Sunday, September 26, 2004

Why we need to change our voting system before it tears us apart

I think the United Stated is a great country, but a great country with a serious problem. I think that problem begins with the way we elect our leaders.

Never mind the electoral college. That has some issues, but I don't think that's the worst of the problems. I want to go to the problems with the principle of whoever has the most votes wins.

On the surface it's not bad, especially because we have a bill of rights to protect us for the most part from Tyranny of the Majority. However in the case of the United States, I believe that it has led to increasing polarization of the people in this country.

Our economy and society is extremely complex. To winnow our choices down to two people at the end of the day doesn't allow for full expression of views to carry forward. I can hear you thinking, "but there are more than two people. What is to stop one from voting for a Green candidate or libertarian?" Well nothing stops us except the system. Even though I may like a Ralph Nader, if I prefer Kerry to Bush, then a vote for Nader can have the unintended consequence of putting Bush, whose views I like less, into office. This isn't a repulican vs. democrat thing though. It happened to the Republicans too in 1992 with Ross Perot. It will happen again.

The only chance to pull a candidate towards the center, which is in fact where more people reside is by having some people in the primaries who have a strong enough showing that the party will adopt some of their policies.

I personally am tired of having to vote for one of two guys simply because I hate him less than the other guy. But how could this be done better? I'm not any kind of genius, but I suggest you take a look at the link attached to this post. It describes several methods of compiling votes, including Condorcet methods.

The voter actually has the opportunity to put his votes in the order he would like to see them applied (i.e in order of preference). It then builds a table of preferences for all voters and turns the election into kind of round robin, as opposed to our current single elimination system.

Although this is not perfect and does introduce some complexity into the system, it would allow for other voices to be heard in an election, and I believe would bring the whole political discourse to a place where people are trying to find solutions instead of hammering each other with positions.

Saturday, September 25, 2004

Portfolio Analysis - Opportunity Evaluation (Beyond IRR and MIRR)

OK so I wrote a long screed against IRR and said that MIRR is a better metric, I consider that a fact. But does that really give the answer?

It is a good start. Given that you have some system to prioritize opportunities, you can end up with the highest value. That is usually not the whole picture though. Within a single project, there are usually distinct alternatives to consider. For example, sometimes a project may be able to trade current capital expenditure for future operational expense. This may have the impact of ultimately reducing margins, but giving the company additional leverage in the short term.

So how do you do it? There's really a continuum of methods ranging from simple standalone analysis to a more complete approach incorporating estimates of risk and uncertainty. I believe that most organizations can benefit from a portfolio analysis approach, which tends to the complete side of the spectrum.

In a perfect world, here's what that looks like. You need an inventory of your current operations at a level of decision granularity that reflects potential decision units. Depending on the industry, it could be product line, geographical area, value chain component, or even related to organizational boundaries. It is also useful to understand some of the flexibility inherent in the operations, e.g is there a scenario to increase or decrease production or divest or increase interest. Is there an investment or investment program that could have an impact on the operations? Next you need an inventory of opportunities and an understanding of the potential decisions around them. Typically the decisions are divest, delay, and accelerate.

Finally, and this is usually the hard part, a sense of the organization's financial and operational goals, metrics, and constraints. Typically, these are things like earnings increases over time, constraints on capital spend reductions in expense, etc.

It's also nice to have a quantitative estimate of the risks and uncertainties for each of the options, but that could be asking a lot of an organization.

Once you assemble the data, there are a number of approaches to take. the first step though is to establish your baseline case. Typically, this is manual. Simply select a set of mutually exclusive choices that represent where you think you are going or that contains the recommended cases from your business units. Then look to see how the data rolls together. Is it a growth pattern that seems sufficient, do the capital needs seem reasonable? If it looks fine, maybe you have your answers,

I suggest you go through another step though. Fiddle with some of your metrics. See if you could increase your earnings growth through selection of different project alternatives while maintaining the same overall level of capital and operational expenditures. Try to understand some of the tradeoffs between growth and earnings.

If you have more than 50 or so decision units or assets to consider, this is very difficult to do manually, even with computers. But modeling techniques have come a long way. Using a program like Excel with What's Best and Crystal Ball added in, or Analytica with the new optimization engine, you can explore the infinite combination of decisions quickly to understand the tradeoffs and possibilities in your business.

This can be a yearly direction setting effort, or what I would recommend is that you keep a fairly current inventory of options and as a project approaches its alternative selection time, put those options into your optimization model and see if there is a best fit with corporate goals and other options that have since been locked in.

All this sounds like a lot, but if you have formal planning and project management processes in place it is really an incremental step.

IRR is Evil

A McKinsey article on IRR (Internal Rate of Return) and why it is EVIL. (My words)

Project and opportunity evaluation has two main types of indicative metrics: value and efficiency. Value is typically expressed as Net Present Value or NPV. There are to typical ways of expressing efficiency: as a percent return on investment or as a ratio. The most commonly used percent function is Internal Rate of Return.

First a little background. Present value methods are based on the idea that most people and companies would rather receive one dollar today, than that same dollar one year from today. The preference is usually expressed as a cost of capital or discount factor (percentage) and should equal an indifference value. For example, if it is the same to you whether you receive $1 today, or $1.10 in a year, your discount factor is said to be 10%. In most cases, it represents either a cost or a lost opportunity.

In project or investment analysis, typically an analyst will generate a set of cash flows over time, incorporating everything he knows about future economic conditions, prices, costs, taxes, etc. The NPV is calculated by discounting the the yearly cash flow at the discount rate back to the present day. To use a simple example, if you have a discount rate of 10%, receiving $1 today would be the same as receiving $1.0 a year from today. They would both have an NPV of $1. Internal rate of return uses a similar methodology, but instead of presupposing a discount rate, IRR calculates the rate at which the NPV is 0. It works well only is there is a stream of negative cash flow followed by a stream of positive.

That seems pretty straightforward, what makes it evil?

Actually, there is really nothing wrong with the calculation, as with many things it's how you interpret the facts.

There are two things that make IRR misleading. First, short term projects that pay-out reasonably can have misleadingly high IRRs. Second, and related to the first, IRRs tend to not reflect what a project or investment is worth in the overall context of the company, it makes no assumptions about what happens with the cash that a project spins off.

So a three year project with a 50% rate of return needs to take the cash that it spins out and reinvest it. Unless all the firm's projects are 50% return projects, the reinvestment rate will be much lower. Probably in many cases less than 12%. If you were to put the project on a 30 year timeline, the same as your 15% infrastructure project, and make an explicit assumption about the rate at which the cash will multiply, it is possible that the firm would prefer the 12% project to the 50% project because at the end of the timeframe, you would have more money with the longer term project. I recognize that I am ignoring risk and a number of other factors, but I am trying to illustrate the concept. This is why IRR is evil; people take it out of context and think that it represents a real rate of return to the firm and that it can be useful for comparison of dissimilar projects.

Luckily, Excel allows for the growth rate of return calculation. It is called MIRR. It is sometimes called Growth Rate of Return.

Some of the ratio metrics are also useful. In particular the benefit-cost ratio (BCR) will give the same relative ranking as MIRR. It is calculated simply as the NPV divided by the maximum cumulative discounted negative exposure of the opportunity. Sometimes 1 is added to make the number have a value something like 1.2, meaning that for every PV dollar invested you are receivng 1.2 PV dollars paid back. If a project has multiple phases, sometimes it will have additional negative net cash flows in later years. Those must also be brought back as present values into the denominator.

Foolish Consistency and the Flip Flop

Ralph Waldo Emerson, in his essay “Self-Reliance” stated “A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. With consistency a great soul has simply nothing to do. He may as well concern himself with his shadow on the wall.” This has such relevance in this election that I just felt the need to bring it up.

His point is that establishing a position and sticking to that position regardless of circumstances is foolish and intellectually lazy. I contend that there are some great principles that are non-foolish consistencies (starting with “Thou shalt not kill”). What should not be consistent is your response to events. There is nothing wrong with giving a leader a strategic negotiating position that allows a diplomatic solution. When that leader then uses that position for reasons outside of the original intent and by the way bungles tactically, it is entirely appropriate to criticize the action. It would be unconscionable of John Kerry to do otherwise. The president on the other hand says that we need to stay the course and it was all the right thing to do, demonstrating that he is a man with not just a “little mind”, but also of small spirit.

Cost-Benefit of Iraq

One side of all the analysis I have not heard much about is a cost-benefit analysis of the war in Iraq.

So first let's think about the goals of the action:
1. Get rid of a very bad man.
2. Make the world safer for America and Americans by a. removing weapons of mass destruction and b. removing Iraq's financing of terrorism.
3. Help secure a source of oil?
4. Send a message to the terrorists.

So of those reasons, which of them would have a direct benefit to the US? Make the world safer and help secure a source of oil would certainly have a benefits. Knocking a bad guy out of office is less clear. Sending a message to the terrorists would also be a good thing.

So, if those are in fact true, what would be the value of those? If in fact Iraq had had WMDs, what was the danger to the US? Saddam certainly did not have the means to deliver significant WMDs to the US, so that has very limited direct value. Iraq appears to have been a relatively minor player in world terrorism, so that doesn't seem like a strong value.

The oil side was never really an issue and actions have demonstrated that. Iraq has large reserves and even more waiting to be discovered, but it will be years before that can be tapped to its potential and that supply would be no more secure than any other.

Finally, concerning the message to the terrorists. I'm afraid that the only message we have sent is that we are big and can beat up any country in a frontal war. We have taught them that covert and terrorist means are their best bet and that we are not particularly interested in diplomacy.

So all I can think s that we have spent hundreds of billions of dollars for no particular reason.


Cut to the Chase (whatever THAT means)

This year's political silly season is giving me heartburn. It seems that so many "analysts" are completely missing the point. I just feel compelled to write some of my thoughts.

This argument about military service is such a side issue that it gives me hives. I want to put it to rest now.

Everyone agrees that Kerry served in Viet Nam right? Everyone agrees that Bush was registered in the National Guard right.

Best Case for Bush:
Bush served admirably, attended at all times. The records are lost.
Kerry went to Viet Nam served on the Swift Boats, but his medals were awarded erroneously.
Result: Tie. Bush served well, but never put himself in harm's way; Kerry put himself in harm's way but didn't serve well.

Best Case for Kerry:
Kerry served on the Swift Boats, earned all his medals, and was in fact a war hero as the official record indicates. Bush evaded service and didn't even take mandatory drug tests because he knew he would not have passed.
Result: Advantage Kerry.

I don't get why Bush and his friends are continuing to harp on military service. The best they can hope for in this is a tie. If Bush had one shred of honor, he would call off the dogs on this one. However as John McCain can attest, W probably lacks that shred.

Some Miscellaneous SNL stuff

I have always been a big fan of Saturday Night Live. for some reason I thought about a few SNL things recently: Decabet and Gillette Trac 3

For some reason I thought of the Decabet today. The idea being that it's kind of a "metric system" alphabet with only 10 letters It's like this:

(Dan Aykroyd) of the U.S. Council of Standards and Measurements explains the "Decabet" the new metric alphabet consisting of 10 letters. "A-B-C and D, our most popular letters, will remain the same. E and F, however, will be combined and graphically simplified to one character. The groupings G-H-I and L-M-N-O will be condensed to single letters. (Incidentally, a boon to those who always thought that L-M-N-O was one letter anyway.) And finally, the 'trash letters,' or P-Q-R-S-T-U-V-W-X-Y and Z, will be condense" to one "easily identifiable dark character."

So then A B C D EF GHI J K LMNOP QR... I don't know why, but it just strikes me as funny today.

The other thing that I think about was the phony ad for a razor with three blades (Triple Trac--because you'll believe anything). Am I the only one who remembers that? When Gillette first announced their real product, I blew my coffee out my nose.