Day 17 – Friday Sept 24th 2010

The first session today was a very heavy one - which was assessing Corporate performance during a financial crisis. In this we discussed the issue of fair value accounting and its impact on financial institutions, thru a case study on State street. This is heavy lifting financial stuff !

Basically there are three types of debt securities:

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  Trading - these are traded in the market; these are carried at fair value in the assets side of the balance sheet; value changes are recognized in the income statements; and the value changes are recognized in the retained earnings in the liabilities side of the balance sheet.
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  Available for sale - these are typically investments in securities which are not classified as 'trading' securities, but can be traded if needed and there is a market for it; these are carried at fair value in the assets side of the balance sheet; value changes are NOT recognized in the income statements; and the value changes are recognized in "accumulated other comprehensive income" segment of total shareholders equity  in the liabilities side of the balance sheet.
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  Hold to maturity - these are typically held till maturity and you cannot normally change the categories unless you have some very strong reason for the change;  these are carried at cost in the assets side of the balance sheet; value changes are NOT recognized in the income statements; and the value changes are NOT recognized in the liabilities side of the balance sheet.

The issue is how do you determine 'fair value' - there is a hierarchy of inputs which are used to determine fair value. And these are: 

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  Level 1 - quoted in the markets actively
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  Level 2 - similar products are quoted in the markets
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  Level 3 - very difficult to decide, not quoted, no similar products quoted and hence lot of judgment required

The case also deals with how organizations apply judgement in deciding the fair value - the details of which are hidden in the fine print somewhere - and once the markets discover this, they will hammer the stock - which is what happened in this case. Since the instruments have also become complex, the standards are trying to keep pace with this change in complexity.

In the second session, we continue our discussion on Industry analysis part of competitive strategy by studying the case of how Sony reacted to the introduction of Wii by Nintendo. This will be the last session on Industry analysis, before we move to competitive advantage. 

In the industry analysis module, the most interesting was the Five Forces Framework, and these are:

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  Rivalry among existing competitors
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  Threat of new entrants
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  Threat of substitutes
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  Bargaining power of suppliers
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  Bargaining power of the customers

The profitability of an industry is determined by the balance among the five competitive forces. Even one bad force is enough to drive the profit out of an industry. The leading uses of the Five Forces Framework are:

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  We can distinguish the inherent attractiveness of an industry with high long run profit potential - for example the PC industry vs soft drinks; the former has  low margins and the later has very high margins
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  We can steer towards good positions within an industry; for this we must find a way to deal with the five forces; for example Ryan and Dell have done this in the past and Nintendo with the Wii

Of course there are many influences on the FFF framework (it sounds funny to call it this way, but I will go ahead anyway). Among the influences the key ones are public policy, technology, demographics and complementors.  Complementors is an interesting concept, which is best explained by an example. Some of you would remember the war for superiority in the recording standard between Sony and JVC , where Sony was pushing for Betamax (which was a superior technology) and JVC was pushing for VHS. JVC won the battle by getting the music studios to endorse the VHS standard - the music studios are the complementors here, and managing them well is critical for success. Similarly in the gaming industry the game developers are key complementors for the gaming console manufacturers.

The other interesting concept is called the network effect - where the willingness to pay by a group increases as the group itself increases; for example the fax industry - just imagine the use if you are the only one to have a fax machine, what will you do with it ? Similarly, if there are More users for a gaming console, that drives more users to that console and in turn drives more developers to write games for that console.  Another example is this: everyone goes to Facebook because everyone else goes to Facebook !

The final session was on the US current account deficit. Prof. Vietor was at his best, when describing all the ills of the consumption driven US culture. Some statistics are stunning - 1971 was the last year when the US ran an export surplus. Almost $290b out of $378b deficit is due to oil imports - there is no clear energy policy.  Curiously, some one in the class made a statement that spending in the US is not linked to her income, but linked to wealth. How is everyone wealthy, because they treat their home as a bank !

Fundamentally, there are three problems at a macro level - there is a huge trade problem, there is a capital account problem and there is a savings problem (actually lack of savings). The trillion dollar question is this : is the large current account deficit sustainable ? Prof. Vietor ended the session by making two dramatic statements :

• Todays' generation gets quality goods cheap, but tomorrows' generation gets the debt
• The US is trading assets for consumption - today these assets are treasury bills, tomorrow it will be equity.

Whatever needs to be done should require lot of courage (such as increasing social security, incentivize savings, tax energy, etc) and needs to be done in collaboration with China.

Any discussion related to China is a hot topic and one of our Chinese colleagues was very upset that some one made a suggestion that Chinese should gamble more to increase local consumption. While the statement was made in jest, it could have been avoided keeping in mind the seriousness of the issues being discussed.

Good day, overall. As you would have noticed the classes are becoming more intense and issues being discussed are complex. More later .....