Half Sigma

Did BP's Alaska management act unethically?

There was a British Petroleum whistleblower on CNBC this morning who claimed that senior management at BP's Alaska oilfields knowingly skimped on necessary maintenance and repairs because their bonuses were tied to cutting costs.

Is this believable? Yes, because people respond to incentives, including the rewards of cheating.

I also believe that senior managment has a greater propensity to cheat because honest people have less success climbing the corporate ladder.

I hope people won't use this news story to indict the entire oil industry, which as a whole is probably more honest than the average industry.

Are CEOs becoming less intelligent?

From a year old article at USA Today, we learn the the percentage of CEOs with Ivy League degrees has been decreasing:

A study by executive search firm Spencer Stuart found that the percentage of CEOs at Fortune 500 companies who were educated at Ivy League schools declined from 16% in 1998 to 11% in 2004. Even the Harvard MBA shows signs of erosion. Among large-company CEOs who have MBAs, 28% received their degrees at Harvard, according to the 1998 study. By 2004, that had slipped to 23%.

A survey by the Wharton School at the Ivy League's University of Pennsylvania indicates the trend extends back 25 years. In 1980, 14% of CEOs at Fortune 100 companies received their undergraduate degrees from an Ivy League school. By 2001, 10% of CEOs received undergraduate degrees at one of the eight Ivies: Brown, Columbia, Cornell, Dartmouth, Harvard, Princeton, University of Pennsylvania and Yale. The percentage of CEOs with undergraduate degrees from public colleges and universities shot up from 32% in 1980 to 48% in 2001.

Why is this happening?

There are two features of Ivy League degree holders:

(1) They have a better credential
(2) They have a higher average IQ. (Hi IQ people can go to non-Ivy schools, but it's harder for lower IQ people to get admitted to Ivy League schools, thus the higher average IQ for Ivy League graduates.)

If credentialism were becoming less important at the very top, that would be a good thing. But I suspect that what has really happened is that the average IQ of CEOs has declined. High IQ is less valued by boards of directors than it was in the past.

The General Social Survey doesn't tell us what's going on at the very top of society, but in the part of society the GSS covers I have observed that intelligence is becoming less correlated with income even as educational attainment is becoming more important.

The same thing is probably happening at the very top.

ALTERNATIVE EXPLANATION

The career tracks which lead to CEO have become less appealing to Ivy League graduates.

Those cheating CEOs

Finance professor Erik Lie has proven, by examining historical stock price data, that many companies have been backdating their options grants in order to enrich management. The options are backdated to a date when the stock price was lower (WSJ article).

He examined options that weren't granted the same date every year and found a striking pattern in which prices fell before the grant date, and rose soon afterward. He also discovered that the stock market as a whole also often rose following option grants at certain companies. "I said, 'look, it's uncanny how good these executives must be at predicting what will happen with future stock prices," he says. He began to wonder "that maybe it wasn't so uncanny."

Calling his hypothesis "novel," he wrote a paper entitled "On the Timing of CEO Stock Option Awards" that suggested that "at least some of the awards are timed retroactively."

"The results are provocative and might cause some investors to cry foul," he wrote. The paper was published a year ago in a journal called "Management Science." He and another researcher, Randall A. Heron, have since completed a forthcoming, follow-up study that looked at a 2002 change in regulatory law that now requires companies to report option grants within 48 hours. The study found that when companies reported options the same day they were granted, there was no pattern of share prices quickly rising. But the pattern continued when companies delayed reporting option grants.

Last week I asked if CEOs are overpaid, and I wrote about Fannie Mae execs who manipulated earnings to increase their pay.

There definitely does seem to be a pattern of greedy CEOs who are willing to break to rules in order to enrich themselves. A CEO who was acting in the best interest of shareholders would not be cheating in order to increase his pay. So why do CEOs get paid so much for harming shareholder interests?

Fannie Mae to pay $400 million in settlement

Yesterday I wrote about whether CEOs are overpaid (and I don't think I directly answered the question). So it's interesting to see in the New York Times today that Fannie Mae is paying a $400 million settlement to the government because its former top executives "manipulated earnings in the 1990s so they could receive bigger bonuses."

As if CEOs don't get paid enough money already, the CEO of Fannie Mae felt the need to cheat in order to make even more money.

Although this story seems to prove something about CEOs, I have two important problems with it:

(1) The current shareholders are being punished for deeds done in the past by executives that most shareholders had no part in hiring. The wrong people are being punished. The blameworthy people are, in descending order of responsibility: (a) the executives; (b) the directors who hired the executives; (c) the auditors and/or accountants who contributed to the fraud.

(2) There are two kinds of companies: (a) companies that manipulate earnings; and (b) companies that manipulate earnings and get caught.

Are CEO's overpaid?

Tyler Cowen has a NY Times column supposedly offering a "contrarian" take on the issue (also see his blog post).

Cowen's viewpoint is that CEOs are paid according to their value, and I don't see why that's contrarian because it's the standard line spouted by pro-free market people.

The proper way to understand CEO pay is to look at it as a winner-takes-all market. A small increase in ability, or luck, results in massively greater earnings. So whether or not CEOs are overpaid depends on how you define "overpaid." Winner-takes-all markets happen to be a naturally occurring phenomena, but if you define "overpaid" as meaning someone makes far more money than someone else without actually contributing any additional value to the economy, then yes, CEOs are certainly overpaid.

As I explained in my post about baseball and Atlas Shrugged, the loss of the world's top baseball players would have little effect on the economy, and the same would apply to the loss of the highest paid CEOs. Other people would step into their roles, and it's doubtful that there would be any noticeable ability difference between the two.

We don't even know how good the selection criteria are for CEOs. Maybe the skills and abilities needed to get hired are not the same skills and abilities need to do the job? In fact, it seems likely to me that in order to make the really big bucks as CEO one must focus on self-promotion at the expense of the interests of shareholders. So by the very nature of the selection process, the highest paid CEOs are inevitably not the best people for the job.

Tyler Cowen explains that CEO pay has risen with market capitalization of companies. Some commenters to his blog have asked why the CEO pay should rise based on external factors (such as the increase in the P/E ratios of all publicly traded companies) which the CEO has no contol over? If CEO pay is based on their contribution to the economy, then they shouldn't get any more money for doing the same job they were doing before. But in fact, CEO pay is not based on what they contribute, but rather what's available in the pool. So rising market capitalizations increase the amount of money available for CEOs to take from the pool. In the same manner, increased profits for baseball enable the best baseball players to earn more money even though their batting average hasn't changed. Increased box office revenues enable the most popular actors to make more money even though their acting skills remain constant.

It's certainly understandable for the average worker to feel that winner-takes-all compensation schemes are unfair, because the people at the top are gettinging paid for all the hard work of the people at the bottom who receive little benefit from the increasing fortunes of their employers.

Perception vs. reality in marketing

Don Boudreaux quoted a comment of mine:

We live in a marketing economy, and companies prosper not by having better products, but by creating the PERCEPTION that they have better products

and had this to say:

Half Sigma’s comment is whoppingly at odds with reality.

If Half Sigma’s claim were correct, then the quality of products widely available today would be little changed from that of products widely available in the past.

First of all I stand by my comment, and further add that it was a praphrase of something I previously wrote about employees of consulting firms:

For a consulting or contracting company, it’s much more important to create the perception of having the best employees than to actually have them. The most profitable company would have the perception of having the best employees, but would actually have the worst, and thus lowest paid, employees. The only problem is that maintaining such a perception is difficult if the employees are really that bad. But the point, nevertheless, is that perception trumps reality.

The same logic applies to all companies. For a consulting or contracting firm, the company's product is its employees. The perception of the best product is more important than actually having the best product. And of course I've already conceded that if the product is really awful then it's difficult to maintain a perception of being the best.

Based upon corporate behavior, companies obviously agree with me. Otherwise they wouldn't spend so much money on marketing. For example, I previously estimated that the drug company Pfizer spends twice as much money on marketing as it does on R&D and manufacturing combined. If highly skilled medical doctors are unable to determine the best drug to prescribe without the help of a college cheerleader, surely a consumer is completely bewildered.

Think about the last time you bought laundry detergent. Do you really have any idea which brand is better? I don't. I recall reading once that Tide has been improved a lot and has various patented ingredients, but this may only mean that P&G spent millions of dollars shmoozing journalists to get articles like that written. Tide certainly costs a lot more than other brands. Is it worth the extra money? I have no idea. Probably the extra price for Tide is just paying for the marketing overhead. All I know for sure is that my clothes never come out perfectly clean like I see on TV ads.

Don Boudreaux wrote about products improving over time, and that's an entirely different issue. One could easily be a wise guy and point out that the current version of Microsoft Word seems worse than the version from 1993, but I certainly agree that manufactured items, espcially high tech items like computers and electronics, have improved substantially in my lifetime. But that really has nothing to do with the proposition that perception trumps reality. The relevant comparison is of two products being sold today, not the comparison of a product sold today to a product sold in years past.

Peak of SUV sales

MSNBC asks Is the era of the oversized SUV near an end?

SUV sales have fallen by 2 or 3 percent in each of the last few years, hurt by changing tastes and a rise in smaller car-based crossover vehicles, or CUVs.

I wouldn't read too much into a few years of declining sales. SUVs have reached such a huge level of success that Americans have been buying less "passenger cars" each year than "light trucks" which is the category that includes SUVs.

Unless you were predicting the passenger car to completely fade away into oblivion and that everyone would drive only SUVs and other types of "light trucks," it was inevitable that there would be a sales peak.

IT: not cool; government not cool either

The new job is far cooler than the last one. I used to work for the government. It was indirectly, as a contractor, but this is normal; the government doesn't hire anyone directly anymore. Right wing free market types will say this is a wonderful example of privatization, but what it really is is big government contractors stealing the taxpayers' money by charging twice the price for the same employees the government could hire directly.

But anyway, the government job wasn't cool. Everyone who worked there was horribly boring. Most of the people were over the age of fifty. They arrived to work at seven and left at three.

The only good thing about the government job was that I didn't have to do much work. There was plenty of time to surf the web and post to my blog, all on the taxpayers' dime.

At the new job in Manhattan, there are all sorts of cool people walking around, and they all look young, and the female people are mostly really attractive. Unfortunately, I don't know any of them. I am cloistered with a bunch of people involved in an IT project, and the IT people are always the least cool people at any organization.

And also, I get to experience first hand how the IT industry has been taken over by foreigners. Not that any of them are bad people or anything, but it's interesting how most Americans think working in IT is somehow beneath them. Foreigners are a lot more practical. They see IT as a career that pays the most money and in which it's easy to find jobs.

* * *

Unfortunately I haven't been reading the newspapers recently, nor reading Instapundit, so I have nothing political to write about. I have to settle for writing boring stuff about my personal life that no one could be interested in reading.

Remote work a good idea? I say no.

This pro-remote work post makes me think of a recent episode of the Apprentice. One team decided to save time by having a telephone conference with the client instead of meeting in person. Donald Trump was very mad at this behavior. He said you should never pass up the opportunity for a face to face meeting.

I thought about this a lot, and I have to put myself in Donald Trump’s camp. Work is not about doing the work, it’s about marketing the work. After all, we are moving to a marketing economy. People simply don’t pay attention to a voice over the telephone as much as they do to a person in front of them. If no one you work for is paying attention to you, don’t expect to get promoted. Don’t expect to accomplish anything that requires you to get other people to help you.

Big money in online poker

Today’s NY Times article about PartyGaming is pretty interesting.

A giant in the online gambling business, PartyGaming is an often-overlooked megasurvivor from the dot-com crash of the late 1990's. As hundreds of profitless commercial sites disappeared into the digital ether, PartyGaming's popular gambling sites - like PartyPoker.com - soared, with revenues and profits growing exponentially year after year.

This week, the company will go public in what is expected to be the largest offering in years on the London Stock Exchange, one that will make billionaires out of its ragtag assortment of founders and major stockholders - including a California lawyer who earned her first fortune in online pornography and phone-sex lines. All told, as much as $9 billion is expected to be raised, with all of the cash going to private shareholders selling portions of their stakes.

But there will be no Wall Street investment houses lapping up fees in the giant deal, no victory dances in the offices of American corporate lawyers. That is because PartyGaming, based in Gibraltar, has no assets in the United States, and its officers or directors could risk being served with a civil suit - or an arrest warrant - if they came to the United States on business.

This article demonstrates two points:

(1) You can make lots of money by providing people with a service that they want, and people really want to gamble.

(2) The old laws don’t work so well in the new internet age, but our lawmakers have yet to wise up to that fact. Just as law enforcement is unable to prevent people from downloading music files, they are unable to prevent people from playing online poker.

Why the best salesman is better than the best engineer

Jim Logan says the following about hring salesmen:

Have you ever heard of the engineering department being told they are to only hire the top gun engineer? Or how about a mantra you will only hire the super star HR manager or the top-flight customer service rep?

Only hire the best of the best! We only want super stars!

I've never heard the customer service organization given such a hiring objective – as a Sales VP, I was challenged on that hiring requirement continuously. Is she a rainmaker - a super star?

Jim’s inside view of sales seem to tie in nicely with one of my posts from a while back, Do companies really want to hire the best employees? I wrote:

Clearly, a government contractor is better off with mediocre employees and the best account managers, who are able to create the perception, in the clients, that they are getting the best employees.

The difference between sales and other functions is that sales is a winner takes all activity. Notice Jim Logan’s use of the word “top gun.” That’s reference to aerial combat, where one pilot flies home a winner and the other one dies. Only the “top gun” salesman can beat the other companies’ salesmen in combat and return to headquarters with a client.

From information economy to marketing economy

Over a year ago I wrote about how the United States is moving to a marketing economy, but I don’t feel like I did a very good job of it. So this essay represents a rewriting of my previous thoughts.

Introduction

It is widely agreed that the United States has moved from an agricultural economy to a manufacturing economy to an information economy. But what most people don’t know is that we are currently in the process of moving from an information economy to a marketing economy.

Small companies have more productive workers

A Harris Poll shows that many people dislike their jobs. (W$J) 59% of employees responded that they were satisfied with their job (presumably leaving 41% dissatisfied). To the statement “I am glad I chose this organization over others,” only 44% agreed.

People don’t think very highly of their company’s upper management. Only 37% agreed with the statement “Top management displays integrity and morality.”

One interesting result is that people who work at small companies (1-49 employees) had significantly more positive attitudes towards their jobs than those working at large companies (5000+ employees). For all but two of the ten questions published in the WSJ, the difference was greater than 10%.

For example, to the statement “For me, this is the best organization to work for,” 25% of large company employees agreed but 43% of small company employees agreed. An 18% difference in favor of smaller companies.

So let me draw some conclusions:

(1) Small companies provide inherently more rewarding work experiences because of basic laws of human nature. It’s difficult, if not impossible, for a big company to duplicate the small company experience.

(2) Happier workers will be more productive. This means that large companies have diseconomies of scale when it comes to worker productivity.

(3) Despite (1) and (2) above, large companies exist. Large companies enjoy some other benefit(s). I believe that the primary benefit of large companies is marketing economies of scale. As I wrote before, good marketing trumps having good employees.

(4) If you are in the position of buying services from a company, you would do yourself a favor by buying from the smaller company because you’re more likely to get happier and more productive workers performing the services. This is contrary to our natural human instinct to favor the big and well known over the small.

Will Yahoo or Google buy a newspaper?

Professor Bainbridge suggests that a big internet portal like Yahoo or Google could easily buy a real news company because the internet companies have much higher stock valuations. Yahoo and Google have market caps of $50 billion and $60 billion respectively while Dow Jones, the publisher of the Wall Street Journal, has a market cap of only $3 billion (according to the quoted LA Times article).

Such a move would arguably be sensible because Yahoo and Google already both provide news on their websites. Why not have direct control over the source of the news?

Of course, many used to think that Amazon.com would use its massive market cap to buy a bricks and mortar bookseller (Borders was always considered the most likely opportunity), but that never happened.