Traveling With David

Sometimes I over-commit my time. That’s been the last few days. Recently I went to visit a friend who had lost his job at a large company, to look over his severance papers, and advise him. He is older, a “minority,” and only been with the firm 5-6 years.

Severance agreements have gotten a lot tighter since the two that I have personally experienced. Corporations dangle some compensation to eliminate possible future legal costs.I pointed out to my friend the most likely reasons he might sue, but added two things:

• The company has a large number of sharp lawyers, so you had better have an open-and-shut case.
• We’re Christians, so we don’t go to court over small matters.

But what impressed me in reading the agreement was how airtight it was — can’t sue over Federal, State, Local, or common law offenses, or anything else. Which made me think about another thing… the connection between entrance and exit doors.

In investing, people are more wiling to invest if they can have their money back at any time. With employment, it is the same — employers are more willing to employ if they can fire people for any reason.

Every protection for those employed makes it harder for those without work to be employed. This also forces jobs to go underground — if advertising them publicly subjects them to regulation, then the good jobs will be filled via “word-of-mouth.”

This takes me back to the early days of the Reagan Administration. They deregulated a lot of things, and the economy grew far more rapidly. We could do the same now, starting with labor and healthcare.

My friend may do fine, but the things that “protected” him at his last job now hinder him in seeking another job. Better to eliminate the protections, and let people compete based on skill and assiduousness.

Part Two

Then I was a judge in a financial analysis competition at a local college. The analysis involved a stock that faced a large investment decision, larger than the current enterprise value of the junk-rated company. Should the hedge fund buy, sell short, or do nothing with the stock? The simple part of the case study was working through the intricacies of the discounted cash flow model, together with changes to the assumptions about cash flows and the weighted average cost of capital.

What I found interesting was the lack of attention to:

• Details of the case study — did you even read it?
• Common sense — we are sorry, but a stock can’t lose 113%. Perhaps you would like to tell us to short the bonds?
• Limitations of complex techniques in finance. Yes, there’s many nifty formulas available to you, but do you understand what they really mean, and what limitations they imply? When are they not valid?
• What markets can and can’t do. No, you can’t do an public issuance of junk debt at the level of current debt. You can’t do an issuance longer than ten years. You can’t do one that is really big without changing market pricing (and the answers from the case study had this wrong as well). Same applies to large secondary IPOs for equity.

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Now, I know these are students. They can’t know what an experienced market professional does. To their credit, they dug up many bits of useful data that the case study did not contemplate. But the case study itself should have noted these things, and to that degree I fault Darden for writing up a subpar case study.

The main thing I would say again to the students is to ignore the academic models with their false certainty, and try to understand the qualitative aspects of the business, out of which the quantitative modeling will grow.

When we were done, each of the judges gave comments to the students. I started off with, “Sorry for being such a hard-nose.” I got a decent laugh from the students, and then explained to them what I have said to you.

Part Three
That evening I went to a talk by last piece on endowment investing . I learned a lot, which makes me happy, because I always like to learn.

Written By: David Merkel