Apple, Google and Schmidt - Chill Out!

There has already been a plethora of commentary on Apple's new Board appointment, so I won't belabor the details. That said, there have been a number of interesting comments on TechCrunch and Tailrank that warrant careful review and thought. After reading much of what's out there on the topic, I feel that a few key points have been missed that merit consideration:

1. This is a distraction for Google

Yeah, yeah, I know, Google is going to take over the world. Right? Not so fast. Now Google is a great company and has done, and will likely continue to do, many great things. But the increasingly saturated and competitive they find their core market, the mounting challenge of maintaining break-neck growth over a larger revenue base and the more confused they become over what to do with their expanding cash pile, the greater the risks of being led astray. We recently read those stories about Google filing for an exemption from the Investment Company Act of 1940, right (which basically means they want to be able to invest their cash hoard in something other than Treasuries without being regulated like an Investment Company)? This was precisely the same issue that was faced by Microsoft, Yahoo!, Internet Capital Group, CMGI and others like them during the late 1990s, and with the exception of Yahoo! most of these stories ended in tears.

So what do they want to do with this money? Hmmm, maybe do some non-core but tangentially-related investment stuff like Microsoft - AT&T, Comcast, Nextel, etc.? We all know what this led to - massive destruction of shareholder value. Hopefully Google is not getting distracted and contemplating the pursuit of some far-afield investments, because I absolutely guarantee that this will end in tears - something clearly not desired by Google's shareholders. I don't know if Apple falls into this camp but there is much speculation surrounding exactly this. Is Apple to Google as Pixar was to Disney? I don't know but for every success there has to be dozens of failures. All I can say is Eric, Larry and Sergey - DON'T DO IT.

2. Being a Board member SUCKS if you want to do business

So, let's say that Google does have some strategic designs on Apple. Eric's catbird seat on the Board is not necessarily helpful in this regard. Why? He'll have great insights and perspectives on Apple, right? But now, what will he be deemed as a Board member of Apple? Hmm, what is that called? Right - an AFFILIATE. Affiliation, in general, is something you don't want if you'd like the free and unfettered ability to do deals with someone as it raises the bugaboo of all issues - conflicts of interest. So, if Google's real intent of his Boardship was to lay the foundation for close strategic venturing I'd think that this was a very inelegant way of going about it.

From Apple's perspective, I'd be more afraid of Eric gaining general insights into their strategies and using them in Google's business than anything else. If the topic of a material partnership with Google did emerge on the Apple Board, then Eric would certainly have to recuse himself and specifically not be party to the discussions. I don't know, it just seems a little too contrived (not to mention legally challenging) for the seeds of a Google/Apple link-up to be sown through Board participation.

Didn't we just see Robert Rubin resign from Ford's Board over the potential issues of conflicts of interest? It practically telegraphed Citigroup's involvement in a matter of strategic import to Ford. The SEC will be all over Citigroup about Rubin's involvement and knowledge once a deal comes out, regardless of whether or not he resigned from the Board. Once you are a Board member, there is no neat way to extricate yourself once strategic discussions are underway. I have got to imagine that Eric Schmidt is much too smart to put himself in a compromising position, which makes me think that his Board-ship can't be directly linked to an intended strategic link-up with Apple. Maybe I'm just being naive...

We'll see. It just seemed to me that most of the commentary was around the "Woo hoo, what a big deal!" when there are both strategic and legal issues that argue for an interpretation more akin to "Whoopty doo, big deal?" Maybe I'm just being a stick-in-the-mud. Maybe.

RSS as an Emerging Market?

I just read two pretty interesting posts about the RSS "phenomenon" - one by Dead 2.0 and another by Scoble. The center of the debate seems to be that if RSS is so damn great and is going to change the world, why do 98% of the people not subscribe to an RSS feed while 89% have no idea what it is? Distilling both posts (and overlaying a little of my own knowledge and common sense), it seems that the biggest issue is that of marketing - the terms "RSS" and "feeds" are just too geeky for normal folks, and, in fact, are off-putting. I kind of buy this argument. One need not be a Luddite to be totally overwhelmed with what's happening in Internet-land, and RSS is only the latest manifestation of people's techno-fear. "RSS Reader? What the hell is that?" That said, RSS is game-changing and will, in fact, change the world. The only questions are: (1) when; and (2) by whom?

Wheneth RSS?

In thinking about the growth and development of RSS and its dissemination across the technology landscape, it really seems to be a parallel to investment in the emerging markets. RSS, as such, is an opportunity, just like the emerging markets are an opportunity. However, investing in the emerging markets is scary because they are unproven and highly volatile - kind of like start-ups leveraging RSS. But the markets themselves are just too big to be ignored, so the key becomes picking the winners and losers (countries and companies) and who has the biggest advantages when investing in these markets. So as to wheneth RSS? Now. But the amounts invested will pick up steam as experience is garnered, "markets" (read: client adoption and marketing success) become more stable and risk is squeezed out of the system.

Some will invest big early because they have conviction and know the biggest rewards come to those who are willing to assume the greatest risks, while others will only want to invest a little to gain some exposure and experience and to see how it goes. This seems to me a lot like the way VCs and strategic investors approach investing in RSS and related technologies - risks are high, yet less for those where there is a strategic advantage (like an oil company buying drilling rights in an emerging market), but warrant investment in any event because the long-term upside is just too big. Making investments at this stage is hard because the information vacuum is so great, though the untold riches are alluring and the fear of "missing the wave" and being left behind is sufficient to attract investment.

Who Will Win?

Beats me. There are many far more qualified than I to make such an assessment. However, if the emerging markets are any guide those who are able to attain scale rapidly will find themselves in the pole position. And given the empirical and anecdotal data concerning adoption of and resistance to RSS, the companies that do the best job making the technology and its applications simple, straight-forward, non-threatening and accessible will be able to create that scale and secure the first-mover advantage. Another fixture of the emerging markets are that those whom are the best at risk management stand the best chance of surviving - and thriving. And given the nascent (yet inevitable) nature of RSS, stumbles are certain to occur and will take down those whom are not sufficiently nimble and adaptive to respond.

Let's just hope we don't see the emerging markets debt crisis of 1998 redux - that, we don't need.

Can You Digg It? - Market Manipulation vs. Wisdom of Crowds

Let me start off by saying that I am neither a techie nor an experienced Digg user, but the lively debate around the habits of top Digg users and Digg management together with my knowledge of market structure has led to me to an interesting parallel - Digg as a vehicle akin to small-capitalization, thinly-traded stock manipulation versus the "wisdom of crowds," which is what I thought the whole social bookmarking phenomenon was about.

Now I don't want to drag other social bookmarking companies into this dialogue - del.icio.us and reddit, for example - but to focus on Digg and why so many people appear angry about its breach of an implicit social contract. I have observed that this contract seems to encompass the principles of free speech, honesty and oversight for the benefit of the larger user community. Somewhere Digg has fallen down, and I think a brief discussion of the why's could be instructive to understanding how people will preference, share, and analyze information out on the web.

Can you Digg It?

So much has been written about Digg lately that it is beyond tiresome - and I don't want to add to the swarm. However, I am providing a set of links below for those who have either missed it or want a quick review of some of the issues that have been raised over the past several months:

Don't Believe the Hype: Digg, Business Week and Accountability

Digg Paths to Profitability and Social Networking

Could Digg be used for Sun Stock Manipulation?

Digg Corrupted: Editor's Playground, not User-Driven Website

Digg is Corrupted

Is Digg Corrupt?

Suspicious Digging?

Forget Paper Millionaire, Digg's Founder's a Vapormillionaire

All of these posts are from venues that have significant followings in the Web 2.0 community, so the criticism and insights are not to be downplayed. And, more importantly, many of these posts focus on the issue of unethical editorial policies and outright manipulation by Digg management. Bad, bad stuff. Suffice it to say, these are not good days for our $60 million dollar man, Mr. Kevin Rose. This is starting to feel like the Sports Illustrated cover jinx in Business Week terms - get on the cover with a big, smiling, arrogant face with big dollar signs attached - and look out. Now, I have absolutely no axe to grind with Kevin, Digg or anyone else associated with the social bookmarking phenomenon, but I do think all this suspicion (which appears to have basis in fact) makes for an interesting case study.

Out of all the stuff I've read, one post in particular caught my interest:

Top 100 Digg Users Control 56% of Digg's HomePage Content

When folks think of Digg, they're often misled into believing that the content seen on the homepage is representative of what a wide base of Internet users think is news-worthy and important. The numbers tell a different story - that of all stories that make it to the front page of Digg, more than 20% come from a select group of 20 users.

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These Top 20 have contributed a total of 5257 stories that have reached the frontpage out of a total of 25,260 stories to ever reach that page - 20.81% to be exact. Many of these top users have, as Digg terms it, a popular ratio of 30% and higher, meaning that almost 1 out of every 3 stories they submit will reach the homepage. Several users (specifically DarkHack & OsterMayer) have popular ratios of over 60%.

A logical extension shows that the top 100 Digg Users have contributed 14,249 stories to the homepage, or 56.41%. At Digg, a very select group of users is dominating the popular homepage content. Far from being a mass of opinion, Digg is instead showing, primarily, the content opinions of just a few, select folks.

These are a few excerpts from the post, and the comments that follow are interesting to read as well. But for a markets guy, the first thing that screams out is that this is not an efficient market, and Digg is the owner of the exchange. Not only that, but it is a thinly-traded market that can be both easily and substantially manipulated, and based upon many of the comments I've read this is exactly what appears to be happening. This kind of market structure and "oversight" will not engender confidence among its user base or serve as a template for expanding that user base. And, far from the "wisdom of crowds" moniker afforded the social networking networking phenomenon, Digg's current community appears to provide anything but (i.e., where is the wisdom? where is the crowd?).

What of Verticality?

So, given the inherent weaknesses in Digg, my question is whether this is more a commentary on Digg itself or horizontal (read: non-topic specific) communities. If you aren't going to create a free market and allow users to truly, and purely, drive the community (are you hearing this, Digg?), then is it better to organize along interest-based vertical communities a la, TechCrunch, GizModo and Engadget with editorial oversight? These sites do a good job creating content and insight in subject areas of interest to its communities, while enabling readers to comment and be part of a subject-specific dialogue. Seems like a good model to me, but distinctly different than that of a social bookmarking site.

This seems like more of a compare/contrast between Google and vertical search engines. Assuming that Digg and other social networking sites are run in a true "wisdom of crowds" manner without editorial manipulation, I think they would start to take on the character of Google, i.e., extremely powerful aggregators of information, based on the wisdom of crowds but with some ability to be gamed by the user community. Google certainly isn't perfect but it is directionally powerful and relevant - quite simply, it is what it is and what it is adds a lot of value. Vertical search engines, narrow in scope but more powerful and accurate than horizontal search tools like Google in their respective domains, appear more akin to the TechCrunches GizModos of the world. Certainly not all things to all people, but providing tremendous value their specific user community.

Conclusion

The key, it seems, is that of integrity. You don't need to be all things to all people or be perfect at what you do. However, what you do has to be done with openness, honesty and with an open ear to criticism. Digg seems to have failed on these scores to date. Over time, markets operated in a corrupt manner inevitably fail as people flee to areas where they can find consistency and truth. These are exactly the things that seem to be lacking in Digg. I hope they can find their way back.

Stock Spamming for Profit - A Sucker Born Every Day

First social networks for stock picking and now this: empirical research showing how stock spamming is a profitable strategy, and those who fall for this lose, on average, 5.25% within the two-day period following the hype. These were the results of a study by professors Laura Frieder of Purdue and Jonathan Zittrain of Oxford. BBC News wrote a nice summary of this research study, and drove home the key points of the abstract:

E-mails typically promote penny shares in the hope of convincing people to buy into a company to raise its price.

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The team found that a spammer who bought shares the day before starting an e-mail campaign and then sold them the day after could make a return on his or her investment of 4.9%.

"If he or she were to be a particularly effective spammer, returns to this strategy would be roughly 6%," they wrote.

Conversely, if someone who received the message chose to invest $1000 (£530) in a promoted company they would be left with $947.50 after two days.

Victims of a large e-mail campaign could be left with $930 after two days.

On average a victim loses $52.50 for every $1000 invested.

However, real losses would be even greater, the team suggest, because the victim would also have had to have paid fees to buy and sell the shares.

Suffice it to say, this is some ugly, ugly stuff. Professor Bainbridge, a law professor at UCLA, also wrote a post concerning this issue. His focus was more on the theory of whether or not stock spam could be successful in an efficient market and the difficulty of being an investor and trying to take advantage of the stock spammer's activity. To me this perspective is interesting but not relevant to the real point: why are tens of thousands of people sufficiently gullible as to fall for this "pump and dump" b.s. again and again and again?

My theory is that the mind-set of those who try and take advantage of "tips" imparted through stock spam is similar to those I described in my earlier post on social networks for stock picking - they are entertainment-seekers for whom deploying capital (now, I am specifically NOT using the term investing) is a game, not a vocation. As a result, the emotional state of those responding to stock spam is akin to that of a gambler - trying to make a quick score, trying to be smart, wanting bragging rights, wanting the "high" of a profitable trade. Mind you, this bears no relation the mind-set of a professional investor (or even the prudent amateur): a keen focus on strategy, controlling all the variables you can, long-term orientation, risk mitigation, taking a deep breath, thinking and then thinking again before entering a position.

I have always thought that gambling, in general, gives rise to externalities because it preys on the weakness of the human spirit and the desperation many people feel. That said, regardless of whether or not stock spam gives rise to a similar externality, until the returns are squeezed out and the "dumb money" stays away, it will be here to stay. My advice to those who think my perspective has redeeming value or for whom any of this or my previous post resonates: JUST SAY NO. The "rush" of a successful trade is a drug (and a highly addictive one at that) for many, and I entreat you to stop. Please.

Internet Information for Alpha Generation

As you may have heard, Lions Gate Entertainment is in discussions with Apple to offer digital movie downloads from its library via iTunes. This story hit Yahoo! News The Motley Fool (thanks for the correction, Alyce) at 3:40pm yesterday. While many have speculated about Apple doing such deals with the studios, Apple had been conspicuously quiet on this topic.

In Lions Gate's earnings-related conference call (catch up with its latest quarter here), CEO Jon Feltheimer revealed some interesting information in the pep-talk segment of the call, according to my copy of the transcript: "We also have digital delivery deals with CinemaNow, Movielink, and iTunes, with upcoming announcements with at least two more industry players."

Say what? We know for sure that movie studios like Lions Gate have been signing on with Cinema Now and Movielink (and even file-sharing site BitTorrent). But the progress of Apple's talks with movie studios has remained in the realm of rumor and innuendo, although there was no doubt something's been going on. (Same goes with Amazon.com (Nasdaq: AMZN - News), although there were more rumblings about that yesterday.)

Lions Gate President Steve Beeks said the content should be available on iTunes by the end of the calendar year, adding, "We know when they are planning on launching, but since they have not announced it publicly, I don't think it is our place to say anything more about that."

Suffice it to say that this is an interesting and meaningful tidbit of information, likely giving comfort to Apple followers that someone is on the ball over there after all the lousy press over the employee stock option pricing issue. Examples of executives suffering from foot-in-mouth disease happen every day, and this just happens to be a particularly high-profile example involving a stock that is widely held, closely followed and "hot." Anyway...

The Story

The interesting thing here is that while the story hit Yahoo! News The Motley Fool yesterday (that's August 22nd for the calendar-challenged), the information contained in the story was actually generated August 9th. See those highlighted words in story snippet above - earnings-related conference call - that happened almost two weeks ago. Huh? Don't you think this should have been picked up by major media somewhat earlier than two weeks after the fact? Wait - don't you think this should have been picked up by Wall Street way before this? This is a classic example of information on the internet being available way out in front of information distributed via conventional news sources (if one can consider Yahoo! News The Motley Fool one of these sources; I mean, we aren't exactly talking about the Wall Street Journal or the New York Times, are we?). But to be clear, information concerning this leak has been bouncing around the web since it happened, and has been making its way into larger and larger forums over time. Let's consider the information dissemination cycle here to better understand what really happened.

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August 9th 4:30PM - The Call

Lions Gate management held a conference call with several Wall Street analysts to discuss Q1 2007 earnings. A transcript of the call was placed on Seeking Alpha shortly afterwards. On the call were the following analysts:

Lowell Singer - SG Cowen; Yolanda Masalan - Credit Suisse; Michael Savner - BofA; David Miller - Sanders Morris Harris; Jacqueline Spring - Thomas Weisel; Barton Crockett - JP Morgan; Eric Handler - Lehman; Matthew Harrigan - Janco Partners; David Bank - RBC; Michael Kelman - Susquehanna; and Berna Barshay - Ingleside.

During this call the President of Lions Gate, Steve Beeks, uttered the following (this taken directly from the call transcript):

"In terms of iTunes movie downloads, I think most likely some time before the end of the year. We know when they are planning on launching, but since they have not announced it publicly, I do not think it is our place to say anything more about that. Calendar year."

Sounds good, Steve. Questions, anyone? Anybody? Anybody??? Not one analyst on the call asked a follow up question related to this. We didn't see the studio analysts running to tell their analyst partners covering Apple of this new insight. So where did this information go? Presumably down a black hole - for now.

August 12th - Lions Gate and iTunes referenced by PaidContent.org

Rafat Ali wrote a short blurb in the wake of the Lions Gate conference call discussing their digital strategy. While the word iTunes was written in his post, it was not specifically referenced as an issue that warranted particular attention. The angle of the story was to review Lions Gate's plans and not the implications for Apple.

August 12-17th - In the Black Hole

Not a whole lot of chatter either in the blogosphere or in the news media during this period. Could the information leaked during the conference call be useful in the hands of a skilled investor? Maybe, could be, certainly couldn't hurt for someone who knows the stock, knows who owns the stock, understands sentiment around the stock, has a view of what news is priced in and what is not, etc. This one-week period "below the radar" spells one thing in my mind: opportunity.

August 17th 3:44AM - Picked up by /FILM

This industry site publishes a story titled "Lions Gate joins Apple's iTunes Movie Store" and adds some additional commentary to the discussion.

Apple was going to announce the new store at the Worldwide Developers Conference which took place last week, but elected to postpone the service's roll-out until September 2006 says Apple insider website Think Secret.

We are still being told that despite Apple's best efforts, the store will only feature movie rentals. In July we reported that Apple has signed agreements with Walt Disney, Universal Studios, Paramount Pictures, and Warner Bros.

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While a online movie rental store is not the perfect situation, it could be great for consumers if Apple offered a subscription model. Consumers would be able to pay a monthly fee (say for example $19.99) and would be able to download and watch (on their iPod or computer) as many movies as they want for as long as they pay the monthly subscription cost. But I doubt the studios would be up for such a service at this point in time. Or will they?

Ok, this is pretty good stuff. They know the industry and topic very well, add some historical perspective, and make a projection of what an digital download rental model might look like. So from here, where does the story go?

August 17th 5:00PM - Picked up by Apple Insider

Slash Lane at Apple Insider penned story titled "Studio spills Apple's iTunes movie store plans." This is the first time the issue started to gain traction. There were 22 commenters to the post all offering their view of whether or not this was news, whether or not the leak was on purpose and if Steve Jobs himself was behind the story. 27 blogs linked to this story, further amplifying the reach of the story.

August 18th - Picked up by those across the Mac world and it's out

Jonny Evan's story in Macworld announced confirmation of Apple's iTunes movie plans, and specifically referenced the /Film story as its source. A quick review of Google News shows how the story has been broadly picked up across the blogosphere.

August 22nd 3:40PM - Yahoo! News The Motley Fool gets the story

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So What?

I guess the key question here is whether or not early insight could have helped a skilled investor make money. Consider this: two days before the Lions Gate earnings call Apple held its highly- anticipated worldwide developers conference, a forum at which many expected Steve Jobs to announce some new and exciting developments and strategies at Apple. iPod and iTunes are the most exciting topics du jour, and much to the chagrin of Apple followers the main topic of Steve's discussion was that of the new Mac Pro line and a review of the new OS Leopard. This was reported on August 7th in Yahoo! Finance via bizjournals.com and the market appeared disappointed by a lack of news.

So, with dissatisfaction over Apple's August 7th disclosures and softness in the stock, could knowledge of the August 9th Lions Gate leak directly related to iTunes have positioned one to make money? I'll let you decide.

Social Networks for Stock Picking? - Give me a Break

Today TechCrunch had a piece on a company called socialPicks, whose tagline is "Putting a Face Behind Every Investment Idea," and which labels itself as "...a community for stock market investors." TechCrunch provides more details on the socialPick's raison d'etre:

Users enter their stock trading activities and thoughts then befriend and rate other users. Reputations are built according to a user’s percentage of winning picks, quality of insights as judged by the community and number of trades made. With commenting, feeds and a list of popular stocks that looks like a tag cloud (just charming really) this site has got most of the requisite features of a standard social network. SocialPicks believes that an emphasis on individual reputation instead of aggregate information will prevent much of the gaming that critics of social stock sites often critique.

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The company is also of the belief that many people want an easy way to share their knowledge with a small group of their friends in a structured way. They are aiming for a del.icio.us model more than a digg model, they say. That’s the main part of their approach that prevents pump and dump activity, they plan to institute activity monitoring that will notify users of suspicious behavior as well.

Needless to say, there are variety of other sites trafficking in this space (with confidence-inducing names such as Feeling Bullish, Bullpoo, Gradr, Stocktickr and Digstock). I don't know if I've been living under a rock or something, but this whole social-networking-for-stocks phenomenon has completely passed me by. And for good reason. It's both stupid and potentially dangerous.

It is particularly interesting to read some of the comments to the TechCrunch article. The diversity of comments pretty much represents that of the investing public - most comments have no appreciation for history or empirical research, a few are so far off the reservation (citing "wisdom of crowds" as the reason why such sites make sense) as to hardly warrant comment while a few actually raise the fundamental issues of indexing, risk management and diversification. The feel one gets from looking at these sites is that investing is somehow supposed to be FUN. For those of you who have lived in the markets for a long time, we all know this to be the kiss of death.

Investing life should not about being the next Jim Cramer - or if it is, may the force be with you. Investing in equities for long term profits is HARD, and unless you are professional (and, I might add, one of the few rare professionals whose record is empirically proven to be due to something other than pure chance), then it is best to get out of the way and to focus on the one thing that really matters to building and preserving personal wealth - asset allocation.

I could cobble together an entire research paper on this topic in an afternoon if I had the time, but the core principles off the top of my head are as follows:

1. "Wisdom of crowds" is the right concept in the markets, including the equity markets, and it already exists - it's called a stock price. Whatever makes you think you know better regardless of what some of your pals think is completely beyond me.

2. Asset allocation accounts for 90% of investment return across a diversified portfolio, e.g., picking the components making up the each of the building blocks accounts for only 10% of the portfolio return. Read: it's all about asset allocation, stupid.

3. Investing is not a game and shouldn't be viewed as a source of entertainment. If it is then call it what it really is - gambling. That's ok - use your brain and focus 95% of your efforts on 95% of your portfolio (meaning choosing asset allocation and using indexes to achieve your portfolio objectives) and mess around with 5%. Just know what you are doing and label each of your activities for what they are - investing and gambling.

4. Unless you have a staggeringly large data set it is almost impossible to attribute a stock-picker's success to skill and not luck. I wrote an entire post on this concept several weeks ago, and I encourage you to take a quick peek. Someone's posted results on a social networking site (even if verified as true and as having happened by members of the site) may or may not be indicative of that person's skill. The issue isn't necessarily the veracity of the claims (which is the big argument made by these stock social networking sites), but whether the claims are statistically meaningful and indicative of skill. If this is a game you want to play, good luck.

I spent over 17 years on Wall Street in M&A, Derivatives and Trading, and I personally don't feel comfortable trading single stocks. Because I'm stupid and don't understand the markets, valuation, and "the Game?" No. Because I am humble and aware of the barriers to success. If you want to play games and have fun on these sites, go ahead. But if you want to be an investor and increase your chances of building and protecting wealth, it is decidedly not fun and it's serious business. No fooling.

It's the Data, Stupid

So Thomson Financial has finally done something that truly reflects the age - using computers and software to churn out commodity-type stories in the wake of U.S. companies' earnings releases. They have the historic data, they have the "training set," and it was only a matter of time before they would connect the dots and give customers what they really want - basic accuracy with lightning speed. In short, to give customers the data they require, in real time (well, 0.3 of a second is pretty good), in order for them to use their expertise to make a decision. I knew this day would come and applaud Thomson for using available technology to manage workflow and optimize scare resources - the time of their premium reporters and writers.

I had an "ah ha" moment concerning this issue when visiting a leading Boston-based VC about nine months ago. This VC, knowing the kinds of things I was interested in, dropped a 50-page research report in front of me and said "this was produced by a machine." Wow. I scanned it, and it looked pretty good. Clearly the software had been trained to understand the writers' style and diction, not to mention having an appreciation of historic context from previous analyst reports. When given new data, the machine was able to craft a report in the style of the analyst that provided the facts and added commentary in a very straight-forward manner. Interesting. But the fact is, reporting the news and providing commentary is a commodity, and precious few analysts add enough value to warrant the buy side shelling out significant dollars for their services. Thomson's recognition of this fact is one of the reasons I find their move worthy of praise. What the VC showed me was an interesting techno-trick, but to my way of thinking way off-point. Leading analysts and traders want to make their own decisions - "give me the data and I'll decide what to do with it" is the mantra I've heard time and time again.

At the end of the day it's clear - smart investors want data. They want interesting, unique data, and they want it fast. Not the same junk everybody else gets, unless it is delivered markedly faster than the speed at which others receive it. This angle is clearly a race to the bottom, as ever-more sophisticated streaming data providers, faster chips and better hardware are splitting milliseconds into ever smaller units to try and create an edge. This is a limit that will soon be reached. This is not a game I would choose to play.

Thomson is giving traders and analysts what they want. But, in fact, they want more. Earnings reports and their interpretation are a necessary but insufficient data point for managing a portfolio. What they are providing is called a commodity.

So where is the edge? Different data, in real time, is what will create the edge. It has to be fast. It has to be different. It has to be relevant. It has to be discoverable. Without these things it will fall into the vortex of the thousands of unread emails or the stack of papers sitting on the left hand side of your desk. So Thomson got it right that it's the data, stupid. But are mechanized earnings reports going to change the world? I think not.

SoaP, the Internet and the Implications for Investment

Have any of you been following the happening that is known on the Internet as "SoaP" - Snakes on a Plane, the new Samuel L. Jackson movie that just hit theaters? In the initial aftermath of its Midnight Thursday release, it seems clear to me that this is the most recent example of an elightened company's use of the Internet to create buzz, create brand, create community, and pre-ordain success, all while keeping costs down. As an investment guy, my first thoughts turn towards two key quesitons: "How can this approach be used to do business better?"; and "What are the implications for Wall Street?" It seems to me that the answers are straight-forward and the implications truly staggering.

Background

The buzz around this movie has been truly insane. Per Technorati, there have been nearly 60,000 blog posts leading up to SoaP. According to BlogPulse statistics, approximately 2.25% of current internet chatter is related to, yes, this movie. This puts hot topics such as Microsoft and Apple in the dust. Further, this traffic is highly dispersed, being spread over literally thousands of different blogs. An excellent overview of the SoaP phenomenon can be found here. The movie's studio, New Line Cinema, even re-shot parts of the movie in response to the desires of its raging online community. And, according to this article, New Line did even more:

New Line even ran a contest through the social networking Web site TagWorld for bands to write a theme song for the movie. The Los Angeles-based electropop duo Captain Ahab beat out over 500 other submissions with their throbbing dance track "Snakes on a Brian."

So, just how much buzz can an interactive marketing campaign drum up?

According to the latest report from market research firm Wordtracker, which monitors data from a variety of Web search engines, "Snakes on a Plane" is the No. 166 most popular query (with the somewhat futile adult content filter turned on). That's slightly below searches for "tattoos" (No. 149), "Pam Anderson" (No. 162) and "jobs" (No. 163), and just above "love" (No. 185), Kelly Clarkson (No. 197) and "FOX News" (No. 204).

Truly staggering.

Implications

Doing business better: It is pretty easy to see how companies can use this approach to gauge the market before a costly launch, and how identifying key influencers and connectors, a la Malcolm Gladwell, can drive awareness and, subsequently, demand. Rather than taking an adversarial approach to those referencing company assets, New Line took a decidedly different approach that clearly inured to their ultimate benefit:

Even top brass at New Line were logging on (to Finkelstein's SoaP blog) regularly. But instead of setting loose a crate of lawsuit-happy lawyers, the studio decided to ride the wave of free publicity.

"Whenever I call New Line, the first thing I always ask is 'Are you going to sue me?' And they always say 'no' and we laugh," Finkelstein said.

"New Line hasn't threatened to sue anybody, and they've been generally genial toward their fans and it's worked hugely to their benefit. I can only hope that other studios take note."

Exactly right. Given the publicity New Line has received for this brilliant and cost effective PR and marketing approach (spending only 7% out of a $30 million marketing budget), I am sure other studios (and businesses of all types) will take note.

Implications for Wall Street: As online marketing of the sort done by New Line with SoaP takes hold, how can Wall Street and institutional investors benefit from this wave? Quite simply, Wall Street and and investment community are going to need to get a lot more savvy in the ways they monitor Internet activity as it relates to specific investments and themes across their portfolios. Current techniques for monitoring Internet buzz, in real-time, are largely used by those in the intelligence community for tracking unusual patters within terrorist chatter and online fraud.

While there is a growing business in studying online chatter within verticals such as pharmaceuticals, telecommunications and autos, this is a largely services-oriented consulting business that is effectively used by PR and brand managers to better understand their audience. While the technology for interrogating specific sites and being notified of when changes occur is more evolved, what of the ability to monitor thousands of sites simulteneously, in real-time, in a way that helps someone access and analyze the information without being overloaded? My belief is that this is the next frontier of technology development, and represents a bridge between the ever-growing and influential online community and a Wall Street and investment community starved for unique insights and information that can be monetized.

The day is almost here. Stay tuned.

A Better Model for Patenting?

As mentioned in an earlier post, I am pretty miffed by the weakened state of the U.S. Patent Office and the IP "land grab" that has ensued. I kind of feel like examiners in the U.S. Patent Office find themselves in the same position as examiners in the NY Department of Buildings, reviewing countless requests for renovation permits in the wake of the Wall Street boom. Patent examiners are being deluged with requests, resulting in an overworked, harried staff that is motivated to move paper instead of giving each application its due. This is not their fault - the system is flawed. But their output impacts us all, with potentially far-reaching and innovation-stifling effects.

One recent suggestion written up in Fortune talks about using a Wikipedia/peer review model to enhance the quality of information considered during the patent examination process:

The issue is that patent applications have tripled in the past two decades, leaving examiners only 20 hours on average to comb through a complex application, research past inventions, and decide whether a patent should be granted.

As a result, critics contend, quality has declined and lucrative patents have been granted for ideas that weren't actually new.

One solution is to let astute outsiders weigh in during the patent-review process, as online encyclopedia Wikipedia does, vastly increasing the information available to the patent examiner.

Wow, what a cool way to harness the power of the collective brain for good. Though writing about a different topic, business development in a Web 2.0 world, Fred Wilson hit on a theme - leveraging good stuff that already exists instead of doing something (that may ultimately be of lesser value) from scratch - that I believe is directly relevant here:

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These days it's often better to just take what's already freely available on the Internet to integrate with other web services. As Caternina explains in this post, the Flickr team didn't really have enough time to focus on the multitude of companies wanting to offer a printing service. Qoop just built one and when Flickr looked at it, it was an easy decision to offer it to their customers.

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The bottom line is that web 2.0 offers a new way to get integration with leading web services and you don't have to waste your time and the time of other busy people trying to craft deals that will probably work out badly anyway. As Caterina says, "Much, much better this way!"

Get the analogy here? There is so much knowledge out there already spread across the increasingly friction-less world, how could a single patent examiner possibly know more than the collective brain of the Internet? It is simply not possible. IBM has already gotten behind this initiative and, along with Microsoft and Hewlett-Packard, is preparing to road-test this concept using a subset of their existing patent portfolios:

Says Dave Kappos, vice president for intellectual-property law at IBM: "It's a very powerful concept because it leverages the enormous capabilities of the entire world of technical talent."

Working with IBM and the Patent Office, Noveck developed a system that will not only permit, for example, an inventor to show that an allegedly new idea is already in practice but also lets reviewers rate one another's submissions, much as they do on eBay (Charts) and Amazon (Charts).

Patent examiners will be given only the ten highest-rated pieces of input, and attempts to sabotage a competitor's application by submitting phony material should theoretically be avoided.

At this point the patenting process is so broken and the stakes are so high that almost any reasonable suggestion should be considered. This patent-with-the-help-of-Wiki idea is just the kind of out-of-the-box thinking we need. The creator of this idea, an NYU Law School professor named Beth Noveck, had the vision to suggest something that seemingly goes against the whole concept of patenting in the first place - I have something unique (I think), I won't tell you what it is for a long time, I am going to protect it, and you can't have it unless you pay me.

However, the unintented consequences of an overworked Patent Office - too many patents granted for ideas that are either too broad or not truly unique - has directly threatened the innovation culture that has made the U.S. an engine for global technology growth. While a little openness may seem anathema to the patenting process, it may be just what we need to align interests, reward true innovation and break the patent log-jam. I am eager to see how the pilot goes. Drastic change is required to get things back on track, and this might be just the ticket.

Baidu in Trouble?

I find the world of internet search very, very interesting, and increasingly so in places like China. While China may seem like a place with little tolerance for online conflict, I have seen evidence of rip-roaring online fisticuffs all over the Chinese BBS for the past two years. Another great thing about these impassioned posts on the BBS is that they often include pictures, showing protesters rallying against their antagonists peacefully but with emotion and intensity. Yet another interesting observation is that really interesting insights and data from the BBS often don't make it to Western media until days or weeks later. Talk about information arbitrage.

The latest area of conflict I have discovered relates to the Chinese language search engine, Baidu, and accusations of that unholy-of-online-holies, click fraud. Further, from what I've read it appears that Baidu is in the midst of a series of Office Space-type bungles that have garnered it some pretty unflattering chatter across the BBS. It seems like they are having a bad-hair month.

Concerning the accusations of click fraud, one poster laid out a pretty damning fact pattern indicating that Baidu might have internally boosted click results for a paid-search client costing that client millions of yuan (hundreds of thousands of US$):

The client, an obscure cancer research clinic (sounds like a shady character itself), says in a statement that they inked a contract with Baidu in early 2003. (From Baidu's vaguely-worded intro to this service on its Web site the idea of the service is that business clients bid for their rankings in searches on certain key words by netizens. Those that pay more ranks higher up in search results and have more chances of getting clicks, hence business, from potential customers. They also pay Baidu for each visit resulting from such a search.)  The clinic says it has spent millions on this service since then, and clicks on their Web site have indeed grown dozens-fold. But actually business never picked up as a result of more Web traffic. The clinic hired outside help and found out that up to 70% of the traffic actually came from cpro.baidu.com. Rings a bell? They concluded that Baidu artificially bloats traffic to their sites in order to collect more fees.

The original basis for this post was taken from a reporter's own BBS site, with the translated text as follows:

Baidu advertisers protest against click fraud

At noontime on August 4, around ten Baidu advertisers gathered together in front of the Baidu building, protesting against supposed click fraud. the protesters held in their hands an official letter of notice from the city of Beijing. Among those protesters included the Beijing Zhongbei Cancer Medical Research Center.

The research center, which has been an advertiser at Baidu since January 4, 2003, alleges taht the click fraud has been as high as 70%, spending over a couple million yuan over the past years. The center complains that since last year, the click rate has increased exponentially without producing actual sales. Through a neutral party's investigation, it was found that more than 70% of the click traffic originated from cpro.baidu.com, which is a subsidiary of Baidu.

The advertisers demand a full refund.

Ouch. If the outside help hired by the research center is right, this is pretty scary stuff. Admittedly I am neither an expert in click fraud nor an authority on Baidu, but I have always thought that click fraud was perpetrated by entities outside of the search engines with consequences for the search engine's paying clients. This is what I thought the click fraud suits involving Google were about - Google's lack of sufficient efforts to combat click fraud, not that Google itself was the instigator of the fraud. Google has also taken steps to address this issue by providing data on click fraud it catches, and reporting these figures to advertisers (whether or not Google's steps to combat click fraud are sufficient is a matter far beyond my ken and better left to those smarter than me). This situation with Baidu appears completely different, however, where the claim is that Baidu itself generated up to 70% of the click volume for which the client was charged.

Yet another interesting topic is the potential manipulation of search results. Remember that Office Space reference above? Well, Baidu fired 45 employees in two hours in a fairly uncermonious fashion. One such employee actually recorded their interaction with Human Resources and the translated transcript can be found here. This isn't so bad - every large company has their Vault-posted nightmare HR stories. What I found particularly interesting is that a friend of mine in China ran a search on this issue in both Baidu and Google with vastly different results - Baidu came back with only about 6,700 returns, while Google's count was closer to 45,000 (that's not a typo - we're talking 7x the number of Baidu). I am also told that Baidu generally does better on these types of searches than Google. So what's going on here? Good question, but the implications are certainly not good.

We'll see if these stories pick up steam across the BBS and enter the mainstream Western press. If they do, I am afraid Baidu might be in for some tough sledding.

Hedge Funds as Asset Management Complexes - The Day Has Come

Yesterday's story in the FT about DE Shaw making a push into traditional asset management was the straw that broke this camel's back. The theme of convergence is one I've written about on several occasions during my short stint as a blogger. Closely related to this theme is that of the structure of the hedge fund industry in general, which, in my opinion, will increasingly resemble that of a barbell (mega-institutional asset managers on one end and emergent single strategy managers on the other). But come on, a few days ago it was talk of the $20+ billion Fortress Investment Management's lingering plans to go public (at some say a valuation of, what, $6 billion?!?) and now this? It was the language in the FT story that really made me sit up and take notice:

Trey Beck, who is in charge of developing the institutional business for DE Shaw, said the group, which manages $23bn in hedge fund strategies, had only about $300m in traditional asset management but planned to increase this substantially and had just won three new mandates.

"We are in the [traditional] business to manage tens of billions of dollars, and I can envisage a time when DE Shaw will have traditional asset management funds in excess of the hedge fund business," he said.

"In ten years' time it will be less important whether you are a hedge fund or a traditional manager, but whether you can generate alpha [above-benchmark returns]", he said.

Trey is certainly sounding very institutional, very un-hedge fund like. He sounds like Barclays Global Investors' describing their Alpha Tilts (index plus alpha) strategy. Let me reiterate; very un-hedge fund like. This is not to say that what DE Shaw is doing is bad or wrong, or that Jim Simons earlier decision to open a long-only strategy at Renaissance is either, only that the hedge fund industry as we know it is changing and will continue to do so.

Take Fortress for a moment. They have special situations, macro, distressed, second-lien financing, and private equity. This, my friends, is an institutional asset manager. All they need is a long-only equity book and they'll have it all. DE Shaw itself has statistical arbitrage, both quantitative and bottoms-up long/short strategies, as well as Laminar, which does distressed debt investing and which occasionally takes an activist stance in reorganizations. I am sure they have other strategies under that massive umbrella as well. With the inclusion of a long-only (or primarily long with a limited ability to short) strategy of scale, DE Shaw itself will become a diversified asset management complex. But why?

Let me offer a few possible reasons:

1. Legacy: Managers like Jim Simons and David Shaw (not to mention Wes Edens and his partners) want to build something that will last beyond their personal involvement. By creating a diversified array of strategies and delegating a sufficient amount of investment and risk management control to their portfolio managers, one can envision a DE Shaw, a Renaissance or a Fortress being successful long after their rock star founders have moved on.

2. Scale: Long/short strategies, by their nature, do not have massive capacity. The short side is forever a constraint that weighs on asset growth beyond a certain threshold, depending upon the capitalization and float of the stocks being shorted. Long-only (or principally long-only) strategies have the benefit of growth far in excess of that of conventional hedge funds; one only need look at the monster funds run by Capital Research or Fidelity to see how performance can be maintained in the face of scale on the long side. Jim Simons said his long-only strategy had capacity of $100 billion. Even without the performance fee that kind of cash flow looks pretty good.

3. Addressing a market need: Top performing managers running high quality, institutional-caliber infrastructures are not easily found. DE Shaw is one of those managers as is Renaissance. There is, quite simply, excess demand for their services. Given the constraints mentioned above concerning scalability of long/short strategies, it stands to reason that they would look beyond their principal areas of focus to address this burgeoning demand. Further, given that they are both quantitatively-oriented shops, it is not a leap for them to adapt their algorithms to a long-only model. This is smart from a business sense and neatly helps to address points (1) and (2) above.

This emergence of the institutional asset manager from traditional hedge fund roots is a new thing and, I believe, a positive thing both for these firms and for their clients. I am very confident in saying that this won't be the last we hear of top hedge funds making the leap into the long-only domain, with the consequence being the development of a hedge fund uber class that dominates the alternative investment landscape.

Wall Street and Intellectual Property - Offense or Defense?

There was a very interesting and provocative article in today's New York Times concerning the growing trend towards Wall Street firms patenting elements of their proprietary technology and business methods. A few of the more interesting excerpts are provided here:

Goldman, viewed by many as a patent leader on Wall Street, has hundreds of patent applications in the pipeline and has received patent rights on a couple of dozen products and systems, according to its chief patent officer, John Squires. He joined Goldman in the new position in 2000 after being a patent lawyer with Allied Signal.

“I think there will be increased filings as the convergence of banking and technology is irreversible,’’ he said. “As people spend more and more building systems and deploying technology, they’re going to want to make sure they have the rights available to them.”

Right. This sounds reasonable. Leading Wall Street firms have annual IT budgets of $1 billion or more, rendering the issue of intellectual property management both topical and consequential. Clearly, if a trading research group is going to create its own data mining/algorithmic trading/electronic execution platform it wants to make sure that its IP investment is protected. But what, exactly, does protection mean?

Having worked on the Street for a long time and specifically working in and around areas with massive IT budgets for new and innovative trading and processing applications, many of the projects currently being worked on are in the same general areas, i.e., electronic trading, messaging, order management systems, data mining and extraction, etc. So what of this rush to patent anything and everything that moves, from the more arcane code underpinning order management algorithms to the more general business processes? I'll tell you what worries me - the same stuff that worries entrepreneurs when they read of Nathan Myhrvold's Intellectual Ventures fund - the potential for patent squatting and the subsequent extortion and squashing of incentives to innovate. This would not be good.

If, as I am sure is the case, Goldman and its Wall Street peers are viewing this rush to patent as a big game of Texas Hold'em, then before long these firms are going to be at each other's throats either in backroom negotiations or in court. Read: a big waste of time and money and a huge, huge distraction to building their businesses and innovating. There is, in fact, some precedence for this happening in the past as discussed in the same NYT article:

No one is ruling out the possibility of a patent war between the financial titans some time down the road. It has happened before. In 1982, Merrill Lynch sued the rival brokerage firm Paine Webber, accusing it of infringing on a patent Merrill received on its cash management accounts. Eventually, the two reached a settlement.

“Right now, because all of the Wall Street banks are showing record profits, there’s not much incentive to sue within the club,” Mr. Millien said. “But three years or so down the road, it’s hard to say.”

The big difference between Intellectual Ventures and Wall Street is that the Street is actually making something, not just building a patent portfolio without their associated businesses or functions. So it is not really Wall Street that is (or could be) at fault here, but the Patent Office.

If the Patent Office is sufficiently rigorous and precise in ensuring that patents are being issued for truly distinguished and differentiated IP, and not the general "business process" stuff that has already caused loads of problems during the innovation explosion of the last decade, then everything will be fine. However, the potential exists for Wall Street to be locked in a costly and wasteful struggle among its denizens for years if the Patent Office doesn't get this right. Be afraid - be very afraid.

Schumpeter and Search

As a student of economics, I have long been fascinated with economist Joseph Schumpeter's concept of "creative destruction" as described in his landmark treatise Capitalism, Socialism and Democracy, and its ramifications for the growth and development of industries. Per Wikipedia:

Creative destruction, introduced in 1942 by the economist Joseph Schumpeter, describes the process of industrial transformation that accompanies radical innovation. In Schumpeter's vision of capitalism, innovative entry by entrepreneurs was the force that sustained long-term economic growth, even as it destroyed the value of established companies that enjoyed some degree of monopoly power.

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There are numerous types of innovation generating creative destruction in an industry:

• New markets or products
• New equipment
• New sources of labor and raw materials
• New methods of organization or management
• New methods of inventory management
• New methods of transportation
• New methods of communication (e.g., the Internet)
• New methods of advertising and marketing
• New financial instruments
• New ways to lobby politicians or new legal strategies

Now you have to admit, this is one cool theory. And the beauty of Schumpeter's theory is that it both makes intuitive sense and requires one to ponder history for only a few seconds to come up with several examples that support his thesis, i.e., Xerox, Polaroid, Kodak and General Motors, to name a few. Why does creative destruction occur to companies that are seemingly leading-edge, have vast financial resources and market power and are poised to squash any competitor that stands in their way? Well, a few of the reasons that come to mind include:

1. Success breeds complacency, and by being so happy with yourself you lose the edge and intensity that got you where you are in the first place. This is bad for hard-driving, entrepreneurial people who want the edge and want to win. They lose touch with the company they once knew and the best people leave.

2. Big companies can be less fun than small companies, and the creative and entrepreneurial minds that developed the successful products and paradigms often don't have as much fun or function as well in large, developed bureaucracies. As with (1) above, the most entrepreneurial people will tire of being subjected to extra policies, procedures and processes that serve to inhibit creative thought and follow-through and will eventually leave the company.

3. The prospect of a big payoff is dampened by scale, as the meteoric rise in equity value naturally slows as it becomes harder to grow as fast across a larger base, new competitors enter and make the business less profitable and the equity incentive for employees loses its luster. Again, the best people will want to identify the next challenge and seek the rush and potential payoff of the new new thing.

And these three reasons only address part of the internal environment - how employees are effected when super successful companies get too big and successful. What about the external environment?

4. Arrogance often becomes a fixture of the super successful company, as they begin to believe that they can do no wrong and know what customers want without actually listening to them (I mean, how long were people really going to buy GM cars as long as they said "They'll buy what we build," which was a common refrain within the company during the 1950's and 1960's).

5. Squandered financial resources on either steps to diversify away from one's core competencies, or on irresponsible R&D projects that become "white elephants" and are not subjected to rigorous ROI analysis.   

Hmmm - complacency, less fun, diminished prospect of a big payoff, arrogance and wastefulness - this doesn't sound good. We saw it happen to the formerly great companies mentioned above. But surely we've all gotten smarter, right, and wouldn't make the same five errors I've just described? Some stuff you just can't help, like getting big by being successful. Bigness happens. Maintaining a breakneck growth rate is mathematically impossible beyond a certain scale. And the stagnant stock price necessarily comes to pass as the growth-stock aura is lost.

Have we seen any recent precedence to support my view here? Well, how about:

Microsoft. Remember them? Still a monster but not the monster it once was. Didn't they seem unstoppable for much of the 1990s? $600 billion market cap, super smart people, thousands of Microsoft Millionaires, and who thought the gravy train would ever end? Well, as the base became too large for organic growth to feed the beast we saw efforts at expansion into cable (AT&T, Comcast), telecommunications (Nextel) and other areas too numerous to mention. By in large, I'd say these efforts were a failure. Oh yes, and then there were all those smart people working to chip away at edifice Microsoft on initiatives like Linux and a panoply of other open source programs. Oops, I forgot Google. Oh, and they also spent hundreds of millions of dollars not to mention priceless management time fighting legal battles over their monopoly power instead of developing new products. So what happened? Stock price floundered. Lots of top performers left and took their money and ambition and went elsewhere. Still a great company, but not the unstoppable force of nature it once was. Creative destruction took its toll and is still doing so to this day.

So what of the three most successful internet companies founded in the 1990s, Yahoo!, Ebay and Google? Can they possibly fall prey to Schumpeter's theories? I'd say so, and I'd even go so far to say that Yahoo! could be shaping up to be the next Microsoft with Ebay nipping at its heels. While Google seems like they are still creating without being destroyed in the process, I also see areas where their seemingly impervious shell could be pierced by a legion of super-bright, highly motivated entrepreneurs who simply want to win.

Yahoo! and Ebay. A recent article in the Wall Street Journal specifically addressed the three internal indicators of creative destruction I mentioned above. A telling excerpt from the article is provided here:

While once workers left other companies to join Yahoo and eBay Inc., many employees are now leaving those firms to work at the newest wave of Web start-ups. The exodus -- the largest outflow, some say, since Yahoo and eBay went public in the late 1990s -- is a sign of how the two companies have matured. Part of the original groundswell of Internet firms, the two are grappling with the same challenge of how to retain employees that other mature tech companies, such as Microsoft Corp., have faced.

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Many are leaving eBay and Yahoo now because they have already grown rich from their stints there. And there is little financial incentive to stay: EBay and Yahoo shares have fallen significantly of late, buffeted by increased competition and their maturing businesses. In the past year, eBay shares have declined 42%, while Yahoo stock has declined about 20%. That has pushed many employee stock options underwater, making the potential of lucrative payoffs at start-ups even more attractive.

Again, great companies but indisputably falling prey to several of the indicators of creative destruction. Stock price weakening, employee retention become more of a challenge, switching from a focus on organic growth to one supplemented by acquisitions (which necessarily increases risk) - these are all signs of Schumpeterian destruction in action.

The good news: lots of new companies and technologies have emerged to augment and even improve upon what Yahoo! and Ebay deliver in the marketplace. This is something from which consumers can only benefit. The bad news: it is harder to manage and grow a company under siege from competitors and innovation on the outside and employee flight and massive cultural changes on the inside. So while the value pie (the asset) is expanding to the benefit of consumers, the shareholder pie (the equity) is being shifted from the incumbents to the upstarts. This is a healthy and natural process, but man, it must really suck when you see it happening to you.

So, what about Google, the glamour gal of the moment? Still pulling in great people, losing few top performers, innovating like crazy, focused on organic growth. So where are the chinks in the armor? As noted in a previous post, Google is really great at general search but pretty crappy at targeted, vertical search. Domain expertise is not their forte, and a massive industry has been born and is being nurtured around this idea of domain-specific vertical search. Depending upon how robust and specialized these search engines get, one can imagine that advertisers would be willing to pay more for eyeballs that have essentially self-selected by living on a particular vertical search tool versus surfing a generalized search tool. This could suck ad dollars away from Google and render their general search model a highly profitable but less rapidly growing enterprise.

This would not be good and would readily translate into a manifestation of creative destruction. While they have clearly created an innovation culture around Google Labs and fostered big-thinking by their employees, they need to turn some of this potential energy into kinetic energy if they are to maintain their growth trajectory, drive stock price and keep employees pumped and excited.

While it is hard to get to the top, time (and our friend J. Schumpeter) has shown that it is even harder to stay there.

Pricing Event Risk and the CDS Market

Much has been written lately about those getting smashed in the credit derivatives market, particularly in the wake of several recent corporate reorganizations that have introduced new and unexpected volatility into the marketplace - spin-offs, split-offs, new financing entities, subsidiary IPOs, etc. The ball kind of got rolling with VNU's subsidiary financing, and has picked up steam in light of Verizon's announced spin-off of its directories unit. Bloomberg issued a story today that highlighted some of the heated emotions over this issue:

Hedge Fund Nightmare

The predicament is akin to battling a rare disease because of the more than 1,000 companies with credit-default swaps bought or sold this year, fewer than 3 percent triggered price swings related to a change of corporate control, or so-called succession event, according to data from Frankfurt-based Deutsche Bank AG.

For hedge funds, unregistered pools of capital where managers participate substantially in the profits of the money invested, the volatility of credit-default swaps is a ``nightmare,'' said Simon Ballard, head of research in London at ARC Securities Ltd., a fixed-income broker. ``Credit derivatives have underpinned the evolution of the hedge fund community for the last few years.''

New York Fed

Even the International Swaps and Derivatives Association, the trade group that has championed credit-default swaps as tools to reduce risks in the debt market, is concerned that increased volatility shows the hazard that the contracts no longer reflect the value of assets they're mimicking.

These ``new problems'' are causing widespread confusion, said Kimberly Summe, ISDA's legal counsel in New York. Summe, who helps set the standards for credit-default swap contracts, coordinates a twice-monthly conference call with 150 bankers, investors and lawyers to tie the contracts more closely to a company's credit risk.

So far, regulators aren't voicing concerns. Last August, the Federal Reserve Bank of New York chastised some of the biggest financial firms, including New York-based JPMorgan Chase & Co., the third-biggest U.S. bank, and Goldman Sachs Group Inc., the most profitable securities firm, for allowing 150,000 credit-default swap contracts to remain uncompleted, leaving traders unsure of their obligations.

First of all, a 3% probability is neither akin to the risks of contracting a rare disease nor is it a "tail event." While there is surely improvement to made to the ISDA credit derivatives template, the bottom line is that this (the risks to CDS prices in the wake of corporate reorganizations) is part of the game. Credit risk is not a static measure, and the derivatives marketplace needs to incorporate the probabilities of restructurings and reorganizations into their prices for these instruments. Whining has no place in the markets, folks. People made boatloads of cash on the ride up, and as markets mature and time passes the ride occasionally gets bumpy. Sorry, that's life.

This reminds me of my days in equity derivatives in the go-go late 1990's, when M&A events and spin-offs of dot-com subsidiaries were all the rage. Say we were long some vega (optionality) on a stock (either by owning puts through a synthetic share buyback program or through a short put/long call sold as hedge of an investment position), and the company underlying our position announces a spin-off of its internet subsidiary. What happens? All of a sudden we have positions on two stocks instead of one. So what? The volatility of the basket of two stocks is less than that of the single stock that spawned the two, rendering our long vega position less valuable. Totally sucks, right? Right. But we survived and that was part of the game. The fact is that this potential outcome needed to be factored into our pricing when we initially provided the hedge.

I am glad to hear that regulators aren't freaked about the current situation. They shouldn't be. They were right to be concerned about the massive number of unconfirmed trades, a matter on which the Street has made tremendous progress over the past year. But regulators shouldn't be stepping in where market forces are designed to take care of the problem. Traders can price event risk. They do it every day. If swap spreads need to widen to take these risks into account, ok. But if they don't, all I can say is caveat emptor - and no whining, please.

Come On, People, Get a LIFO

While accounting policy is not a normal area of comment for me, there was a story in today's Wall Street Journal about LIFO accounting that just made my blood boil. The implication of the story is that Exxon is systematically understating both their profits and taxable income by utilizing LIFO accounting for inventory. Let me say in advance that I am neither a defender nor a critic of Big Oil, but that this article and related commentary is such a piece of garbage that it almost defies comment (but not quite).

The 2 second summary of LIFO is this: LIFO means "Last In, First Out." The idea is to try and match revenues with costs, and given that the acquisition cost of inventory varies over time and generally bears some relationship to the revenues generated that it makes sense to match current revenues (i.e., the money garnered from the retail pump at today's prices) with current costs (i.e., the prices paid most recently for oil delivered to retail, be it at spot or delivered pursuant to forward contracts). This, friends, is called Generally Accepted Accounting Principles (GAAP), which is the basis upon which financial statements are (or, at least, should be) prepared.

Companies have a choice of inventory valuation methods - FIFO, LIFO, Average Cost, etc. - and depending upon your perspective arguments can be made for each. Further, depending upon whether one's cost of inventory is rising or falling, the impact of LIFO may be to "overstate" profits and taxable income (relative to the average carrying value of inventory). However, it cannot be disputed that income statement presentation and earnings power is most accurately reflected using LIFO due to the fact that it reflects TODAY's environment. Any other method distorts the picture and makes financial statements much less useful for the financial analyst.

The thing that really irks me is that nobody seems to have a memory here - this witch hunt goes on EVERY UP CYCLE IN PRICES. Did anybody squawk when oil prices fell from $40 to $10 per barrel in the mid-1990s, and poor Exxon was reporting higher profits and paying higher taxes? No, but they sure did in the 1970s. Can't we stop wasting time and column inches by re-hashing old issues that have no intellectual currency? Listen: Exxon is making a lot of money. Yes, they have a large LIFO reserve and a matching deferred tax liability due to their choice of accounting method. SO WHAT!?! Their acccounting is clear, consistent, GAAP-compliant and provides better income statement and earnings power information than any other method. So let's move on, shall we?

Congratulations, Commissioner

The SEC, after much saber-rattling, decided not to try and appeal the court ruling invalidating the hedge fund registration rule. It is nice to see that cooler heads prevailed. As noted in today's Wall Street Journal, Commissioner Cox raised two very important areas where a measure of SEC regulation would be both welcome and appropriate:

Mr. Cox said the SEC will propose an antifraud rule that would deem hedge-fund investors to be clients, reversing a side effect of the court's decision that regulators worried might undercut investor protections, and will consider increasing minimum asset and income requirements for hedge-fund investors.

Commissioner Cox also went on to note a point I have made in previous posts, that the SEC has both the jurisdiction and responsibility to enforce federal securities laws regardless of whether or not a hedge fund is registered:

Mr. Cox said SEC staffers plan to issue other guidance that will help hedge-fund advisers who are already registered with the SEC to stay registered. He noted the agency will continue to enforce federal securities laws when it finds wrongdoing.

This is the right answer, Commissioner. I am happy that you were able to rise above the uneducated and irresponsible banter and focus on the areas where the SEC can truly add value, and not to add unnecessary costs and bureaucracy in order to placate noisy politicians.

The Google Train Rolls On

As I'm sure you've seen, Google just