Our Love-Hate Relationship with Monetary Incentives

Whether you're passionate about a career in sales, service or any of the other ... Firms should lower their expectations of monetary incentives and become ...... tions, he broke into a thousand-watt grin. ...... Andrew Burnell, Alan James Partners.
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The Alumni Magazine of the Rotman School of Management

Fall 2004

The

Money Issue

Our Love-Hate Relationship with Monetary Incentives Also, Abby Joseph Cohen, Sir John Templeton, and Who Needs Budgets?

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Contents

Fall 2004

Features

Departments

4

3 From the Dean 22 Point of View:

Our Love-Hate Relationship with Monetary Incentives Firms should lower their expectations of monetary incentives and become more cognizant about creating a context that reduces the tendency for extreme behaviour. by Roger Martin

24 CEO’s Corner:

10 Interview with a Pioneer: Abby Joseph Cohen One of Wall Street’s brightest lights talks about the American economy, global investment opportunities, and what she refers to as the market’s ‘staircase pattern’. by Karen Christensen

14

18

28

David Batstone

Who Needs Budgets? So long as the budget process dominates business planning, a self-motivated and adaptable workforce is a fantasy. by Jeremy Hope and Robin Fraser

Philip Taylor

32 Point of View: Mihnea Moldoveanu

38 Questions for: Eric Kirzner

44 Questions for: Exchange Rates and Shock Absorbers The Canadian economy is best served by an exchange rate that is formally flexible but essentially stable because of sound and solid fundamentals. by Don Brean Success That Lasts Money isn’t synonymous with success. The four interrelated components of enduring success are happiness, achievement, significance, and legacy. by Laura Nash and Howard Stevenson

34 Much Ado About Business Trusts The Federal Government is overly concerned with possible ‘tax leakage’ arising from business trusts, and it should not impose investment constraints on pension funds. by Paul Halpern

40 Islamic Banking Comes of Age – But What’s Next? Islamic banking has grown into an industry with assets of hundreds of billions of dollars, but can it make the leap to become a revolutionary force in the financial world? from Knowledge@Wharton Rotman Magazine Fall 2004 Editor: Karen Christensen Contributors: Steve Arenburg, David Batstone, Donald Brean, Matthew Fox, Mary Ann Gratton, Paul Halpern, Jennifer Hildebrandt, Eric Kirzner, Rod Lohin, Roger Martin, Ken McGuffin, Mihnea Moldoveanu, Anita Shuper, Jack Thompson Design: Ove Design & Communications Ltd. Cover: Michael Gibbs Photography: Jim Allen, Ken McGuffin, John Hryniuk All rights reserved.

Sir John Templeton

46 Life-Long Learning 2004 48 Executive Programs Spotlight 50 Campaign Update 52 News Briefs 58 Alumni Profiles 60 Alumni Capsules 64 Alumni Director’s Corner 65 Class Notes 80 Upcoming Events

Rotman Magazine is published three times per year for alumni and friends of the Joseph L. Rotman School of Management, University of Toronto. Subscriptions are available for $99 per year.To subscribe, go to www.rotman.utoronto.ca/subscribe All rights reserved. To submit a change of address, please contact us at: Rotman Magazine, Joseph L. Rotman School of Management 105 St. George Street,Toronto, ON M5S 3E6 Tel: 416-978-0240 Fax: 416-978-1373 E-mail: [email protected] Web: www.rotman.utoronto.ca

Rotman Magazine • 1

From the Dean: Roger Martin

The Money Issue It’s hard to argue with the old axiom, ‘Money makes the world go round’.The truth is, money influences almost every aspect of our lives, from our value systems, to our relationships, to our hopes and dreams.Whether we have plenty of it or want for it, the allure of money is one thing most of us agree on. As Voltaire said, “When it is a question of money, everybody is of the same religion.” On the bright side, the more society has come to recognize the inherent value and potential of human capital, the more productive the individual, society and money itself have become. But as we have seen with the corporate debacles of recent years, how a person behaves towards money is often a good test of their authenticity – which says as much about human weakness as it does about the power of money. Economics is full of synonyms for money: income, wealth, assets, wages, costs, revenue, investment and more. In this issue of Rotman Magazine, we look at money from several of these perspectives in an attempt to address the myriad ways in which it pervades our lives. I kick things off on page 4 with “Our Love-Hate Relationship with Monetary Incentives,” where I argue that firms should lower their expectations of monetary incentives and become more cognizant about creating a context that reduces the tendency for extreme behaviour. One of the most closely-watched analysts on the planet, Abby Joseph Cohen of Goldman Sachs, chats with our editor about her rise to the top of the industry and what makes her so bullish about the American economy, on page 10. As much as we like to think we are in control of our money, we often don’t notice how subtly it exercises control over us. Take budgets, for instance. The vast majority of organizations and individuals run their lives by budgets of some sort. But

is this the best way for organizations to thrive and grasp opportunities in today’s ever-changing environment? Harvard Business Review contributors Jeremy Hope and Robin Fraser don’t think so. “Who Needs Budgets?” begins on page 14. While the American greenback is by far the world’s most popular currency (60 per cent of global transactions employ it – hence George Washington’s likeness on our cover), the Canadian dollar has made great strides recently. Professor of Finance Don Brean puts the loonie under the microscope on page 18.

page 34; John H. Watson Chair in Value Investing Eric Kirzner discusses hedge funds on page 37; we take a peek inside the world of Islamic banking, on page 40; and legendary fund manager Sir John Templeton gives his current views on investing on page 44. Contemporary economic science can boast great achievements in the development of methods of controlling money flows. However, we must look for the essence of money not only in the regularities of the market, but also in the regularities of social development. Money

How a person behaves towards money is often a good test of their authenticity – which says as much about human weakness as it does about the power of money. As we all know, money isn’t everything – and there are plenty of miserable rich people around to prove it. Enduring success requires a more holistic approach to life, as Harvard professors Laura Nash and Howard Stevenson argue in “Success That Lasts,” beginning on page 28. Elsewhere in this issue, Aim Trimark Investments’ CEO Philip Taylor is featured in our CEO’s Corner on page 24; TSX Chair in Capital Markets Paul Halpern examines business trusts on

is both a product of civilization and an instrument of its further development that has grown in its power not because society has accorded it ultimate value, but because it has become an instrument and medium for fulfilling human aspirations. As a symbol of the infinite potential for human accomplishment, money has released enormous energy, creativity and initiative in society. But in the end, without human capital, money isn’t worth the paper it’s printed on. Rotman Magazine • 3

Our Love-Hate Relationship Monetary with

Incentives

Depending heavily on monetary incentives to motivate people is nothing short of dangerous, especially for a firm whose mission is to maximize shareholder value. Dean Roger Martin explains.

Roger Martin

Take a cursory look around at today’s business environment, and you’ll find we have a complicated relationship with monetary incentives. All the way from the CEO’s suite to the shop floor, we love that they motivate employees to do whatever is necessary to carry out an organization’s mission. But we also hate that they cause those same employees to engage in extreme and unproductive activities, such as manipulating financial results or abusing customers in order to maximize their incentive compensation. Like most motivational tools, monetary incentives have limitations and produce differing levels of utility in different contexts.To produce more beneficial results for their stakeholders and society at large, firms must lower their expectations of monetary incentives and be more cognizant about setting them within a context that reduces the tendency for extremes of behaviour.

The love-hate rationale

One of the reasons we love monetary incentives is that we have seen them drive individual behaviour time and time again, and drive it powerfully. When Coca-Cola Co. provided Robert Goizueta with the most lucrative monetary incentive package in the history of public corporations, he retired a very rich man, with approximately $700 million to his name. But happily for Coke’s shareholders, that amount seemed minuscule in comparison to the mammoth increase in Coca-Cola’s value during Goizueta’s 16-year reign. From the time he was named CEO in March of 1981 until his death in 1997, Coke’s stock rose an amazing 3,800 per cent, making the ‘Goizueta years’ the stuff of corporate legend. We also love monetary incentives when we see them as instrumental in building and repairing society. After the massive 1994 earthquake in Northridge, California – which caused $40 billion of damage – construction teams rebuilt roads and bridges in a fraction of the time predicted, thanks to completion-time incentives that motivated them to work 24 hours a day rather than the usual 9 to 5 ‘punch-clock’ approach. But we hate monetary incentives when we see them drive individual and collective behaviour – from the very top to the bottom of firms – that is profoundly counterproductive and embarrassing. In 1989, at its eponymous Auto Centres, Sears introduced a monetary incentive system that based compensation on the average revenue per customer visit. Employees took the incentive to heart, proceeding to convince customers that unnecessary services were in fact vital to their car’s performance. Revenueper-customer rose dramatically, but the behaviour it engendered resulted in a huge public scandal. A 1999 class-action lawsuit claimed Sears had defrauded its customers nationwide of $400 million, with up to 30 million people affected between 1989 and Rotman Magazine • 5

1994. Just this past March, the company was charged again.This time, New Jersey’s Attorney General filed suit against Sears for overcharging thousands of customers at its car-repair centers across the state. Closer to home is the ongoing scandal at Nortel Networks. In the post-bubble crash, mired in years of losses and mammoth write-offs, the Nortel board put into place a powerful monetary incentive for its leaders to achieve coveted break-even status. If Nortel could achieve break-even for one quarter, it would be worth US$13.6 million in incentive compensation for the management team, with another $30 million on offer for achieving three consecutive quarters of profitable operation. This program allegedly drove senior management to massively under-report income in 2002 in order to make sure that 2003 was a break-even year. In July of 2003, Nortel management received its bonuses in cash and stock: sincedeposed CEO Frank Dunn’s take was $2.15-million, while Douglas Beatty, the sacked CFO, got $831,000. Nortel’s performance crashed in early 2004, and thankfully for the shareholders that alerted the board to investigate, the CEO and CFO were subsequently fired for cause.As the company moves forward, only one thing is certain: Nortel has been forever changed. Its remarkable turnaround since 2002 proved to be exaggerated, if not completely bogus, and shareholder confidence has been shattered. In case any doubt remains, there is ample scientific evidence that monetary incentives have a powerful impact on individual behaviour. Perhaps the most striking study of their effects was performed by Donald Roy and published in the American Journal of Sociology in 1952.As a young PhD student, Roy demonstrated his dedication to his research by working in a machine shop for ten months in order to collect data on the effect of piece-work pay schedules on performance. He found the work of his fellow machine operators to be powerfully influenced by the prevailing incentive compensation structure. And perhaps most shocking to himself – a PhD student, not an elementary school educated labourer – his own work patterns began to model those of his co-workers under the incentive compensation structure (see sidebar). 6 • Rotman Magazine

Donald Roy: Quota Restriction and Goldbricking in a Machine Shop (American Journal of Sociology, 1952) Donald Roy’s machine shop was a classic piece-work shop of its day. Its machinetool operators fabricated a wide variety of items at their stations, with each assigned a point value based on management’s assessment of the level of difficulty required to produce the item, as assessed by engineers from the ‘timing department’. If an operator turned in 125 points in an hour, he (all were male) would earn $1.25 for that hour of work.The company provided the operators with base pay of $0.85 per hour, such that if the points they turned in were lower than 85, they would still earn the minimum amount. For anything over 85 points per hour, the direct monetary incentive was that one more point generated one more cent in hourly compensation. Roy observed that the incentives embedded in the compensation structure generated behaviours that at first seemed quite odd. The largest fraction of work turned in (47 per cent of total hours) was for point totals between 115 and 134.The second largest fraction (24 per cent) was between 35 and 54 points. Every other range had tiny proportions of the total hours (see Exhibit One). What caused these two high-frequency ranges at such odd levels? It turns out that amongst the workers, jobs associated with these ranges were referred to as ‘gravy’ and ‘stinker’, respectively.‘Stinker jobs’ were so difficult – i.e. their point totals were too low in relation to the work required – that the operator declared defeat immediately and slacked off – or ‘goldbricked’ to use the vernacular. But why not goldbrick entirely, not turn in 35 to 54 points? As Roy found out, any operator who turned in less than 35 to 54 points in an hour risked being fired for

incompetence. So the extreme of goldbricking was in the range of 35-54 points per hour, which netted the basic $0.85 compensation. In contrast,‘gravy jobs’ were so easy in relation to their point values that the minimum could be reached with only a modicum of effort. But why stop at accumulating 134 points per hour? Roy found out – by himself hitting 150 on a gravy job and being accosted by angry coworkers – that whenever a job yielded more than about 134 points per hour, the timing department would descend on the shop and lower – often dramatically – the point value for the job. So while the monetary incentive to keep working until accumulating 134 points was high, the monetary disincentive to go even a point past 134 was even higher. As a result, the operators engaged in ‘quota restriction’, by which they would work at an artificially slow pace or loaf for hours at a time to restrict themselves from turning in a point total over the informal maximum. Exhibit One (page 7) overlays the true compensation structure – including threat of termination below 35 points per hour and threatened re-timing above 134 points per hour – on the distribution of work to demonstrate the power of monetary incentives to drive behaviour patterns that appear inexplicable at first blush. Roy estimated that goldbricking and quota restriction – which, within a month of joining the shop, he engaged in as dutifully as his co-workers – caused the machine shop to work at approximately half of its potential productivity, all a direct function of the structure of the monetary incentives.

Despite the clear evidence of the power of monetary incentives on individual behaviour, the evidence of influence on firm performance is quite mixed. In “Do Incentives Work? The Perception of A Worldwide Sample of Senior Executives” (Human Resource Planning 26, no. 3, 2003) Michael Beer and Nancy Katz review the findings on incentive compensation and come to the conclusion that they are “ambiguous”. Some studies find significant positive effects of compensation structures with strong monetary incentives – pay for performance like Coca-Cola and Roy’s machine shop – while others find no obvious positive effect. And as the Sears, Nortel and Roy’s machine shop examples illustrate, monetary incentives can have decidedly negative effects on firm performance. The Problem with Monetary Incentives

Ironically, the problem is that monetary incentives work – too dramatically. Just as animal trainers can use the right set of incentives to get lions to jump through flaming hoops or elephants to walk on their hind legs, monetary incentives can get workers to engage in ‘unnatural’ behaviours. Indeed, in the right environment, they can produce almost any behaviour. And as Roy’s machine shop shows, monetary incentives often drive behaviour to extremes. ‘Stinker’ jobs don’t produce

that it is enormously challenging to design a monetary incentive system that is in any degree balanced. For example, stock brokerage firms have been challenged by a widespread reputation for their brokers ‘churning’ the portfolios of their clients in order to generate commissions. This should come as no great surprise in that until recently, compensation for brokers tended to be paid strictly on the basis of commissions: for

The rise of shareholder value maximization as the primary mission of corporations has created a context that exacerbates extreme reactions to monetary incentive compensation. work effort in the $0.60 range, and ‘gravy’ jobs don’t produce work effort in the $1.00 range: stinker jobs produce work on the margin of dismissal, and gravy jobs on the margin of re-timing. The power to drive individuals to extremes of behaviour is largely responsible for our love-hate relationship with monetary incentives and the ambiguity as to their effectiveness at the firm level. The truth is

every dollar of commission revenue generated for their firm, brokers earned a fixed percentage (ranging as high as 60 per cent) as incentive compensation. This compensation structure is inclined to push individual brokers to the extreme of generating as much trading as possible up to the point where a client will ‘pull the plug’ because he or she views the broker as trading for the broker’s own benefit, not

theirs. In essence, the broker’s welfare is maximized, rather than the client’s. The result has been the rise of the self-directed brokerage and a response by brokerage firms to move toward non-commission-based compensation structures in order to deal with client perceptions of portfolio-churning. The Importance of Context

Incentive compensation sends a very powerful message to employees. It screams from the rooftops: “We want you to do more of X, and if you do, we will give you more money as a reward.” Ignoring the incentive offered is the moral equivalent of ignoring the wishes of the firm – and would be seen as a form of insubordination. In this respect, the context of the firm, whether Roy’s machine shop in 1952 or Nortel Networks post-2000, plays an important role in producing or ameliorating the tendency toward extremism in response to the incentive. One has only to read between the lines of Roy’s description of the machine shop to draw conclusions as to the key features of the problematic context in question. The overall impression is of a firm that is littleloved by its machine operators. Operators appear to have no customer contact and no particular knowledge as to what happens to a part once it leaves their workstation.They appear highly distrustful of their employer, Rotman Magazine • 7

who swoops in to re-time jobs whenever the output seems too easy to achieve. They treat the firm as simply a money-making operation for the owners, whereby more money is made for the owners by reducing the money made by operators – a classic capitalist-worker class struggle. With no purpose to compete with or leaven the drive for personal money-making, the operators move to the extremes of goldbricking and quota restriction. In fact, their only motivation is solidarity with one another against the firm – something Roy learned as he began adhering to the group norms. In the post-bubble Nortel context, with the company’s stock price having fallen to one-hundredth of its bubble high,

Ironically, the rise of a tool – monetary incentive compensation – that has a design weakness (the tendency to produce extreme behaviours) has been driven by the rise of a context – where the firm’s mission is shareholder value maximization – that exacerbates the very weakness in the tool of choice. Toward More Love and Less Hate

So, are monetary incentives and shareholder value maximization inherently bad? No. They are just a volatile combination – sort of like Richard Burton and Elizabeth Taylor. And they are most volatile in combination when they are employed in a singular fashion: that is,

A firm where customer satisfaction is the central goal provides a more suitable context for monetary incentives. the obsession was with stock market performance: reassuring the stock market by returning to profitability became an end unto itself. It was translated into a singular goal – ‘break-even or bust’. Nothing else mattered, and the monetary incentives were organized strictly around this singular goal. As a result, other goals faded into the background – goals related to innovation, customer satisfaction, and sustainable performance, amongst others. In a way, there was perfect alignment at Nortel: the corporate goal was to breakeven, and management’s incentive was to break-even. One dollar short of break-even meant nothing, while the next dollar meant $14 million in incentive compensation.The result was extreme behaviour to produce break-even status – even at the cost of alleged major accounting fraud. The rise of shareholder value maximization as the stated primary mission of corporations has created a context that exacerbates extreme employee reaction to monetary incentive compensation structures, and it has been accompanied by the rise of the importance of incentive compensation as a share of total compensation.

8 • Rotman Magazine

when the corporation indicates that the only thing that matters is shareholder value maximization, and the only incentive for performance is monetary compensation. This combination is self-defeating because customers – whose satisfaction is critical to long-term shareholder value maximization – come to understand quite clearly where they stand in the pecking order: a long way down the line. Employees spend their time maximizing their own incentive compensation, subject to keeping customers minimally satisfied, and the firm spends its time maximizing its returns, subject to the same constraint. Little, if anything, in the context encourages the true delight of customers. As the great 20th Century philosophers John Lennon and Paul McCartney wrote, “Money can’t buy me love.” And money, in the form of incentive compensation in a shareholder value-driven firm, can’t buy ‘love’ for the customers. In this context, the objects of maximization are personal compensation and firm value enhancement. In contrast, there is no motivation to maximize customer love. Rather it is simply a minimum constraint; as long as the firm and

its employees don’t treat the customer too badly, they will remain customers. A firm where customer satisfaction is the central goal provides a more suitable context for monetary incentives. If the firm believes that serving its customers brilliantly is its primary goal and that shareholder value appreciation will naturally follow, incentive compensation geared toward encouraging superior customer service or customer-oriented innovation has a better chance of not producing extremes of personal monetarymaximization behaviour. In such a context, the pride and happiness that comes from serving customers well comprises an important part of the ‘psychic compensation’ of employees.This is particularly the case if social stature within the firm is related more to satisfying customers than to earning higher compensation. This competition of goals within a firm can serve to effectively replace extremism in pursuit of personal economic goals with the pursuit of a broader set of goals, which includes ‘loving’ one’s customers. Monetary incentives are not ignored by any means, but non-monetary incentives – the feeling of pride in contributing to an organization’s goal of offering the best product or service to its customers – compete closely. In essence, if a firm is more than simply a money-making machine, its employees can more easily see their roles as being more than personal money-making machines. While there can be no arguing that the power of monetary incentives is great, their effectiveness in producing the desired end is entirely more speculative – and hence our prevailing love-hate relationship with them. In the end, depending heavily (or gasp, entirely) on monetary incentives is nothing short of dangerous, especially for a firm that has as its mission to maximize shareholder value. When it comes to incentives, balancing them and dulling their ‘sharp edges’ with a supportive firm context is far preferable – for employees, the firm and for society – to unleashing them on their own. We’ve already seen abundant proof of what happens when they are left to their own devices.

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10 • Rotman Magazine

Interview Pioneer

with a

by Karen Christensen Our editor talks to renowned Wall Street analyst Abby Joseph Cohen, chair of the Investment Policy Committee at Goldman Sachs, about her thoughts on the American economy, global investment opportunities, and what she refers to as the market’s ‘staircase pattern’. Rotman Magazine • 11

Karen Christensen: To what do you

KC: You have a reputation for being

attribute your success on Wall Street?

relentlessly bullish abut the American economy. Are you feeling bullish

I’ve been very fortunate in that I’ve been given opportunities throughout my career to work on issues and projects that I really enjoyed, which in turn allows me to work hard and stay focused. I consider myself quite fortunate – but as they say, “good fortune is about 90 per cent hard work and 10 per cent luck.” Abby Joseph Cohen:

KC: What do you enjoy most about your role at Goldman Sachs? AJC: The

intellectual content of my job is very exciting to me. I view market analysis and the economic analysis that underlies it as a jigsaw puzzle in constant motion. My job is to consider how the different pieces fit together, and reach conclusions about what the picture is going to look like. Also, I have opportunities to work with some of the brightest and most interesting people – not just my colleagues, but also our clients. I travel extensively for the firm and spend time in Europe, Asia, and the Middle East. It’s stimulating to meet with thought leaders who are making critical decisions in other nations – decisions related not just to portfolios, but also to economic and other government policies.

KC: Throughout your career, you must have been the only woman in the room on many occasions. How difficult was that?

It’s true that, when I started out, there were very few women in the investment industry, and one consequence was that there were few role models. Another consequence was that men were often uncertain about how to work well with female colleagues. It has been gratifying to see that women are now entering the industry in larger numbers. Is this a good business for women? I would say yes. Success in this business is ultimately driven by whether an individual is capable and has the intellectual capacity to add value to our clients. Firms in our industry are looking to hire the best people – it’s clearly a mistake to automatically eliminate 50 per cent of the possible candidates.

AJC:

12 • Rotman Magazine

these days?

That observation is not quite correct. In 1990, for example, The Wall Street Journal identified me as the single most ‘bearish’ analyst on Wall Street. At that time, I thought the economy was heading for recession and that the market was overvalued. Within six months, the economy had begun to shrink and the S&P 500 was down about 25 per cent. In March 2000, at the peak of the last bull market, I suggested that clients reduce their stock holdings, especially in technology. My views on the stock market are driven by analysis of the economy and the manner in

AJC:

Goldman Sachs has research professionals stationed around the world who help provide answers to your question, and we regularly share information and analysis.Today, for example, I began my morning at 5:30 eastern time with a conversation with portfolio strategy colleagues based in Tokyo, London, and Hong Kong. As a group, we believe that some of the best investment opportunities, long-term, are in emerging Asian economies. The workforces are becoming increasingly productive. On a short term basis, there are concerns about volatility, and that some of these markets are already pricing in quite a bit of good news. Among the larger stock markets, we prefer Japan and the United States. The European economy has less favorable growth characteristics.

AJC:

History shows that the stock market can occasionally move very dramatically – as typified by a large upward step. I believe that we are now stuck on such a ‘step.’ which stocks are valued, not the momentum of the marketplace. Currently, the U.S. economy is in very good condition. The productivity growth of our workers is double what it was in 1990, and family incomes are rising. Corporate profitability is quite robust, balance sheets are solid, and cash generation is strong. Corporate leaders are confident enough about the future to hire new workers and invest in capital goods, leading to further economic expansion. Nonetheless, we are concerned about some possible developments. We’re carefully monitoring the direction of the budget deficit; economic developments outside of the U.S., including slow growth in Europe and likely deceleration in China; and of course we are concerned about the geo-political environment – developments in Iraq, energy markets, and so on. KC: Outside of the U.S., what region offers the best long-term investment opportunities at the moment?

KC: You have described the market as moving in a ‘Staircase Pattern’. What are the implications of this for the average investor? AJC: This pattern suggests that investors should demonstrate patience. History shows that the stock market can occasionally move very dramatically – as typified by a large upward step – but then becomes ‘stuck’ on the riser, as investors await the next bundle of economic news. I believe that we are now stuck on such a ‘step.’ Between March 2003 and February 2004, stock prices in the U. S. rose 40 per cent – a very substantial increase over a short period of time. But since then, we’ve been stuck in a trading range – think of that as the riser on the step. Investors are now contemplating economic and other issues, including the upcoming election. We expect that clarity on these will set the stage for the next upward step. The next gain is more likely to be around 15 per cent

or so, more moderate than the 40 per cent gain enjoyed through February. KC: Do you think quarterly reporting by corporations is a good thing, or are you

when this information is over-interpreted, or when investors expect to see smooth sailing from one quarter to the next, rather than the natural volatility that exists in almost every business.

in favour of companies embracing alternate reporting methods?

KC: What are you most proud of?

The nations that previously required only semi-annual reporting are now moving to the U.S. model of quarterly reporting. While some people raise concerns that the quarterly model creates too much focus on the short term, we believe that there is some value in frequent reporting because it provides more information to investors. However, problems can arise

AJC: I’m very pleased that I’ve been able to enjoy my professional life, and at the same time, raise a family and give back to the community. In the past, I’ve served on the board of the Chartered Financial Analysts Institute, the leading professional organization in our industry globally, and was given the distinguished service award at a wonderful event in Toronto a couple of years ago. Despite a

AJC:

Abby’s Forecast

heavy workload, which is common in our industry, I’ve also had opportunities to work with some major universities in the U.S. [Abby is a trustee of Cornell University, her alma mater, and also sits on the board of Cornell’s medical school]. I visit several business schools each year to speak to students about economics and economic policy, and have done similar programs at public schools here in NewYork City. Getting young people interested and engaged in economics is very rewarding for me.

Abby Joseph Cohen is chair of the Investment Policy Committee and is responsible for U.S. portfolio strategy at Goldman, Sachs & Co. in New York City. She was inducted into the Wall Street Week Hall of Fame in 1997.

Mobil, which not only would enjoy greater earnings growth, but start to make more long-term investments in exploration and production. Exxon Mobil’s long-term earnings are growing about six per cent a year. The stock trades for about 14 times earnings, and yields 2.5 per cent.

Which sectors are likely to do best [in the short-term]? Economically-sensitive sectors that benefit from a long cycle. At the top of the list

How badly would $30 to $40 oil hurt the economy?

is information technology. As CEOs feel more confident about demand, they are

We’d be more concerned about other economies. Korea and Japan require

willing to make long-term investments in technology and workers. In the past 12

more energy per unit of GDP than the U.S. We’re also studying China. We

months, total industrial production was up about five per cent, but spending on

think the Chinese will be successful in slowing growth modestly. The govern-

IT was up 25 per cent. Corporate balance sheets look great, and companies

ment is approaching policy in a sensible way. Instead of raising interest rates

are willing to add capacity. Our tech analysts say we’re well past the point of

across the board, it has raised reserve requirements for banks that have had

just replacement demand. The one lackluster region is Europe, which is impor-

a history of making the worst loans. The third uncertainty for investors is the

tant for U.S. companies because in the late 1990s, they sold a lot of IT goods

upcoming presidential election. In most election years, stocks rise after the

and services to Europe. There’s also a broader story here. Our trade deficit is

election. One exception was 2000, because the election wasn’t over until

widening because export growth has been disappointing. While every body

December. But when uncertainty recedes, the market tends to move higher.

talks about China, Europe is our largest customer outside North America. Will the [U.S.] stock market tank when the Fed finally Are you positive on financial services?

raises rates?

I feel positive about financial services because intermediate and long yields

To the extent that bond yields already reflect a coming increase, we don’t expect

on government bonds already reflect that the Fed will raise interest rates.

a dramatic negative impact on the equity market. In 1994, when the Fed began

Thus, financial-services stocks probably will reverse their poor relative per-

to raise rates, the stock and bond markets fell sharply. We’ve already seen that

formance over the past few months. Many companies can do well with the

response. In the past two to three months [April and May 2004], many institu-

yield curve we’re expecting. It will become less steep, but not flat.

tional money managers have been preparing their portfolios. We also have more risk-aversion than normal. Overall, the market looks OK, but the great val-

What should investors be most concerned with these days?

uation opportunity in the winter of 2003 has been in part used up. At that point

Energy is at the top of the list. Higher energy prices would have a dampen-

the stock market was about 40 per cent undervalued. Now it’s about 15 per

ing effect on economic growth, even more so outside the U.S. We think the

cent undervalued, which is good, not great. After a huge sigh-of-relief rally, what

clearing price for oil in a flat economy is about $28 per barrel, though oth-

matters most is that investors are confident of the sustainability of economic

ers think it will be several dollars below that. You would expect to pay more

growth. Add to that stronger corporate balance sheets, and the picture is good.

when economies are growing more rapidly, so think in terms of the low $30s. If prices stay around those levels, it will benefit such companies as Exxon

Reprinted from Barron’s, June 21, 2004

Rotman Magazine • 13

WHO NEEDS

BUDGETS?

By Jeremy Hope and Robin Fraser

14 • Rotman Magazine

Jeremy Hope

Robin Fraser

The traditional budgeting model used by most organizations stifles product and strategy innovation and leads to unethical behaviour, and it should be replaced with a more adaptive alternative. Budgeting, as most corporations practice it, should be abolished. That may sound like a radical proposition, but it would be merely the culmination of long-running efforts to transform organizations from centralized hierarchies into devolved networks that allow for nimble adjustments to market conditions. Most of the other building blocks are in place. Companies have invested huge sums in IT networks, process reengineering, and a range of management tools including EVA (Economic Value Added), balanced scorecards, and activity accounting. But they have been unable to establish a new order because the budget and the command and control culture that it supports remain predominant.

Senior executives have been heard to proclaim that their people have all the authority of the chairman. In practice, they marshal the power of computer systems to uncover mind-numbing levels of detail and, using the budget as a benchmark, demand to know why a sales team has rung up higher-than-normal telephone charges, for instance, or why it has under-spent the quarter’s entertainment allowance. And where is “all the authority of the chairman” when the team finds it can’t meet the budget’s sales targets? Fearing the consequences, the team will lean on customers to order goods they have every intention of returning. And if by some chance the team thinks it will exceed its targets, it will press customers to accept delivery in the next fiscal period, delaying valuable cash flows. In extreme cases, use of the budget to force performance improvements may lead to a breakdown in corporate ethics. People who worked at WorldCom said CEO Bernard Ebbers’s rigid demands were an overwhelming fact of life there. “You would have a budget, and he would mandate that you had to be two per cent under budget,” said a person who worked at WorldCom, according to an article in the Financial Times last year. “Nothing else was acceptable.” WorldCom, Enron, Barings Bank, and other failed companies had tight budgetary control processes that funneled information only to those with a “need to know.’’ In short, the same companies that vow to stay close to the customer, so that they can respond quickly to precious intelligence about market shifts, cling tenaciously to budgeting – a process that disempowers the front line, discourages information sharing, and slows the response to market developments until it’s too late. A number of companies have recognized the full extent of the damage done by budgeting. They have rejected the reliance on obsolete data and the protracted, selfinterested wrangling over what the data indicate about the future. And they have rejected the foregone conclusions embedded in traditional budgets – conclusions that render pointless the interpretation and circulation of current market information, the stock-in-trade of the knowledge-based, networked company. In the absence of budgets, alternative

goals and measures – some financial, such as cost-to-income ratios, and some nonfinancial, such as time to market – move to the foreground.And business units and personnel, now responsible for producing results, are no longer expected to meet pre-determined, internally-selected financial targets. Rather, every part of the company is judged on how well its performance compares with its peers’ and against world-class benchmarks. In companies using these standards of performance, business units become smaller, more numerous, and more entre-

objective is to keep improving your position until you become the league leader. Abandoning budget targets – those solemn but ultimately hollow promises to investors – frees a business to give a wide variety of emerging information its due. Sharing that information can form the basis of a new kind of relationship with the capital markets. UBS, the Swiss financial services company, hasn’t discarded budgets, but it has changed how it communicates. “We provide very few financialperformance commitments,” says Mark Branson, the company’s chief communi-

Abandoning budget targets frees a business to give a wide variety of emerging information its due. preneurial. Strategy becomes a grassroots endeavor. The aggregate result of many small teams exploiting local opportunities is a much more adaptive organization. But that’s not to say these companies abandon their high expectations.They don’t naively assume that everyone who is given more autonomy will improve his or her performance. In fact, they require employees to do something much tougher than meet a fixed target. They ask them to measure themselves against how well comparable groups inside and outside the company will turn out to have done in the same period, given the economic conditions prevailing at the time. Because employees won’t know whether they’ve succeeded, or by how much, until the period is over, they must use every ounce of their energy and ingenuity to ensure that their performance is better than that of their peers. Business units, plants, branches, and other groupings can measure their progress against comparable units within the company through the use of a few key financial measures. In order to measure themselves against external peers, they can use operational benchmarks based on industry-wide best practices. (In some cases, companies that have rejected budgets rely on benchmarks collected and prepared by specialist firms that understand the particular industry.) As in sports, the

cation officer. “Our experience shows they are counterproductive, building pressure for short-term action to save the credibility of forecasts. In effect, we show analysts and investors how the business works. This shifts the emphasis from meeting short-term promises to improving our competitive position year after year. The result is much more accurate interpretation of our results and news flow, meaning less volatility in our shares. Analysts like and respect our approach. They no longer ask for numbers-based forecasts.” The willingness of the company’s investors to live without such promises has inspired UBS to shift its focus from detailed plans to trend analyses and rolling forecasts. Breaking Free from the Budget Vise

Though the first companies to reject budgets were located in Northern Europe, organizations that have gone beyond budgeting can be found today in a range of countries, industries, and cultures. At these companies, an annual fixed-performance contract no longer defines what subordinates must deliver to superiors in the year ahead. Budgets no longer determine how resources are allocated or what business units make and sell or how the performance of those units and their people will be evaluated and rewarded. Some project leaders estimate that they have saved 95 per Rotman Magazine • 15

cent of the time that used to be spent on budgeting and forecasting. Instead of adopting fixed annual targets, business units set longer-term goals based on benchmarks such as return on capital. The elements or factors measured are key performance indicators (KPIs) such as profits, cash flows, cost ratios, customer satisfaction, and quality. The criteria of measurement are the performance of internal or external peer groups and the results in prior periods. Two of the important corporate goals at Borealis, a Danish

measured and rewarded on the basis of how well they reduced fixed costs and improved uptime in comparison to best-in-class industry benchmarks. In an empowered organization, people are free to make mistakes and equally free to fix them. Managers have wide discretion in making decisions; as a result, they can obtain resources more quickly than in traditional companies and without having to document need quite so elaborately, partly because they are accountable for the profitability of their units and can therefore be

So long as the budget process dominates business planning, a self-motivated and adaptable workforce is a fantasy – however many cutting-edge tools and techniques a company embraces. petrochemicals company, have been the reduction of fixed costs by 30 per cent over five years and a decrease in time lost to accidents in its plants. However, the company’s business units and personnel are

expected to shed any excess in the event that demand falls. In such a system, the “spend it or lose it” philosophy that’s at work in traditional organizations has no meaning. And employees, because they

don’t require much supervision, don’t need the extensive central services that most organizations provide. Eliminating those services has a dramatic effect on a company’s cost structure. Key performance indicators – which tend to be financial at the top of an organization and more operational the nearer a unit is to the front line – fulfill the self-regulatory functions of budgets. But KPIs don’t need to be so precise. UK charity Sight Savers International, for example, has begun to develop target ranges for its KPIs. While managers are free to devise ways of achieving results within these ranges, senior executives look at the risks and test the assumptions of strategic initiatives that require very substantial resources. At many such companies, rolling forecasts that look five to eight quarters into the future play an important role in the strategic process. The forecast, typically generated each quarter, helps managers to continually reassess current action plans as market and economic conditions change. Without budget expectations to worry about, staff members can do something with the nonconforming customer and market information they collect – other than hide it. The reporting of unusual pat-

Exhibit A: Svenska Handelsbanken Though not large by international banking standards – it has 550 branches in the four Scandinavian countries and the UK and 20 offices in major cities around the world – this Swedish firm offers corporate finance, home and consumer financing, life insurance, mutual funds, and banking services. Since it abandoned budgeting in the early 1970s, the bank has outperformed its Scandinavian rivals on return on equity, total shareholder return, earnings per share, cost-to-income ratio, and customer satisfaction. In March 2004, Moody’s rating agency upgraded the bank’s rating to Aa1 – giving it the highest rating amongst all Nordic banks. In the late 1960s, it was a different story.The bank was losing customers, especially to a smaller rival run by Jan 16 • Rotman Magazine

Wallander. So Handelsbanken invited him to become its CEO. He accepted, on the condition that the bank agree to drastically decentralize operations. His years as an economist and non-executive director of Ericsson, the Swedish electronics company, taught him that few forecasts are worth the paper they are written on. His conclusion was that “either a budget will prove roughly right and then it will be trite, or it will be disastrously wrong and in that case will be dangerous.” Here is what Handelsbanken looks like today. Organization

The bank has only three layers – branch managers, regional managers, and the chief executive – and no organization chart. The spans of control are therefore very wide,

precluding micromanagement. The few decisions that require high-level approval are kicked upstairs almost immediately, with an answer usually arriving within 24 hours.To promote a sense of ownership and accountability among as many people as possible, the bank has created some 600 profit centers, including regions and branches.Though each branch is free to set prices and discounts and decide which products to sell, it knows that costs must be around 40 per cent of income and that this requires every staff person to contribute to profitability. In contrast to the approach at many other financial services companies, Handelsbanken dispenses with a central marketing function (except in the case of product launches) and sales targets. Instead, the individual branches are given

terns and trends as they unfold helps the business avoid shortages or overages and formulate changes in direction. Instead of being imposed from above, strategy seeps up from below. How the Budget Problem Grew

For most participants, the traditional budgeting process starts at least four months before the beginning of the fiscal year. Operating divisions, business units, and departments receive ‘budget packs’ that include forms asking for forecasts of sales, profits, and capital expenditures. The forecasts are reviewed at a high level, and after several rounds of give-and-take, the budget document is finalized. The budget is a vast compendium of details. It lists the capital and operational resources that the corporate centre is to make available to operating units, the obligations made by each unit for the coming year, and the commitments that business or operating units have made to one another, such as a production unit’s pledge to meet the sales plan. It also states what will happen to individuals’ compensation if targets are missed or surpassed. Over the course of the fiscal year, each unit is expected to file regular reports on its progress toward meeting the targets.

responsibility for reducing costs, satisfying customer needs, and boosting income. Performance

Regions and branches set their own targets, and the company’s 11 regions compete like teams in a league – trying to top one another on return on equity, a measure the markets use to judge the bank and its rivals. TBranches compete with one another on their cost-to-income ratio as well as on profit per employee and total profit. Standings are prominently displayed in what the company refers to as ‘league tables’. According to Wallander, the honorary chairman, “Managers know what is ‘acceptable’ performance – you can’t linger in the depths of the league table for long. No branch manager wants to let down the regional team.” In a traditional company,

Despite the number-crunching abilities of powerful computers, budgeting remains a protracted and expensive process, absorbing up to 30 per cent of management’s time. A 1998 study of global companies showed that on average they invested more than 25,000 persondays per $1 billion of revenue in the planning and performance-measurement processes. Ford Motor Company is reported to have figured that its total cost amounted to $1.2 billion per year. For companies involved in mergers, acquisitions, spin-offs, and other reorganizations, the budgeting workload can be overwhelming. Increasingly, even finance people question the value of budgeting. One published report says nine out of ten think it is cumbersome and unreliable. Among their complaints: It takes time away from activities that add greater value, such as supplying managers with the information they need to make decisions. A recent global best-practices study concluded that finance personnel spent only 21 per cent of their time analyzing and interpreting the numbers; they spent the rest doing “lowervalue-added activities” such as gathering and processing data, often for budgetrelated discussions.

Conclusion

teams that are fighting one another for customers and resources are unlikely to share data, leads, or insights. Two policies at Handelsbanken keep competition and cooperation in balance. One requires every customer to be attached to a particular branch; this avoids disputes over who gets the benefit of a customer order that has been handled by two branches. The other puts a portion of the company’s profits in a company-wide pool from which every employee derives an equal share. A teambased and open organization like Handelsbanken that is governed by peer pressure exposes free riders very quickly.

sands of transactions. Handelsbanken has the ability to monitor region and branch profitability online and to analyze patterns of excessive discounts, defecting customers, and unusual transaction volumes. Rolling cash forecasts, prepared every quarter, signal whether cash flow is improving or declining; if a problem looms, they make clear that steps need to be taken to ensure adequate liquidity. The cash forecasts are prepared by the finance department and seen by the vice president of finance and the CEO only. “Other banks have access to the same technology, so the difference must be down to how we work,” says Arne Martensson, the bank’s chairman. “Problems are transparent; they are not hidden within the nooks and crannies of management layers and allowed to fester.”

Information

Of course, a company without a budget requires a fast and effective information system capable of monitoring tens of thou-

So long as the budget process dominates business planning, a self-motivated and adaptable workforce is a fantasy – however many cutting-edge tools and techniques a company embraces. That’s because all of the principles and practices of budgeting assume, and perpetuate, central control. People at the front line of a top-down operation are hardly likely to report bad news if the inevitable result is a verbal beating – or to report good news, for that matter, if their reward is more ambitious targets. In contrast, companies that dispense with budgets can unleash the full power of modern information systems and tools. Corporate planning ceases to be a series of breathless sprints and instead becomes an endless conversation. Knowledge flows from frontline people to headquarters and back again, permitting the full potential of a radically decentralized organization to be realized. Jeremy Hope and Robin Fraser head up the UK-based Beyond Budgeting Roundtable (www.BBRT.org), an international independent research collaborative with academic associates at the London School of Economics and Stanford University. They are the authors of Beyond Budgeting: How Managers Can Break Free from the Annual Performance Trap (Harvard Business School Press, 2003.) This article recently appeared in Harvard Business Review.

Rotman Magazine • 17

Exchange Rates and Shock

Absorbers

The Canadian economy is best served by an exchange rate that is formally flexible but essentially stable because of sound and solid fundamentals. by Don Brean

A couple of years ago, as the Canadian dollar drooped toward its historical low of 62 U.S. cents and was sadly dubbed the ‘northern peso’, I wrote in Rotman Magazine that the weakness of our currency would have serious industrial consequences if it persisted. The slide toward 62 U.S. cents had begun in 1992, and each down-tick of our dollar changed crucial incentives for Canadian industry, sheltering inefficient firms and delaying the productivityenhancing adjustments that were the promise of deeper integration of the North American market. Although export volumes were buoyant, revenues and profits could not follow suit. In short, we were selling our goods at a discount. Then something remarkable happened: the loonie soared. In 2003, the Canadian dollar rose 25 per cent against the U.S. dollar, from 62 U.S. cents to 78.While our dollar has since settled down in the range of 73 U.S. cents, it nevertheless remains well above the nadir of 2001. The rise in our currency’s value is as impressive in its speed as in the bottom-to-top change. Both dimensions seem to defy explanations in terms of underlying economic fundamentals.What exactly happened here? Money, prices, and interest rates are intertwined in ways that perplex policymakers and baffle the rest of us. Exchange rates, which are driven by prices and interest rates, seem even more mysterious. Fortunately, in important ways, the world’s money issues have become somewhat more transparent and manageable of late. Greater clarity on money matters stems from the fact that most nations of the world have purged their systems of inflation. Back in the 1970s and ‘80s, when inflation was high everywhere, it was also volatile everywhere. Since an exchange rate is simply the price that one country pays for another country’s currency, the clash of inflations put exchange rates on a rollercoaster. And alas, for Canada, it seemed to go down more often than it went up. When you take inflation out of the picture, as we have now done, the major influences on exchange rates are real interest rates, economic growth, and risk. For a while these three stars were aligned for the American dollar and, in contrast, the

Canadian dollar slumped. Through the 1990s, the U.S. enjoyed spectacular economic growth and it was also a safe haven for foreign investors – two factors that gave strength to its currency. Meanwhile, Canada’s responsible reduction of its national debt had the effect of lowering our interest rates, thus reducing the incentive for foreigners to buy our dollar en route to buying our bonds. Instead, they bought U.S. paper. Furthermore the well-publicized productivity gap between the U.S. and Canada, until recently, was a powerful attraction to U.S. investment, keeping the U.S. dollar strong against all currencies, including the

either at home or abroad. For example, the recent run-up in our dollar in part reflected a worldwide sell-off of the U.S. dollar, against which Canada had some relief because of our exchange-rate flexibility. Our dollar fell less against the euro and the yen than the U.S. dollar did. On the other hand, if our exchange rate is inflexible, Canada would be forced to make internal adjustments, usually involving a combination of unemployment and domestic inflation, when we are economically ‘shocked’ from abroad. For example, with a fixed exchange rate, a rapid increase in Canadian exports would trigger domestic inflation, as opposed to a

The most significant threat to stability is worryingly close to home – rooted right next door to us in the U.S. Canadian dollar. Finally, there is risk, of which Canada has had its share. Through the 1990’s, the political rumblings in Québec hurt our dollar. It took some time to convince the rest of the world of the credibility of Canada’s newfound political stability and fiscal responsibility. The Canadian dollar was being punished for past sins. Today we have a much stronger currency. And while Canadian industry will have a tougher time dealing with the cold winds of international competition, that would be a good thing, because it drives the pursuit of innovation, best practices and industrial efficiency. All of this prompts two questions. First, is Canada wise to maintain a flexible exchange rate? And second, are storms gathering abroad that could disturb the relative tranquility of today’s array of exchange rates? On whether ‘to fix or not to fix’, it is useful to consider the official position of the Bank of Canada, the arbiter of such decisions. The Bank holds the view that exchange rate flexibility serves us well, and will do so increasingly as our fiscal and monetary credibility becomes globally recognized. A flexible exchange rate acts as a shock absorber against economic ‘bumps’,

more natural rise in the Canadian dollar. In a world of low inflation, our flexible exchange rate is an appropriately-functioning real price that serves our national economic interests better today than it did in the more inflation-ridden past. So what are the gathering storms in international finance? The most significant threat to stability is worryingly close to home – rooted right next door to us in the U.S. Think of two big numbers: $500 billion and $500 billion.The first $500 billion is the size of the U.S. trade deficit. The voracious U.S. demand for foreign goods – from Canada, China, and Europe – must be financed or, if it fails to be smoothly financed, U.S. interest rates will rise. U.S. interest rates seem set to rise regardless, but skittish foreign holders of U.S. paper could exacerbate things. The second $500 billion is the size of the U.S. fiscal deficit – a distressing turnaround from the healthy surpluses that the U.S. enjoyed as recently as 2000.The fiscal deficit, which to some extent drives the trade deficit, must also be financed. Again, much of this financing comes from abroad, as foreigners hold more and more U.S. securities. If the foreign appetite for U.S. paper subsides, then U.S. policymakers face a tough choice between ramping up Rotman Magazine • 19

interest rates or allowing the U.S. dollar to slide.There are signs that the central banks of Asia – Japan, China,Taiwan and Malaysia in particular, the largest off-shore holders of U.S. debt – are starting to adjust their balances of foreign currencies from dollars

– looks like a smile, and Canadian business has reason to be happy. For all intents and purposes, the Canadian dollar discount is gone. In global business, a stronger currency trumps a weaker one. A strong and stable currency underlies confidence in

Notwithstanding the benefits of a strong and stable Canadian dollar, the exchange rate itself is no basis for corporate strategy. to euro.The threat in all of this is that U.S. would become less of a locomotive pulling the world economy.While a fall in the value of the U.S. dollar is a market mechanism to correct the U.S. trade imbalance, it inevitably means that the U.S. would import less as its dollar falls and its economy is dampened by higher interest rates. Currency slides and rising interest rates tend to go hand in hand. A flexible exchange rate is a market price, indeed perhaps the most important price that most businesses deal with. A graph of the Canadian exchange rate over the past several years – down, across and up 20 • Rotman Magazine

decisions involving foreign market access, export pricing, foreign investment and the currency denomination of debt. Notwithstanding the benefits of a strong and stable Canadian dollar, the exchange rate itself – or prognostications of exchange rate changes to come – is no basis for corporate strategy. It is unwise to make long-term business bets based on an exchange rate. In fact the best forecast of the exchange rate next period – regardless of whether it is next week, next month or next year – is the exchange rate today. A stabilizing exchange rate, which is what we are beginning to see in the

Canadian dollar, is one in which the range of error is reduced in that rather simple forecasting framework. A lingering threat for Canada is the prospect of a downward bias in the Canadian exchange rate. The Canadian dollar is not a major international currency, unlike the U.S. dollar, the yen or the euro. In the accounts and vaults of the world, the Canadian dollar is small change.As exchange rates are more and more determined by international capital movements, and since such mobile capital seeks security and liquidity as well as returns, marginal currencies are at a disadvantage for offering neither substantial security nor deep liquidity. The good news is that the Canadian dollar has moved smartly to a new, highervalue plateau. It should stay there. Though the threat of a reversal is real, sound monetary policy and solid industrial growth are effective currency stabilizers. Canadian industry and the Canadian economy are best served by an exchange rate that is formally flexible but essentially stable because of sound and solid fundamentals. Don Brean is a professor of Finance and Business Economics at the Rotman School.

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Point of View: David Batstone

A Rant Against Quarterly Reporting Business 2.0’s founding editor thinks quarterly reporting is a bad idea. Here’s why. Over the past 25 years, public markets have become unrealistic about the growth curve that individual enterprises can achieve. Even the best-run company is subject to the rise and fall of economic cycles. But in today’s market, one bad quarterly earnings report, and a company’s stock is mugged on the trading floor. Senior managers feel tremendous pressure to ‘make their numbers’ – to match or, preferably, outperform Wall Street expectations, and create the appearance of steadily improving results. Such a quarterly vision entices them to look for shortcuts that will inflate earnings results at the expense of the long-term health of the enterprise. The spate of recent corporate scandals was in no small part prompted by the desire

business world could only guess the secret to his operational mastery. Now we know the truth. From 1999-2001, Qwest was swapping telecommunications capacity with other companies and counted the phantom activity as revenue. During that period, Nacchio personally cashed in $227 million of company stock, and Philip Anschutz, a member of Qwest’s board and largest shareholder, garnered almost $1.5 billion selling company shares. Qwest was later forced to readjust its numbers, but its admission of improper accounting did not impact retroactively the stock sales of executives and directors. It is not all that difficult for a company to temporarily increase sales through loading, or to drive profits upward by burying

I have come to the conclusion that quarterly reports contribute to the momentum toward deception and undermine efforts to build a business in a sustainable way. for management to meet expectations of financial analysts as the marketplace and investors react to short-term financial information flow. Indeed, some senior executives appear to be managing their stock more than managing the company. When Joseph Naccio sat in the chief executive suite at Qwest Communications in the late 1990s, he crowed about the company’s winning streak of meeting earnings projections one quarter after another. At the time, the 22 • Rotman Magazine

marketing expenses. Numbers manipulation produces its own momentum. Once an inflated profit is reported, the financial markets expect an even better performance the ensuing quarter. The company also needs to compensate for the loading of the earlier period. Bit by bit, the snowball of a ‘white lie’ grows bigger and develops into an avalanche of deception. I have come to the conclusion that quarterly reports, as they are presently practiced, contribute to this momentum

toward deception and undermine efforts to build a business in a sustainable way. Put bluntly, they promote short-term decisionmaking and strategic goals among directors and managers, as well as for shareholders. Now that I have made an outlandish claim, permit me to take a step backwards; perhaps my target is too broad. Quarterly reports, admittedly, can be part and parcel of strong corporate governance. After all, they enable management to effectively discharge its responsibilities to its stakeholders by establishing a regular channel of communication, make important disclosures and encourage transparency. The value of that reporting hinges on the degree to which it gives a reasonable picture of management’s overview of the company’s health.Truth be told, shareholders just as easily could gain this information from regular management discussion & analysis (MD&A) reports, in particular an analysis of current and short-term financial results balanced with a discussion of longer-range items such as strategy, vision and performance targets. The quarterly report in practice has turned into something more, however. ‘Earnings guidance’ – the forecast management makes about how they expect their companies to perform financially in the near future – has taken center stage. These forecasts also are known as ‘forward-looking statements’ because they focus on sales or earnings expectations in light of industry and macroeconomic trends. Earnings guidance is a relatively new term to describe an old practice. In previous incarnations, it was known as ‘the whisper number’.The key difference is that companies could talk privately with analysts so that they could warn their top

clients. Fair disclosure laws made this practice illegal, and companies now have to broadcast their expectations publicly, giving all investors access to this information at the same time. That development was a wonderful gain for the small investor. It is critical for management to address future financial prospects, of course. The source of the problem is the time frame and the narrow vision it spawns. Earnings guidance every three months is the equivalent of the ‘tip sheet’ for the racetrack junkie.All the emphasis is on, “did you meet it or beat it?” Earnings guidance aims to convince investors and analysts that business is predictable. But in actual fact, business is not predictable. When you see regular, predictable earnings, it is usually because management is smoothing the numbers out through some accounting gimmicks. There can be little doubt that companies manage their earnings forecasts like a Hollywood set. In a competitive environment as volatile as ours, can a company really predict – down to the penny – what its earnings per share will be four quarters from now? I think not, and yet a spate of research demonstrates that there are ridiculously more companies that meet their earnings forecast to the cent – or beat it by a cent – than there are those that miss it. In bull markets, companies are more likely to offer optimistic forecasts and join the bandwagon generated by stocks with fast-growing earnings-per-share. In bear markets, companies are apt to lower expectations so that they can beat their numbers and show strength in a tough season. It is the analyst’s job to evaluate management expectations and judge if these expectations are too optimistic or too low. Unfortunately, analysts have not been exactly trustworthy when it comes to performing this task with objectivity. I therefore applaud the decision that a small but growing number of companies are making to forego earnings guidance in their quarterly reports. More than one out of four U.S. companies are considering discontinuing the practice, according to a 2003 survey conducted by the National Investor Relations Institute. That group includes major corporations like

Coca-Cola, Gillette, and Berkshire Hathaway, all of which no longer include earnings guidance in their quarterly reports. A key link connecting these three companies is Warren Buffett. Buffet is both major shareholder and board director

performance. Management also should be able to offer insight into what’s happening for the company in the current quarter, and explain how it will run the business and manage expenses based on various revenue levels.

Quarterly estimates have proven to be a fairly shallow measurement of a company’s actual health. of Coca-Cola and an ardent proponent of investing for the long-term rather than reacting to short-term prospects. But doesn’t this movement undercut investors’ pleas for more disclosure in the post-Enron era? Not at all; quarterly estimates have proven to be a fairly shallow measurement of a company’s actual health. It would be more helpful for a company to disclose to investors and analysts a long and short history of the firm’s actual operating

Above all, management has to decide what information to disclose and how often to disclose it.Then they should paint that picture consistently, in good times as well as bad.

David Batstone is author of Saving the Corporate Soul (JosseyBass, 2003). A founding editor of Business 2.0 magazine and a professor at the University of San Francisco, he delivered the keynote address at the 2004 Conference on Corporate Social Responsibility at the Rotman School of Management.

Rotman Magazine • 23

CEO’s Corner: Philip Taylor

AIM Trimark’s Winning Strategy Karen Christensen talks to AIM Trimark Investments’ President and CEO Philip Taylor about how the firm distinguishes itself on a crowded playing field, uncovering some of the reasons why it has been named company of the year twice in a row at the Canadian Investment Awards. Karen Christensen: As the CEO of one of Canada’s largest mutual fund companies (with over $40 billion in assets under management), what is your greatest challenge?

It may not be what you think. If you’re expecting me to point to regulatory issues, margin compression, the maturing of our market, our fund company competitors buying into distribution or the oversupply of product – you’ll be disappointed. Sure, they’re all challenges we have to overcome to remain successful. But our people are at the centre of my chal-

Philip Taylor:

that’s not enough.We also have to have full alignment of the behaviours of all 900-plus employees with our mission statement, brand framework and business objectives. We can’t begin to address those external challenges I mentioned until we have the right people, culture and atmosphere firmly in place. KC: How is AIM Trimark meeting this challenge?

We’ve done three things. We created a mission statement; a set of core beliefs or principles; and we surveyed staff to

PT:

We should never lose sight of the fact that our reputations are founded on the principle of putting investors’ interests first. lenge. We’re not in a capital-intensive business. We don’t have factories, patented product formulations or manufacturing processes. We don’t even produce or sell a tangible product. So our biggest point of leverage is the men and women of AIM Trimark. Our challenge, our opportunity in fact, is to attract and retain the right people, and to motivate and engage them. But

24 • Rotman Magazine

find out what’s on their minds. To understand how important these initiatives are, I ask you to turn the clock back to 2000 just after AIM Funds Management Inc. bought Trimark Investment Management Inc. At the time, the two companies had very different cultures, were in different phases of development, and our post-acquisition logo looked like

a co-sponsorship initiative between two companies – we just kind of pasted them together. More important, few employees could consistently articulate what it was that made us unique. Although both companies had been successful, we lacked a unified vision to take us all together to a higher level. The first step for us was the creation of a mission statement with the help of senior management. I then used one of our semiannual, all-employee Town Hall meetings to invite staff to help management fine-tune the mission statement and develop a set of core beliefs, or principles. This was an ambitious undertaking, but we felt it was important that these beliefs didn’t come down from the ‘top’. We invited all employees to attend a series of focus groups where we asked them to discuss what AIM Trimark means to them. Our six principles were born from these sessions, and they now act as principles that guide our behaviour. The next step was conducting our first employee survey to benchmark how close we were to our principles. The participation rate was over 90 per cent, and the areas that required further development were acknowledged by the senior executive and turned into action items. A second survey, conducted last winter, highlighted our progress against these priorities, and we will continue to survey for greater understanding in the years ahead. Today, four

years after the merger, I’m pleased to say that we have one brand name, one logo, a clearly defined culture, alignment on our business goals, and all staff know what makes AIM Trimark unique.

high-performing staff in the short-and-long terms in accordance with our business results, but we don’t want people to work here just for the money. KC: As an overall philosophy, does AIM

KC: How does AIM Trimark distinguish

Trimark encourage its fund managers to

itself in the crowded financial services

take risks, or do you take a more con-

arena?

servative approach?

AIM Trimark has been referred to as both risky and conservative, depending on current market conditions and the prevailing wisdom. PT: Three defining attributes set us apart from the crowd: proven investment expertise, strong advisor partnerships, and an exceptional service ethic. Our investment expertise lies at the core of our business. Whether it’s AIM funds, which are driven by opportunity, or Trimark funds, which are guided by the Trimark investment discipline of being ‘patient business acquirers’, our demonstrated excellence through all market conditions has made us the preferred investment choice among investors. Another key differentiator for us is the relationships we have with advisors. Put simply, we strive to become indispensable partners with advisors who sell our funds by providing the tools and advice necessary for them to do their jobs more effectively.

PT: Is buying an out-of-favour company with a high-quality business and strong management risky? Or is refusing to pay for high-flying technology companies at the height of the tech craze conservative? I don’t mean to be flippant, but AIM Trimark has been referred to as both risky and conservative, depending on current market conditions and the prevailing wis-

dom. Our dominant style is a disciplined approach that uses insightful proprietary research to identify fundamentally-strong businesses, then patiently waits to acquire them at low prices. The phrase “business people buying businesses” is the one most often associated with this discipline, because each potential holding is viewed as a long-term business investment as opposed to a short-term stock trade. As a result, our portfolio managers ignore much of the short-term news that has little impact on an investment’s long-term return potential. Usually, this leads to views about companies that are quite different from what other investors are saying about the company. We don’t attempt to time markets, trade securities for shortterm gains or substantially change portfolios based on economic or market forecasts. And the majority of our investment managers’ compensation comes from long-term performance. KC: The mutual fund industry has certainly been under intense regulatory and consumer scrutiny in the U.S. for the past year, and less so in Canada. Do you have some prescriptive advice?

KC: The Wall Street/Bay Street culture tends to attract and reward aggressive employees whose main motivation is money. Is this true at AIM Trimark? PT: No.We aim to attract, reward and work with people who are highly ethical, believe in our investment discipline, want to be part of a team that consistently exceeds expectations, and are collaborative in nature.They must also support our mission to deliver enduring solutions to our investors and their advisors. We’ll reward

Philip Taylor President and CEO, AIM Trimark Investments

Rotman Magazine • 25

PT: I believe mutual funds and financial advi-

sors perform a valuable, needed function that benefits millions of Canadians. We should never lose sight of the fact that our – and the industry’s – reputations are founded on the principle of putting investors’ interests first. That means investors should be treated equally, be protected by a mandatory code of ethics, enjoy independent fund oversight and only be offered mutual funds that stand the test of time.

estimates. You may have increased the probability that you’ll do something for the short term to the detriment of the long term. If you focus on the long term when many others aren’t, you’ll increase your odds of winning in the years to come.

KC: What AIM Trimark initiative are you KC: You recently began offering your and/or global expansion a key focus for AIM Trimark going forward?

in favour of companies embracing alternate methods? PT: All in all, I think the more reporting and disclosure, the better. But I do wonder how much this distracts corporate management from their real job of creating wealth over the long term.Why is it a distraction? Can you imagine trying to build a business for the next three, five, and 10 years while having to explain to the analysts who cover your company why your margins were down, say 15 basis points (bps) on the quarter? Better yet,

We have a unique approach to managing money in Toronto, and it’s rewarding to see the AIM Trimark brand accepted by

PT:

26 • Rotman Magazine

PT: Research has told us that the key to fulfilling long-term investment goals such as retirement lies in a written financial plan. This led our product development team to further explore the potential of a new product that would eventually be

The key to fulfilling long-term investment goals such as retirement lies in a written financial plan. our U.S. sister company (Houston-based AIM Investments) and in the world’s largest and most competitive financial market.While the most recently-launched

If you focus on the long term when many others aren’t, you’ll increase your odds of winning in the years to come. your stock is down 20 per cent because the analysts thought your margins should have been up 15 bps like your competitor – while the truth is your competitor cut back on product development to meet the Street’s quarterly estimates, and your margins are down because you just launched new products into a new market that could someday potentially double your earnings. Your stock is down and your competitor’s is up on the day. Who’s the winner? After experiencing the pain of that quarter’s stock drop, you may start to figure out how to beat next quarter’s

currently most excited about, and why?

funds to U.S. investors. Is American

KC: Do you think quarterly reporting by corporations is a good thing, or are you

assets under management in 21 countries. AMVESCAP is always looking to add investment expertise and investment style differentiation in markets where it operates, just as we’re proud to offer U.S.-managed funds to Canadians.

funds in the U.S. got most of the limelight from the press, we also manage money out of Toronto for other external markets that recognize the investment accomplishments of the Trimark funds through some of the toughest market conditions possible. The global awakening to and acceptance of the Trimark investment discipline does, however, have less to do with any expansionist ambitions from us and more to do with the global nature of our U.K-based parent, AMVESCAP. It’s one of the world’s largest investment management companies, with over $500 billion in

called Dialogue Wealth Management. Launched in June, it’s our newest offering, and it does something quite simple: it incorporates a written financial plan with a flexible portfolio management solution to deliver a better wealth management experience for investors. The Dialogue Wealth Management launch is remarkable for three reasons. First and most important, it’ll help investors. Second, it satisfies the enduring notion in our mission statement, because it’s a product that will stand the test of time. Third, given the amount of cross-functional coordination it took at AIM Trimark, it’s the best example yet of how our new principles are now guiding our behaviour. KC: What stocks do you like these days?

With the exception of two stocks, AMVESCAP and Investors Group Inc. (a former employer), I leave it up to full-time dedicated experts to manage my money. And of course, the majority of my investments are in AIM Trimark mutual funds.

PT:

Four distinct management teams. Four proven investment styles. One leading investment management company.

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