Fundamentals 101 (Part 2)

In my post about fundamentals on September 15, 2008, I started at the top…with the administration that has been in office in Washington, D. C. for almost eight years and the (supposedly) independent Federal Reserve System. My point is that the tone, the environment, the culture of the society starts at the top. And, if the leaders of our government are undisciplined and believe that they can do just about any thing they want to do without considering what others are doing, then this will set the pattern for other leaders within the society. It will pay…at least in the short run…to act in an undisciplined and irresponsible way.

Now, I would like to present what I believe to be some fundamentals for moving forward on the personal or business level. I believe that these fundamentals apply most of the time…the difficulty now is to re-establish them in an ambiguous and chaotic world. But, I am assuming that we will soon get some political leaders that will adhere to some of the fundamentals that were discussed in the previous post…we need an overall environment in which our leaders are disciplined and open.

The first of the personal or business fundamentals I would like to argue for today is for people to minimize the use of debt. The question is asked, “Where should I put my money today? In the stock market? In gold? Where?” My response is, pay off your debt as much as possible. I can think of very few instances today where a person or business can earn more on an investment of cash in something than they can reduce costs by paying down their debt. Plus, reducing debt reduces risk…not a bad thing to do in this environment.

A second fundamental of personal or business behavior is to re-focus and cut back on what one is doing. The tendency in times that are robust and heady is to diversify and stick your hand into a lot of different opportunities. Diversification looks good and enhances ones’ ability to grow and expand. Yet, we see over and over again that having a largely mixed portfolio can cause us to lose focus and, in particular, result in problems related to lack of oversight and a failure at risk management. People and businesses need to shed those things that are not within the scope of their primary interest and capability.

Another fundamental of operation that should be adhered to today is…reduce expenses…use resources more efficiently…especially resources that require a long term or fixed commitment. Not only does this protect cash flows…it also allows for greater flexibility of operations. Again, there is a benefit to performance over time, but there is also a reduction in risk because one can respond more rapidly to a changing environment or surprises.

Furthermore, don’t over produce. In such an environment it is better to have people want more of what you produce than to exceed demand and have to deal with unsold goods or services. As we have seen, an excess supply of anything can only be disposed of at ‘fire sale’ prices. This is not healthy for either the bottom line or for the market’s perception of what you do. If the market sees that customers aren’t buying all you produce, they will focus on the unsold inventory and not on the amount that is purchased. This also applies to financial institutions whose business it is to make loans.

Finally, I can’t stress enough the need for openness and transparency. There are two reasons for this. First, in terms of asymmetric information: in times like these where there is a substantial amount of uncertainty in the air, others will pull back from you if they do not know or understand what you are doing. As a consequence, values can drop and often they can drop precipitously. Being open and transparent about what you do and your problems and how you are attacking them is the best way to attempt to keep relationships alive. People will be more willing to do business with you if they believe you are being up front with them and open in your dealings.

There is a second aspect to openness and transparency that I believe is even more important than the first. This is the effect that a policy of openness and transparency has on your own behavior and the behavior of those that work with you. If you have a policy of keeping things out in the open you and your colleagues will respond more rapidly to problems as they arise and resolve these problems as quickly as you can. If you do this you will do your best to not allow problems to grow and become major issues that result in disruptive solutions.

I know that many of these ‘fundamentals’ seem to be conventional platitudes and are obvious. Sometimes, however, they just need to be restated and re-emphasized so as to bring us back to reality. There are reasons these things are called fundamentals. It is because they have long run survival value.

The problem with acting on these fundamental operational principles is that if a lot of people adhere to them there will be ‘macro’ difficulties for the economy as a whole. The general term given to such aggregate behavior is ‘debt deflation.’ If people reduce the amount of debt outstanding and cut back on producing and spending, the economy will spiral downward.

This was the situation John Maynard Keynes believed the world faced when he developed his theory of aggregate demand. His conclusion was that the only way to get out of a situation in which the private sector was withdrawing their expenditures was to substitute government expenditures for the private expenditures to expand aggregate demand. If people were attempting to retrench and get their economic and financial situation under control, government must step in and pick up the slack until confidence returned to the private sector so that its spending would rebound.

It should be noted that in his original work Keynes did not propose tax cuts as a way to stimulate aggregate demand…he proposed government projects that would directly put people back to work again. What is wrong with tax cuts in these circumstances? Well, if people are attempting to protect themselves financially and are becoming more risk averse, tax cuts will primarily be used to pay off debt or to hoard cash. This would not put people back to work again. Employment and confidence could only be regained by direct hiring which would raise incomes.

But, one can’t just keep buying ones self out of their problem.

Since Keynes wrote we have learned that much of what has been described above, when it is applied to business behavior, is a supply side response and not a demand side problem. That is,
businesses and financial institutions have over expanded in the past and now they are attempting to return to a more reasonable and controllable size of operation. Public expenditures that attempt to return them to their over expanded states only perpetrate the situation and postpone any correction for another time. Of course, if the government has continually underwritten business expansion in the past and perpetrated bloated operations and excessive risk taking, the adjustment that finally comes might just be immune to further efforts to keep the bubble from bursting until another time.

The basic problem is that humans, individually, as well as collectively, cannot continuously ignore fundamental principles. Again, to use a sports analogy, a player or a team that neglects the fundamentals of their sport will eventually come up against a competitor that does focus on the fundamentals and will be defeated, even if they are the better athlete. The United States may be in that situation now!

This is a tough time. There is going to be a lot of pain going forward. Eventually, however, the piper will be paid. The best thing that we can do is to get back to the basics and focus on those individuals and companies that also concentrate on the fundamentals and are disciplined enough to execute at a high level.