnarounds by campaigning against a Democrat-controlled legislature with approval ratings in the 20s.... that is a national referendum. Brown didn't run against Coakley - he never said anything negative about Coakley - he ran against Pelosi and Reid. When New Jersey and Massachusetts (very, very blue states) elect Republicans within two months of each other, coincident with those terrible approval ratings, there is something going on other than a strong candidate.
Would Brown have won if Coakley ran a better campaign? Probably not. Would the turnaround still have been huge? Yes... this was a THIRTY ONE POINT TURNAROUND. If you figure about 50% of people have their mind made up on the party they're voting for, regardless of the candidate and the environment, that means that 62% of voters who actually look at issues and candidates changed their mind. Independents have swung 3 to 1 against the Dems in all three states. A quarter of registered Democrats crossed party lines this time, largely listing healthcare as their concern, and again, that doesn't happen in races featuring similar pairs of candidates in MA.
You don't want banks treating the government as a normal source of financing, albeit a countercyclical and highly unsophisticated one. Banks receiving bailouts should NEED it. Taxing banks that didn't need bailouts creates a bizarro moral hazard by which banks seek bailouts even when they DON'T need it. That's a real handout to the financial sector, and a completely unwarranted one.
Tuesday, January 19, 2010
"In no way does Hope show Obama as a saint," the musical's organizers say on their Web site. And truly, as the mostly American cast tells, through song and dance, the story of Mr. Obama's rise from a Chicago community organizer to the White House, we learn of the president's human imperfections—or at least one: "He's an idealist," the Mrs. Obama character says with a hint of disapproval. Despite this serious character flaw, the ensemble sings upon his election: "Celebrate! Celebrate! Around the world every nation celebrate."
Sen. Harry Reid will probably be pleased to learn that the actor playing Mr. Obama is sufficiently "light skinned" to portray the president and did not sing with any discernable "Negro accent." And, always a plus for an actor as well as a president, he was able to perform without a teleprompter. He got to sing numbers like "Yes We Can," and "Look Without Hands," which I first thought was a commentary on the president's foreign and economic policies but turned out to be a eulogy to his grandmother.
Much of the material was taken from stump speeches, but there was also a lot of "original" writing. Take the romantic highlight of the show, when Barack woos Michelle in a love duet. "I think we fit together like a hand inside a glove—I know this is no ordinary kind of love." One would HOPE that even Mr. Obama's speech writers could have rhymed better than this.
In one cliffhanger, Michelle is stricken by self-doubt—I guess that's what they mean by "artistic freedom." Without spoiling too much of the plot, Michelle's mother manages to reassure her that she has what it takes to be a First Lady. "You were chosen for this time . . . walk in your glory. Think like a queen, for you are royalty."
Of course no story is complete with just a hero, even if he is of the über variety. And so enter the villains: drug dealers in Mr. Obama's community organizing days and, in more recent times—you've guessed it—Republicans. In his solo, Sen. John McCain challenges Mr. Obama with lines like: "See you in November, and I'm the Great Defender." Personally, I prefer the real maverick's performance, Sen. McCain's unforgettable rendition of that old Beach Boy song, "Bomb Iran."
Strangely, Mr. McCain was played by a German, hence his introduction of Sarah Palin as his "Runny mate." Mrs. Palin, by the way, whose solo was bizarrely accompanied by scantily clad dancers in gothic outfits, was played by the same actress also standing in as Hillary Clinton—a subtle hint to the president, perhaps, not to trust his secretary of state.
In what the writer probably thought was a clever plot construction, a parallel story line centers on the residents of a "typical" Chicago neighborhood hit by unemployment, foreclosures and the war. The pre-Obama era is "Chaos!" as the first song reminds us. Among the assorted stereotypes is the unemployed Ricardo, sporting one of the worst Puerto Rican accents in the history of show business; the Obama-supporting African-American Johnson family; and your archetypical Republican: an elderly woman of German background who doesn't think much of "colored" people. But, with the Obama spirit already healing the planet, the German bigot and Mr. Johnson declare in a heart-warming duet after the elections: "We can be friends." Yes, we can.
When the Johnsons learn that their son has gone missing in Iraq, they are consoled by none other than Rev. Jeremiah Wright. Perhaps the news about the good Reverend's tragic accident with the campaign bus didn't make it to Germany. Thankfully, neither did any of his anti-American sermons. Instead, the Wright character gets to sing a couple of soaring gospels, promising "Everything will be all right, all right, he'll make it all right."
And so He did. No sooner has Mr. Obama been elected than the Johnsons learn their missing son is alive and that the war will probably soon be over. Call it the inauguration miracle...
The musical's American composer and lyricist, Randall Hutchins, who lives in Germany, says his show is not "political." Right, but only in the sense that Leni Riefenstahl's "Triumph of the Will" was just a documentary. The audience's standing ovation at the end was probably as ideologically overdetermined as my trashing of this hagiography."
Friday, January 15, 2010
My favorite financial reform perspective, infrastucture bank, not losing your luggage on planes, and the best time to do things
I've promised links posts would be rare, and have now made three in three days. I apologize... this won't continue! However, the Pettis link was too good to give up, and the rest of it was interesting and unusual as well.
Michael Pettis is probably my favorite blogger, edging out Mankiw and Cowen. He's a Chinese economics expert, and is second to none in his deep understanding of Chinese financial economics and macroeconomics. Here, he talks about currency pressure, the potential for trade hostility and US demand for goods. He's worth spending time on. (Hat tip to Paul for the recommendation). I quote liberally below, only because I agree with it so strongly:
"If we were to see a break in the [Chinese] housing bubble, there are broadly speaking two ways to address the problem. The so-called "Anglo-Saxon" model would involve a rapid liquidation of loans, the seizing and selling of collateral, and bankruptcies. The advantage of this model is that assets are quickly re-priced and allocated to their most profitable or efficient uses.
Assets that are non-viable at their original costs, in other words, are marked down and returned to the economy, and very often the new users engage in rapid innovation and the creation of new industries. One obvious example is the massive railroad bankruptcies that occurred in the US after 1873. The railroads were liquidated and purchased by new investors at steep discounts, allowing them to cut freight costs sharply, thereby spurring a whole series of new industries, most famously, I think, the mail-order retail business. More recently the collapse of the broadband suppliers and the subsequent drop in internet costs permitted the existence of Amazon.com, Ebay, Google and a host of other new technology companies.
But there is a cost. Liquidation can be brutal – businesses close down, land and assets are seized, workers lose jobs, families are forced to leave their homes, and so on. Americans, for whatever reason, have been more tolerant than many other societies of these kinds of disruptions, perhaps because of a combination of innate optimism and a robust political framework that absorbs some of the costs and anger. Other societies are less so.
The second way, broadly speaking, that the break in the housing bubble might occur, and without the brutal social adjustments, is what has sometimes been called the "Japanese" model. Rather than force bankruptcies and rapid liquidation, borrowers would be permitted easily to roll over their loans, financing costs would be kept low (at savers' expense of course), and excess inventory taken off the market. The disadvantage of this kind of process is that assets are very slowly reallocated – sometimes after many years – to more efficient uses, and those assets taken off the market become a pure dead-weight to the economy. In addition the need to keep financing costs low, so as to delay recognition of the losses, hampers future growth by encouraging continued misallocation of capital and slowing the development of domestic consumption by forcing households to bear most of the cost of the adjustment via low interest rates on their savings. The advantage, of course, is that it much less socially disruptive and painful...
...Financial crises are usually the way a distorted system rebalances, and although they are often necessary in the long run, they can obviously be painful in the short. Needless to say there is nothing like a financial crisis to bring out calls for the reform of the financial system, but I think we should be very cautious about what kinds of reform we ask for. The recent financial crisis, which seemed most to affect "Anglo-Saxon" financial systems, have brought out, predictably enough, fervent warnings about the riskiness of deregulated and fragmented financial systems, along with a pride of proposals for reform, many of which aim to prod and force financial systems into more rigid and constrained forms.
But we risk, as always, drawing the wrong lessons from the crisis, and confusing the triggers with the underlying causes of the crisis. Every major financial financial crisis in history was preceded by a massive liquidity build-up. which the financial sector was forced to accommodate, as it always does, by taking on too much risk. Hyman Minsky, and his disciples like Charles Kindleberg, describe this process vividly, with banks and other entities taking on too much risk as a function of excess liquidity and excessively low costs of capital. It doesn't matter if the system is highly fragmented and deregulated or highly regulated and monolithic. After all a large part of the prestige of the "Anglo-Saxon" model derives from the spectacular collapse of its antithesis, the Japanese model of the 1980s, which seemed — mistakenly again — to prove the superiority of deregulated systems, with their breakneck innovation, over highly regulated and very rigid systems.
So which is it that can best prevent crisis and the associated economic costs — the very open systems or the very rigid systems? Neither, it turns out. All of them react more or less the same way to excessive liquidity and too-cheap capital — by taking on too much risk, whether in the form of complex derivatives and securitizations, in the case of the former, or in the form of very old fashioned collateralized loans, in the case of the latter.
So is there no room for financial sector reform? Of course there is, but the purpose of reform should not be to allow us to turn from the crisis and proclaim "Never again!" That is silly. It will happen again and again and again. Instead, the purpose of regulation should be to ensure that the financial system does a better job of allocating capital during "normal" periods. A financial system designed to minimize the risks of crisis is probably a waste of time. It should be designed to create the best mix of risk capital and safety consistent with a rapidly growing economy over the long run. Periodic financial crises are a necessary evil, and there is little we can do about them except try to create automatic structures (counter-cyclical in national balance sheets, as Mnsky argued) that minimize their transmissions into the real economy. So in China's case, contrary to breathless advice by press and experts, the US financial crisis teaches almost nothing about how to manage financial sector risk. It neither proves nor disproves the usefulness of a highly deregulated and innovative financial system. China´s financial sector issues are different. China´s systematic misallocation of capital is its biggest financial problem. China needs serious governance reform and interest rate liberalization so that capital can flow to the most dynamic parts of the economy and be made available to risk-taking entrepreneurs in a way the fosters productivity growth. It needs capital to be correctly valued so that it is not wasted on creating overcapacity, asset market bubbles, and trophy projects, all of which detract from future consumption growth."
Best time to have surgery: Morning (4x less likely to have complications in the morning than between 3-4PM)
Best time to get a human being on the phone when calling a company's customer service line: As early as possible (lowest call volume)
Best day of the week to eat dinner out: Tuesday (freshest food, no crowds)
Best day to fly: Saturday (fewer flights means fewer delays, shorter lines, less stress)
Best time to fly: Noon (varies but pilots say airport rush hours coincide with workday rush hours)
Best time to exercise: 6-8PM (body temp highest, peak time for strength and flexibility)
Best time to have sex: 10PM-1AM (skin sensitivity is highest in late evening)
economists and media talking heads think that an asset bubble is a
sign of highly irrational and greedy financial professionals. However,
many of these folks have never managed money or dealt with clients,
which means they are largely missing some important pieces of
Many, possibly most, professionals who look at securities in a bubble
understand that a bubble is one explanation for the price rise; maybe
they'll underestimate it, maybe they'll even dismiss it, but they
understand it. A great many participants will understand perfectly
that a bubble is happening.
However, there's an agency problem. One senior official in a financial
firm once told me (referring to one particular asset bubble), "we all
knew it was happening, but if you get out too early, you underperform
as it approaches its heights. We participate because our clients won't
tolerate underperformance for any period of time. If we didn't
participate, we'd be fired."
I never wish to use personal anecdote as a source of evidence, but I
happen to have been actively investing and doing research for another
large financial firm, partly on energy, during the energy bubble. I
claim no skill, just luck, in getting out unscathed. I took a risk I
shouldn't have - a lesson I've taken to heart as I look at the Chinese
asset bubble and the effects on securities around the globe. But my
choice to take a risk is not a choice for others.
While there certainly were legitimate questions about how high oil and
other energy prices could go based on growth trajectories in emerging
markets, a substantial fraction of us knew that oil was in a bubble
and would have to come back down. I remember considering both sides
and realizing that the marginal cost of producing a barrel of oil from
the most expensive conventional fields was about $90 or $95 a barrel,
and that while capacity was constrained in the short run, there was
potential for expansion at that level of marginal cost. Meanwhile, I
owned a number of energy stocks, including a very sizable position in
a company that built refineries (and whose earnings was thus
intricately tied to the price of oil, as long as credit was
When I bought in, oil was in the high $70s. When oil cleared 90, I
started wondering if it was a bubble, and when it hit 110, I became
convinced and was worried about when it would pop. I could have
certainly sold out right then, but the aim when selling a stock is
(obviously) to sell at the best price possible - you don't get extra
credit for recognizing and selling early (in fact, you lose if you
don't have a strong alternative security to own lined up, which I
didn't at the time). I started gauging sentiment (something I've
always hated doing), and didn't get spooked til oil hit 135. Oil
eventually got to 147 before collapsing, and the credit bubble popped,
and the rest is history.
Despite what everyone likes to say about all sorts of money management
incentives, the ultimate incentives of a money manager are to a)
manage as much money as possible and b) have the money you manage go
up as much as possible. Both of these are only achieved via
outperformance. They face the same incentives I did - maximize
outperformance while minimizing risks - except if they fail at either,
they lose their jobs. I became aware of the possibility of an oil
bubble when oil was in the high 80s/low 90s, became convinced of one
when oil was at 110/115, but because I wasn't convinced that everyone
ELSE was convinced of one, I stayed in. It's not a game I like to
play, and as I've learned more about alternate types of securities, I
avoid those situations more and more (I've removed all exposure from
China, for example). However, participating in the energy bubble
wasn't blind, it wasn't schizophrenic, it was calculated and in my
extremely lucky case, paid off. I'm not unique in this regard - some
people really did think oil was headed straight to 200, 300 and even
500**, but a lot of people played the casino game despite
understanding what was happening.
Which brings me to the point. Just as this credit crisis was
originally caused by consumers being so shortsighted that they bought
houses they could not afford (mortgage lenders like Countrywide were
certainly complicit in this), asset bubbles in general can partly spur
from a shortsightedness (or perhaps a lack of financial education) on
the part of people who are choosing financial advisers. Every
manager, no matter how good, underperforms periodically - Warren
Buffett, the best investor ever, has underperformed in 7 of his last
22 years (that's almost 1/3 of the time!) and has some years where he
is CRUSHED - in 2009 he underperformed by over 20%, and in 1999 he
underperformed by 40%. Warren Buffett is lucky and smart in that he
has set himself up in a position where he cannot be fired based on one
bad year, so he uses his tremendous intelligence and foresight to
compile an impressive record despite blips.
Most of the rest of finance isn't so well-positioned. When one bad
year by a manager leads to a mass exodus of capital, a firm has almost
no choice but to fire that manager in order to preserve the fund.
Managers who prioritize not getting fired then make sure they never
underperform too drastically in one year, which means that most of
them have to participate in bubbles.
Just as a public that understood how to live within its means could
not have caused a credit crisis with mortgages or anything else, a
more longsighted, patient public, who doesn't abandon a manager at the
first sign of underperformance, would be the single biggest factor in
preventing asset bubbles - more than anything you could do with
How do we achieve that? Fortunately, we don't need a patient public to
make the public act patient.
One possibility would be the introduction of back-end loads to mutual
and hedge funds in exchange for a reduction in annual fees, thus
strongly rewarding longer term investors. Less effective but
functionally similar would be a (voluntary or involuntary) "lockup"
period with withdrawal penalty in exchange for lower fees (this stops
working after the lockup period is done, however, while an end load
works forever). Another would be be better investor education, if
that's possible (we can't even teach reading consistently, though, so
that's going to be tough).
Far less effective would be the idiotically populist transactions tax
that Obama has proposed, because it cannot get large enough to stifle
that sort of activity without crippling our capital markets. Somewhat
effective would be a turnover tax, which I have outlined in a prior
post, found here:
A turnover tax wouldn't prevent fundamental investors from
participating in bubbles, but it would prevent high-frequency traders
from speeding up the ascent and descent of equity and standardized
credit bubbles, which they do by a factor of 2 or 3 in both directions
(best estimate, based on volume of HFT transactions). Speed
exacerbates bubbles significantly because participants don't have time
to react before becoming insolvent, and the Fed doesn't have time to
react with appropriate monetary policy. Removing high frequency
traders could reduce the impact of bubbles, even if it couldn't easily
There are measures an agency can take, but they're more limited than
the government realizes, and are better at dealing with credit crises
than asset bubbles (related but different). Standardizing the products
that can be standardized and placing them on exchanges is a great idea
because it limits the web of counterparty risk that characterized this
recession, reducing the need for bailouts. Coming up with ways to
quickly, fairly, efficiently and consistently break apart illiquid
financial institutions to satisfy creditors would reduce the panic and
liquidity effects from a failure like Lehman's. Working with financial
institutions to implement the end load/lower fee plan or a turnover
tax would be helpful. Insulating the Fed from political pressure would
be useful, and investor education on accounting, economics and
financial markets will always be helpful. Creating mandatory processes
for evaluating the creditworthiness of consumers would be a
possibility- you don't want to limit who can be lent to, but you do
want to force lenders to go through a reasonable series of steps to
ensure that they are lending to people or firms who are representing
their assets and income truthfully, so that lenders can't advertise
"immediate credit" as a sales pitch and make mistakes when they do it.
The other issues - regulating bank bonuses, instituting bank taxes,
etc - will be highly counterproductive (I've listed a great deal of
why here: http://tfideas.blogspot.com/2010/01/media-incompetence-aigs-necessity-and.html)
and are mostly likely to result in costs to shareholders and customers
than they are to mitigate risky behavior. Trust me - no regulator can
keep up with the sophisticated products and processes that are in
finance. Regulators don't draw enough talented people, they're
perpetually understaffed and they face political pressure. It's better
to regulate and align the incentives of clients with a safe system
than the incentives of banks with a safe system because clients change
less and they're more fundamentally at the root of the problem
(financial firms wouldn't do it if their clients didn't require it).
**(I posted that report on the wall of my office because it was so
funny - oil was at 140, I'd just sold out after watching oil almost
triple already, and people were projecting $500 oil?)
Thursday, January 14, 2010
Please note that this is an ad-supported blog. If you are interested in the product displayed in the ads, please click! Anyone more savvy with blogger is more than welcome to help me spruce this up - please let me know. If I've made any errors, feel free to note them in the comments. Special thanks to Jason P, Gillian L, Graham F and Rowan F.
This is a guide to how to prepare for case interviews for Finance and Consulting.
FOUR KINDS OF QUESTIONS (Each firm prefers different types)
1. Logic / Arithmetic (usually, but not always, in finance)
“What’s 42 x 37?”
“You have a 5L jug and a 3L jug. Measure out 4L in as few steps as possible.”
2. Market Sizing
“How many lightbulbs were sold in Australia last year?” (Approximate)
3. Strategy (Consulting. Sometimes finance)
“You’ve been brought in to a small pharmaceutical company to help them assess whether to proceed with a drug development project. Ask any questions you like.”
4. Mathematics / Statistics (Quant)
“There’s a jar with 1000 coins. 999 have heads and tails. One has two heads. You pull out one coin randomly and flip it 10 times, getting 10 heads in a row. What is the probability you pulled out the coin with 2 heads?”
Usually not regular consulting or banking – usually a more quantitative job, i.e., hedge fund.
I will go through each of them, one at a time.
1. ARITHMETIC AND LOGIC
Can’t help you with this much.
If it helps you, break logic questions into math.
For straight arithmetic it can be helpful to split into 10’s and ones.
e.g. 42 x 37 = (40 + 2) x (30 + 7) = (40 x 20) + (2 x 30) + (7 x 40) + (2 x 7)
Relax, and take your time.
It’s better to get the right answer slowly than the wrong answer fast.
2. MARKET SIZING
Basically dimensional analysis (remember middle school science?)
Oranges consumed in Europe = Oranges consumed per person x people in Europe
Sprinklers sold in the US =
Sprinklers sold to golf courses + Sprinklers sold to professional gardening services + Sprinklers sold to individuals
It's easy to make this too complicated, and you can get bogged down.
Amount of gas consumed in the US =
(# PEOPLE x CARS/PERSON x MILES/CAR x GALLONS/MILE) + (GALLONS/MILE x MILES/FLIGHT x (CITIES IN US / 2) x FLIGHTS PER PAIR OF CITIES) + ((LAWNMOWERS/GOLF COURSE x GOLF COURSES IN US) + (LAWNMOWERS/PROFESSIONAL SERVICES x PROFESSIONAL SERVICES IN US)………
1. Break the Problem Down
Number of Beetles in the Congo -> ???
Beetles/Tree x Trees/Mile x Miles of Forest/Congo -> You can roughly estimate these
2. Orders of Magnitude, Not Real Numbers
1 million vs. 2 million doesn’t matter
1 million vs. 10 billion does
Define the scope of the problem, don’t tackle everything.
Gas in North America -> ???
Gas used in trucks in North America for shipping things -> EASIER
Skip this for one second
If you’re asked and have no idea, get a piece of paper + pen and slowly work through it logically.
If you get it wrong, don’t give up hope. If you were logical but just got stuck, or made an arithmetic error, it doesn’t rule you out.
Stay calm and confident. Take your time.
To start: Ensure you are focusing on the correct question. The first key to this is listening to the interviewer. You can verify what you're working on by asking - "So, in summary, I'm looking at both the revenue and cost sides of operations for a hard drive manufacturer, and coming up with a plan for them to increase their profitability. Is that correct?"
Additionally, feel free to ask any followup questions. As long as it's not something stupid ("how would you do it?"), it can provide helpful information ("What sort of parts go into a hard drive?" would be one possibility, for example). If they don't want to tell you, they'll tell you.
Because these things are inherently logical, it will be useful for clarity and for ensuring that you hit everything for you to state the framework on which you're operating. So, if I were doing this (and you'll see this all below), I'd say "I'm going to first look at the industry, then I'm going to go down the income statement, starting with revenues, then variable costs, then fixed costs, and I'll conclude by going over to the balance sheet and looking at working capital". If industry analysis is relevant, I'd start with that. Having laid all of this out at the beginning, it'll help you pace yourself and stay on topic, and give them the chance to pace you and keep you on the right track.
So - onto the actual framework itself. I like using financial statements because businesses are measured with their financial statements. Working on things that affect financial statements is a guaranteed way to talk about things that matter. If done correctly, they also have the advantage of not being way overused, like Porter's Five Forces (mentioned below because its still useful, especially for entering new industries) or some other BCG and McKinsey strategies that I won't go into here.
2 Big Statements to Think About:
The set of revenues, profits and costs that came in and out in the period
Flow. It's the in- and outflows for the period
The set of assets and liabilities you have
Snapshot. It's the list of stuff you have at a given time.
An analogy is that the Income Statement is your salary, and the Balance Sheet is your bank account and mortgage.
Here is where blogger's formatting hurts, so I'll try to keep this simple.
SIMPLIFIED INCOME STATEMENT
Price * Volume
(Price per chicken * Chickens you sold)
- COST OF GOODS SOLD
Variable costs (costs that fluctuate with the number of things you sell)
(Chickens * Chicken Feed/Chicken, Chickens * Hours of Labor/Chicken)
= GROSS PROFIT
Short for Sales, General and Administrative Costs
Fixed costs (costs that don't directly fluctuate with the number of things you sell)
(Chicken coop maintenance costs. CEO Salary. Salespeople salaries)
= OPERATING PROFIT
- Interest, Taxes, and other stuff you can safely ignore for interviews
= NET INCOME
Total Profit for the Company, to be split up among owners of the company
SIMPLIFIED BALANCE SHEET
Assets: Stuff that will eventually result in money for you
Liabilities: Stuff that will result in you paying money
Equity: The residual value (Assets - Liabilities)
Money you get - Money you give = What it's worth
By definition, A - L = E.
This is usually written A = L + E, because it's easier to set up the balance sheet that way.
It is vitally important to note that this is recorded at original cost, and then lowered ("depreciated" or "amortized", depending on the asset) over time as it loses value. Thus, if I bought a building in 1920 for $300, it will be no more than $300 on the Balance Sheet.
Thus, equity on a balance sheet is only a rough estimate of the actual value. It's a better estimate of the money that has been put into the company to build it. Don't worry about this too much, but understand it.
Typical Balance Sheet:
Cash + Marketable Securities
Hard Assets (buildings,
vehicles, property, etc)
Acquired Intangible Assets
(patents, acquired brands,
customer lists, "goodwill",
etc. These can only be added
to a balance sheet when you
buy them, not when you
make them. This is because BS
measures what you've put into
the business, and if you make them,
they've already been reflected through
expenses that hit the equity account)
Don't sweat the equity account too much - just know that profits get added here each year, and payouts (dividends and buybacks) get subtracted.
I don't know how to do it on Blogger, but this is typically arranged like you're looking at the pages of an open book. On the left page are assets, at the top of the right page are liabilities, and underneath liabilities are equity. (Thus, why A = L + E is the right format - it's all additive, you don't have to worry about which section to subtract, so the right page all added together equals the left page). Some companies do put them sequentially like I have, but that's beyond the scope of this presentation.
Cash: Cash. $ in the bank
Marketable Securities: Stocks, bonds, Bank CDs, etc, that can be easily sold
Inventory: The cost of making the goods you have to sell but haven't sold yet. Want this to be just high enough to sell what you need, and no higher
Receivables: What people owe you
Payables: What you owe people (think credit cards you pay at the end of the month)
"Goodwill": A measure of the additional amount you paid for an acquisition that isn't reflected in their other assets. Just remember - this is designed to measure how much has been put into the business, so paying up for "intangible awesomeness" counts.
EVERYTHING YOU SAY SHOULD IMPROVE ONE OF THESE:
1. Increase Revenues -> price per unit * units sold
2. Reduce Fixed Costs
3. Reduce Variable Costs
4. Balance Sheet Efficiency
Less inventory is good because there's less spoilage, and less money invested in stuff that
just sits there.
Less receivables per unit of revenue is good because you're getting your $ faster, and you
don't have to wait for it (and there's less risk they won't pay)
More payables per unit of COGS is usually good because you can wait longer til actually
paying and do something else productive with the money in the interim
FOCUS ON #1, then #3, then #2, then if you get it, #4. #4 is (usually) less important in interviews.
Three concepts you should know: EXPECTED VALUE, RETURN ON INVESTED CAPITAL and EARNINGS PER SHARE.
The probability-weighted amount something is worth
EV(project) = (amount you make in scenario A x probability scenario A happens) +(amt you make in scenario B x probability scenario B happens)... across all scenarios
A pirate is deciding whether to hunt for buried treasure. If he finds it, he'll get 1000 doubloons. If he doesn't find it, he gets nothing. The expedition will cost 250 doubloons. The chance of finding treasure is 30%. Should he undertake the endeavor?
(1000-250)x(30%) + (0-250)x(70%) = 50.
The expected value of the search is 50, which is greater than 0. The expectation is that he makes money, so he should do it.
This concept is how casinos and lotteries make money... all of your bets are expected value negative for you and positive for the casino, even if some outcomes are positive for you and negative for the casino.
RETURN ON INVESTED CAPITAL
The amount of profit you make on money you invest.
Different to costs.
If I buy $10 of wood and make a chair out of it and sell it, the wood is gone and the money I put into buying it is gone - it's a COST.
If I spend $1000 on opening a store, or researching a patent, and then use that store or patent to sell things, I can sell and still own the store or the patent -
it's an INVESTMENT.
Individual projects have a return on invested capital (ROIC):
I open a store for $1000
I make $200 a year profit from the store
My ROIC is 200/1000 = 20%.
This works for expected values, too:
I open a store for $50
My expected value profit is $5 from the store
My expected value ROIC is 5/50 = 10%.
Putting it in context:
You want your ROIC to be more than the "cost of capital" - If you have to borrow money at 10% interest to invest in a project that returns 8%, you're losing money.
This is why it's such a bad idea to invest in the stock market when you have credit card debt - the amount you're paying by having credit card debt is so much higher than any reasonable stock market return, that your "cost of capital" exceeds your expected ROIC and it's a bad investment, even if your stocks go up.
Thus, profits going up is not necessarily a good thing if you could have done better things with that money.
Thus, be careful if you're presented with profits that quadruple! If it required a lot of capital to achieve, it's not that impressive.
What a "good" ROIC is depends on how risky the project is. If it's over 15% it's likely a good ROIC. If it's under 10% and it's risky, it's more likely to be bad. If it's truly risk-free, it can be a very low ROIC and still be ok.
Whole companies have ROICs, also. Their invested capital consists of equity and debt. (Think about it - if you're running a business and you need money, you can either borrow it - debt - or give someone a share of the profits in exchange for money - equity. Then, you pay off debtholders first, and whatever is left is divided between the equityholders. This is similar in concept but different in specifics to the equity on the balance sheet.)
Generally, average ROIC for whole companies is somewhere between 11 and 13%.
Investment = the equity capital and debt capital that went in
Return = net income out
ROIC = Net Income / (Debt + Equity)
Whole company ROIC is far more important for finance than consulting. Its use is nuanced, look it up if you're curious.
EARNINGS PER SHARE
One more note on equity as invested capital. If a company issues equity to raise capital (a cut of the future profits in exchange for money), the people who already owned equity lose money because they're now getting a smaller percentage of the profits. The "profits" attributable to each share is called earnings per share (EPS), and it can be calculated for public companies for a given year by Net Income / Shares Outstanding. You can actually have net income go up and EPS go down if shares outstanding rises too fast (and stock price is usually judged by EPS). These profits aren't all paid out immediately - some of them will be used by the company to grow. The part that is paid out is called a dividend. Some companies buy back shares instead of paying dividends to increase future EPS for the rest of their owners. This is mathematically identical to paying dividends, but they're taxed differently.
PORTER'S FIVE FORCES:
Everyone and their mother has a preferred way of analyzing firms and industries. While many of these are useful in other contexts, I think they have the ability to send you down irrelevant or less central paths in interviews. If you can remember everything and keep it straight, that's great, but if you're time-constrained, some of them are more useful than others. One of the best, because its founded in actual economic principle, is Porter's Five Forces. It's particularly useful for analyzing the ongoing competitive strength of a company or industry, which is really nice when you're looking at questions like "Should I enter this industry?" or "Should I develop this new product?/What product should I develop?". (Michael Porter is a very famous HBS professor).
According to Porter, the strength of a company in general can be measured with five large assessments:
1. Threat of substitution. How easy would it be for customers to switch to other products or services instead of buying yours? This can be affected by many things - brand loyalty and product differentiation, importance of the product, advantage of the product over competitors' products, relative prices, switching costs, quality, etc.
2. Barriers to entry. If the market is profitable, others will want to participate, increasing competition and decreasing profitability. How easy is this? Think of patents, contracts, brand, economies of scale, switching or sunk costs, capital requirements, learning curves in manufacturing, government policy, industry profitability, distribution, etc.
3. Competition by incumbents. Innovation, advertising and product differentiation are important here. This is also where things like collusion, cooperation, price wars, etc. come in.
4. Customer power. How much can customers dictate your prices and your product features? If a customer has a lot of power, they can force you to spend more on your product and take less money for it. Anyone who sells to Wal-Mart or the Department of Defense would face this. Indications of customer power include number and size of important customers, fixed/sunk vs variable cost balance (customers can be forced to pay variable cost but not fixed or sunk costs), relative switching costs (Wal-Mart can switch easily, you can't), substitute products or distribution mechanisms on either side, buyer price sensitivity, product differentiation.
5. Supplier power. Similar to customer power, but instead, it's the people you're buying from, not selling to. Same considerations apply.
Economics - You can probably skip this if you're really pressed for time and understand extremely basic supply and demand, but this can be very useful.
Supply and demand are extremely important. Generally, as supply goes up, quantity supplied goes up and price goes down. As demand goes up, quantity supplied goes up and price goes up.
For example, if you're buying wheat, then if twice the number of people show up to your same farm to buy wheat than did yesterday, the price is going to go up because demand has increased - the demand curve has shifted. However, if the same number of people as yesterday come back tomorrow, then the price will revert to its original level - you're moving along a stable supply curve with a shifting demand curve.
If, however, there is so much rain this summer that supplying the same amount of grain costs far less, then the supply curve has shifted, so more people show up and pay less for their grain.
The percentage by which quantity changes relative to the percentage by which price changes is called elasticity. There's a price elasticity of demand and a price elasticity of supply.
Examples of elasticity:
elastic supply: High tech (expensive) deep sea oil wells. If price a supplier can get for their good drops even a little bit, they produce a lot less cuz its no longer profitable.
inelastic supply: Software or Movies. Once you've put in the development cost, the marginal cost is almost nothing, so price can drop a TON and the company will still be willing to sell lots of copies.
elastic demand: Newspapers in 2010, Cars, TV dinners, books, beef, many commodities. As price goes up even a little bit, they become a lot less attractive relative to alternatives, so you consume a lot less.
inelastic demand: Medical care, cigarettes, newspapers in 1950. Price can go up a ton and everyone will still buy.
If you want to know more, take an intro economics class, or read the rest of my blog at http://www.econthoughts.com/, because elasticity something I talk about with reasonable frequency (esp vis a vis China, housing, and sometimes healthcare or carbon emissions).
Be able to draw a supply and demand graph. Supply goes up, and demand goes down, with quantity on the x axis and price on the y axis.
Also be able to "think on the margin". The price of a good isn't set by what everyone is willing to pay for it, it's set by what an incremental customer is willing to pay for it. In fact, most decisions need to think "on the margin". Think of it this way:
You have no job and have so much free time that you're bored. Someone offers you work for an hour a day at $7 an hour. Should you take it?
You have a job for 7 hours a day at $7 an hour. Someone offers you an additional hour of work per day at $7 an hour. Should you take it?
You have a job for 14 hours a day at $7 an hour. Someone offers you an additional hour of work per day at $7 an hour. Should you take it?
You have a job for 14 hours a day at $25 an hour. Someone offers you an additional hour of work per day at $7 an hour. Should you take it?
The answer to all of these questions is very different, because you don't look at the value of your time on average, you need to think "what is the value of one ADDITIONAL hour of work vs free time for me, given the amount of time I work and the amount of money I have?"
This also goes for goods. If you are in the desert with no water, how much would you pay for a cup of water? If you are in your living room with a case of water that you could open now or later, how much would you pay for a cup of water? If you were drowning in the Poland Springs bottling plant, how much would you pay for a cup of water?
Again, water doesn't have an inherent value - its value is how much you'd pay for one more of it (which would certainly be positive and large in the first case, positive and small in the second case, and negative and large in the last case).
An example of where this is important is tax policy. If you tax corporate profits if the supply curve has a positive slope (like most normal ones do after a point), then producing that last widget isn't worth it, so the company makes less widgets. If you tax income, then working that last hour isn't worth it, so the worker works fewer hours.
This also applies to cost shocks - if your input costs go up and you can't raise prices, then you'll produce less because that last unit you're making is no longer profitable.
You've been brought in to advise a local clothing store on how to grow profits. It's a high-end women's fancy clothing maker, and they currently have 5 stores in NYC, Boston, LA and Chicago.
What are the company's sources of revenue?
What are trends in these revenue sources?
What are the variable costs associated with the revenue?
What are the fixed costs associated with the revenue?
Trends in variable costs (material):
Trends in fixed costs (storefronts):
Competitors and how strong they are/how you can beat them (price? product differentiation?)
Substitutes for the company's product/how you can beat them (price? product differentiation?)
Some suggestions to boost revenue (not right or wrong, just some ideas)
expanding to high-end men's goods
opening new stores
expanding existing stores
improving store locations - where should they be?
opening a partner brand for lower-end clothing
Some suggestions to lower variable costs:
Install a better inventory system so it takes salespeople less time to sell
Some suggestions to lower fixed costs:
Improve distribution centers
Finding cheaper, "nichey" store locations
Some suggestions for balance sheet efficiency:
Install an inventory-tracking system (could be a loyalty program) so you can reduce inventory w/o affecting sales
this reduces a) inventory hours by salespeople
b) the amount of money you have tied up in clothes sitting in a backroom - the $ can be used elsewhere!
as a note, Wal-Mart is a GENIUS at this, and it's one major reason they've succeeded
You've been brought in by a company that makes airplanes to help them cut costs. Where would you look?
You've been brought in by a pharmaceutical company to evaluate whether the company should try and develop a cure for ingrown toenails. Create a framework to help them make this decision.
You've been brought in by a movie theater to help boost overall profits. How would you approach the problem?
A tractor-maker has invented a technology that lets their tractors hover. They don't know what to do with it. Help them figure out how to offer it to the marketplace.
Your client needs help deciding whether to buy a chain of upscale, trendy grocery stores (think Whole Foods) that's been struggling lately. What can they do to turn it around, and how should they decide whether to buy?
Other Recommended Reading:
Case in Point (check it out on Amazon)
summarized here: http://consulting.caltech.edu/cit-only/case_in_point.ppt
Nate Silver devotes an entire article to the fact that states that ban gay marriage have higher divorce rates, and says he thinks it's interesting.
Some possibilities I thought of:
-States with high divorce rates tend to be poorer (because poor couples are more likely to divorce, either because of the money issue or because they tend to marry younger), which corresponds with more religious regions of the country, either by coincidence or cause (I suspect cause but I have little evidence, so I'll accept either explanation).
-Getting married as a gay person is harder, so those who do it are more committed and more likely to stay together (small contributor at best)
-People in unhappy marriages are less happy in general, and are stronger in their religion (thus banning gay marriage) or simply becoming bitter (and hating those who are different, like gay people)
I tend towards the [edit: FIRST] explanation. [I changed the order].
Another possibility, of course, is that it's a coincidence the same as the link between number of pirates in the world and global warming. As the number of pirates have gone down over the past few centuries, the earth has gotten warmer! (and if the world has in fact gotten a bit cooler in the past few years (due to a megacycle or a temporary fluctuation), the temperature has dropped as Somali pirates have risen in number!)
If Nate Silver were to be reading this post, I'd caution against thinking that statistical relations imply anything even remotely interesting without some sort of counterintuitive explanation for it. This is going to be intrinsically related to religion, with no surprising results.