Sunday, October 26, 2008

Hard to Avoid Higher Taxes

I have a reflexive reaction to higher taxes, particularly on the most productive members of society. I always think “will congress/state legislatures deploy the tax revenue more productively than society at large?”. Generally speaking, I think not. There is also the issue of tribute paid to members of congress to curry favor with various interest groups. When an entity has the power to redistribute wealth via tax policy, it has a corrupting influence on everyone involved.

Given the fiscal problems in our Federal and State houses, I don’t see how we will avoid higher taxes. I also believe the “top 5%” targeted by Obama today will become the top 50% in 12 months. Unless we make major changes to the way our federal and state governments are run, the politicians will need to raise taxes by a large amount to fund the myriad programs. It is going to be ugly. Keep in mind that a major tax increase will occur in 2011 regardless of who is in office because the 2002tax cuts are set to expire. One thing I would really like to see is an expiration date on tax increases.

Thursday, October 23, 2008

Gather Market Intelligence in Q4

Quick comment on something I have been suggesting to my companies since the financial crisis unfolded. Q4 2008 may be one of of the most uncertain time periods, in terms of customer demand forecasting, that I have experienced since Q4 2001. So how should management teams cope with this really unpleasant fact? My advice is to institute a data gathering process immediately. Start polling customers (existing and potential) and rigorously rolling up and evaluating your findings. The office of the CFO or Marketing Department is probably the right group within the company to be aggregating this information. Look at this information every week. Be sure to track how expected customer spending patterns are changing from week to week. As far as 2009 goes, I would recommend building your sales (and spending forecasts) on a quarter by quarter basis. Q1 2009 (and possibly Q2) could be a particulary selling environment. 2009 operating plans will be finalized in November and December. Most of those budgets will restrict all discretionaly capital spending until later in the year.

Ready, Aim, Aim, Aim, Fire

Companies should always be careful about how they spend their money, but the reality is, they sometimes get lazy. In these very challenging times where fund raising has become difficult, it is critical to spend cash wisely. I bring this up today because I am thinking about all of the companies that raised money in the past 1 or 2years. One thing I would bet on: most (if not all) of these management teams wish they could rewind the clock on how they spent their venture funding. As a venture capitalist, one of toughest choices I have to make is when to encourage a company to ramp headcount and ultimately spending. It feels good to grow headcount, move to a bigger office, take on more projects and vertical markets. But in times like these, it is worth remembering how important it is to wait until your business really understands the market (and customer adoption rate of your technology or service) before ramping spending. One of my partners uses the phrase "ready, aim, aim, aim fire" to describe the process for growing your business. Resist the urge to grow your business headcount (and related expenses) until you have HIGH confidence that you have the right product and the customer base is ready to buy. It is so much easier to grow your busines than it is to shrink it.
Some factoids I heard on CNBC today were pretty shocking.

- 750,000 foreclosures in Q3.
- In 2004, 2005, 2006, Americans took out between $500B and $800 billion per year in home equity loans. What the heck were these people doing with that money.
- On the other hand 80% of all homeowners have sufficient equity to weather the current crisis. It gets ugly, however, if home prices drop another 20%. Then a lot more people may walk away.

Thursday, October 9, 2008

Remaining Objective When Fear is in the Air

It is hard to believe that just 8 years ago, venture capitalists were facing what we all thought would be the ‘great crash’ of our lifetimes. Meaning the one and only significant crash we would see before we retired. After all, even with two world wars, a cold war, and an unprecedented energy shock in the 1970’s, the 20th century only had one Great Depression. The Dow dropped 90% from its high during the Great Depression. NASDAQ dropped 80% from its high after the tech bubble burst. Market collapses of that order are only supposed to happen once in a lifetime. But now, due to the financial crisis of 2008, the consensus opinion among wall street and venture investors is that we are at the beginning of another great crash and long term economic malaise (note Sequoia’s amazing comment about a 15 year secular bear market).

If this were my first bubble bursting experience, I might buy into that dire consensus view. But it isn’t and I don’t. The figure that stays with me more than any other during these trying times is the performance of the Internet and hospitality sectors from 2002 to 2007. In the dark days of 2002, two years after the tech bubble collapsed and a year after the terrorist attacks, the hospitality sector was crushed (who wanted to fly) and many Internet stocks were trading near their cash balances. What happened? Over the next 5 years, Internet and hospitality stocks, which you could barely give away in 2002, were the #2 and #3 best performing sectors out of 75 tracked by Wilshire Associates. The only better performing sector was coal - due to unprecedented growth in emerging market energy consumption.

When the tech bubble burst, lead by collapse of the Internet and telecom sectors, there was widespread believe that these were not ‘real businesses’. It was easy to see why people felt that way. Few Internet or telco executives were talking about cash flow and profits. Of course, the reason for this was that the public markets were not rewarding those things. Five years after the dot com crash, investors came to realize that in fact Internet and telco centric business models (think Google, RIMM) were among the most profitable businesses of our era. This lesson is now well known. What does that mean? I believe this time around the entire tech sector will not be abandoned. If anything, there will be more conviction around the best businesses and business ideas. This very same phenomenon is happening now in the banking sector. In the middle of the panic phase of the financial crisis, investors speak highly of BofA, JP Morgan, US Bankcorp.

We can’t deny that people are worried, even scared, about what is happening on Wall Street. Venture capitalists read the headlines and assume the worst. I believe the root cause of the deep anxiety being felt about the stock market and economy is the speed and severity with which it has taken hold. People have only so much capacity for dramatic change, especially when that change is negative. The pace of mortgage defaults and bank failures this year has been too much for most of us to keep up with. Images of a banana republic come to mind. But consider this point. Over half of all subprime mortgages originated in the trouble years of 2005-2007 have already been written off – to zero. Many of the remaining troubled loans are being worked out. The upshot? There is a historical wealth transfer taking place between global financial institutions and US home owners. Housing debt ratios for consumers will be cut by 40% when the write-offs and loan adjustments are complete. Consumer leverage will be close to what it was in 2001, at the beginning of the housing bubble. While unsettling, the speed at which financial institutions and governments are disposing of problem assets and injecting liquidity into the economy will accelerate economic recovery by 2010, perhaps beginning in the second half of 2009.

And what of those shaky financial institutions that triggered the crash of 2008? The consensus view, reflected by their stock prices, is that more banks will disappear and most will be permanently impaired. Now look at the numbers. The book value of global financial firms was $4 trillion in 2007. Today, it stands at $4.2 trillion. This takes into account the $300B of asset write-downs (net of tax effect) offset by $300B of equity infusions and $400B of newly retained earnings. The stock prices don’t reflect it yet, but the bulk of financial firms have addressed their problems, either by taking massive write downs or merging with stronger partners. So why does it feel so awful? Because these corrective actions have place at a speed we have never seen before. The 1980’s S&L crisis was 5 years in the making and took another 5 to fix. 2000 banks failed during that period. This time feels worse because we are taking all of the bad news at once. In just a few months, US banks have written off more of their troubled loans than the Japanese banks did with their problem loans in 15 years. Have faith in this: once the bad loans have been charged off, a process that might take another 6 months, US banks will have confidence in their own - and each other’s - balance sheets. At that point, reasonable lending practices will return. That is what always happens.

Aside from the painful – but ultimately positive- massive deleveraging by consumers, the scourge of inflation is being wiped out. Headline inflation (which includes food and energy costs) has been running 5% per annum over the past 5 years. It is now projected be near zero for the next 2 years. Reductions in housing, energy and basic consumer staples are the primary reasons for the decline. That means growth in real wages.

Goldman Sach’s recently proclaimed that a deep recession was likely. In their estimates, the US economy could contract by 7% in the next 12 months. We must keep in perspective, however, that just a few weeks ago Goldman was rumored to be on the road to collapse. I can’t help but assume that their deeply pessimistic institutional views have been colored by their proximity to the financial epicenter. But even if we assume that Goldman’s 7% economic contraction estimate is correct, that means that 93% of business and consumer spending continues. Certain sectors like automotive, housing and hospitality will undoubtedly be hard hit. On the other hand, affordable entertainment and productivity enhancing purchases, like investments in business technology, should fare much better.

In summary, this is not a normal economic cycle. The problems in our economy were created by irresponsible home borrowers and lenders, not the typical recessionary forces triggered by excess industrial capacity The blast radius of this crisis has threatened to engulf the whole economy because banks uniquely touch every aspect of commerce. They provide the liquidity for borrowing and lending. There is reason for optimism. With the measures being taken by banks and our government, we are working our way out of this mess. We understand the problems and are addressing them. When we get to a period where 90 days go by without a major financial institution failing, I believe the frayed investor nerves will start to heal. Until then, we must have the discipline to remain informed and objective.