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…from my Multinational Firms and Strategy class

We recently had a class assignment – Analyze Alan Greenspan’s decision to keep the interest low for a long time and raising it very slowly. Many say this policy along with a lackluster regulatory policy led to the current housing led credit crisis.

It was a very interesting exercise and though I wasn’t able to reach the “right” conclusion, I felt that the he did indeed keep the interests low for a longer time than needed. This conclusion came based on my analysis of the GDP gap as perceived (based on Taylor rule and then data) by Greenspan vs. my own estimate of the GDP gap. The increasing natural rate of unemployment also provided some direction towards my conclusion. I cannot exactly share my data, charts, and analysis here because … it was an assignment that may be given next year also and I don’t yet know my grades on the assignment .

What I want to discuss here is one of the statements made during the class –  The economists have not yet build a model that can capture the true relationship between Alan Greenspan’s decisions and the housing crisis. My question is – Can such a model be built? Can it be predictive in nature, and not just retrospective? Lets start by asking a more fundamental question…

Can consumer behavior be modeled? To some extent, yes. Marketers tend to model behaviors all the time in order to sell consumers exactly what they want, and do not want, in the most (un)appropriate times. Numerati (Stephen Baker’s book) talks about various such models and how it is revolutionizing the industry. But this behavior is always predicted based on certain other behavioral patterns and not on demographics, access to cash, and spending power (Note that such models also do exist but may not be the right way to segment consumers).

How can you predict what a consumer will do when he is given easy access to large amount of cash? We look for patterns. We look around ourselves and see what do people do in such cases. When a person gets a great job that comes with large salary incentives, what does he purchase first? When a new generation enters the workforce, what do parent recommend them they do with the money earned? When somebody wins a lottery, what is the one thing he invests in? Does ‘buying a house’ answer all the questions above to some extent? Probably yes.

How can we test this hypothesis? Can this pattern be quantified in an equation? Can it lead to building a model that can actually prove that Greenspan is the root cause of this disaster? Thoughts?

Words from our economics professor Ray Hill. He is correct in saying that and I also believe that everyone in business (not just MBAs) should know what inflation is and how to calculate the rate of inflation.

What is Inflation? Per Wikipedia, the definition is – inflation is a rise in the general level of prices of goods and services in an economy over a period of time. So far so good. We all understand this basic concept very well.

Now, how is the rate of inflation calculated? What measures should one use to calculate the rate?  Basically, there are some other measures (or indices) that should be known to you before you decide to calculate the rate. First is CPI or Consumer Price Index – an estimate of average price for goods and services purchased by households. Second is GDP deflator – a measure of level of prices of goods and services that are produced domestically. Third is PCEPI or Personal Consumption Expenditures Price Index – derived from the largest component of the GDP (personal consumption) and measures the change in prices of goods and services consumed by individuals. I will not go into the details of what each of these are and how they differ because lots of literature is already available on the internet.

Calculation of the rate of inflation is very simple indeed.

Rate of inflation (between time period t and T, T>t) = (Value of the index at time T)/(Value of Index at time t) – 1.0

For e.g. – Between December 2006 and 2007, the inflation rate was 4.08% (based on CPI)

But this is where the fun begins. Using these concepts how do you find out what is the real price of a good based on prices in a certain year in the past? Say Coca Cola, 6 pack 12Oz., used to cost 50 cents in 1974 and $1.50 in 2004 (illustrative figures). This $1.50 is the Nominal price of Coca Cola. What is the real price in 1974 dollars? Say the rate of inflation between these time period is 283% (2.83) (this is actually true). Then,

Real price (in 1974 dollars) = Price in 2004/Rate of inflation = 1.5/2.83 = 53 cents. Huh. Not bad is it!

There is another question that begs answering – What index should one use to calculate inflation rate? CPI is measured using a fixed basket..not a good idea because a typical household’s basket of goods purchased changes over time, new products are introduced, and quality of goods changed (for e.g computers, cars…). There have been some changes in the ‘algorithm’ used but still it tends to have an upward bias in the calculation. GDP deflator helps a little bit because it does not rely on a fixed basket but the actual consumption/expenditure patterns of individuals in a given year. This tends to eliminate the upward bias, but not by much.

Some products, specifically food and energy, tend to be affected by supply shocks and the price change may be temporary (we know about the oil prices, right?). So including these components in calculating true inflation may be misleading. If these are eliminated we may be able to see the real picture. This is where Core Inflation, calculated using PCEPI, comes into picture. In fact, Fed nowadays uses this measure to calculate inflation and take monetary decisions.

Note that inflation can be calculated for specific set of assets such as commodities, services, and wages.These set of values are just subsets of the net inflation but the rules of calculations remain the same.

Some important direct links:

CPI (unadjusted) Data Download

GDP Deflator Data Download

PCEPI (Less food and energy) Data Download

News Flash – September inflation data indicated that consumer prices declined 1.3% during the prior 12 months and that core annual inflation, which excludes volatile food and energy prices, rose just 1.5% — well within the Federal Reserve’s comfort range of between 1%-2%.

Hope you now understand what this means…

To understand what a 10-K is and what aspects should be read, I will refer to Home Depot’s 10-k document filed on 4/2/2009. As with all filings, 10-K document can be downloaded from the company’s website – in this case, here, or from secinfo.com – for Home Depot here.

A preliminary guide to the report can be found on Wikipedia. We will not cover the basics in this document.

The article on Wikipedia also covers the various sections within a 10-K report. We will delve a little deeper into most of the sections in this guide.

A 10-K document should always be read by a serious investor if he/she wishes to determine the current state of a company. A 10-K will help to gauge the health of a company, its operations, and its various other initiatives. Without a doubt, a single 10-K report is not enough for anyone to come to any conclusions. Typically, one should compare consecutive year 10-K reports so that a definite direction in which the company is going can be determined. At the same time, comparisons should be made with a competitor’s results, industry averages, so as to peg a company in relation to other players in the industry.

Similarly, a 10-K report does not provide any indication of how a company is going to perform in the future. The report only provides information of what has been, not what will be. An investor has to derive intuitive conclusions, based on economic, market, political, and other trends to gauge the performance in the future. Even if the conclusion is well supported by facts, it is impossible to accurately predict anything about the future.

But, with experience, good judgment, and detailed analysis an investor is expected to be right more than wrong most times.

So let’s see what Home Depot’s 10-K report tells us about the company.

Home Depot’s 10-K

Part 1 – Item 1 – BUSINESS

This section of 10-K gives a brief introduction to the company and the industry within which it operates. A very important item, it will help you to know what the company does, where is it located, what are its different product offerings, and who are its customers. This section will also list out different sources of revenue for the company and the various strategies it employs to stay ahead of its competitors. An investor should keep an open eye towards the risks mentioned in this item. Sometimes common sense, it is important to understand the risks because only then will an investor identify the impact of external forces such as market, political, and economic conditions.

Excerpts from Home Depot’s 10-K – Note that this list is not exhaustive. A complete reading of the report is needed to gather all necessary information.

“The Home Depot, Inc. is the world’s largest home improvement retailer based on Net Sales for the fiscal year ended February 1, 2009 (“fiscal 2008”).” – So we know it is the largest home improvement retailer.

“As of the end of fiscal 2008, we had 2,233 The Home Depot stores located throughout the United States…Commonwealth of Puerto Rico…U.S. Virgin Islands and Guam (“U.S.”), Canada, China and Mexico.” – They are present in different countries, mostly around the US. They have entered the China market, one of the fastest growing economies.

“We shifted our focus from new square footage growth to maximizing the productivity of our existing store base… to make them simpler, more consistent and more customer-focused… associate hours to be more customer facing and refocused our efforts…” – This tells us that they had been expanding quite rapidly earlier but have slowed down the process in exchange of increasing productivity at existing stores.

Their customers predominantly include home owners, and professionals in the building industry. We may infer that Home Depot’s business is highly dependent on the housing industry. In the face of any other kinds of products, any downfall in the housing industry cannot be mitigated by any of their other services very easily.

They have 4 categories of products:

· Plumbing, electrical and kitchen

· Hardware and seasonal

· Building materials, lumber and millwork

· Paint and flooring

It should also be observes that all categories contribute almost equally to sales even though plumbing, electrical, and kitchen contributes the largest.

“In fiscal 2008, we reduced our inventory while maintaining a favorable in-stock rate.” – They are in the right direction as they implement better forecasting and inventory management tools.

“We also reduced a number of one-time discount promotions…continued to introduce innovative and distinctive products… we have formed strategic alliances and exclusive relationships with selected suppliers” – If you remember the discussion we had on the retail industry earlier, Home Depot is following certain best practices that will help it differentiate from its competitors and stay ahead of the game. These are – reducing intermittent promotions to avoid stock piling and sell through, introducing store brands to maintain exclusivity, and forming strategic alliances to get better terms and reduced costs.

“…we have three sourcing offices located in the Chinese cities of Shanghai, Shenzhen and Dalian, and offices in …India…Italy…Mexico and Canada.” – Their products are made all over, not exclusively USA or China.

“we continued to make information technology investments…in our supply chain and merchandising tools to improve inventory management capabilities and streamline our operations.” – An analyzed above…

“Our business is highly competitive, based in part on price, store location, customer service and assortment of merchandise.” – Rightly said. We also see the impact of the 4 important characteristics of a retail company on Home Depot’s competitiveness.

Risk Factors

All companies are required to list the various risk factors that could adversely or materially affect its business. Investors should make a close note of all the risks and match them up with their knowledge of the current market conditions. It will help him/her make valuable judgment on a company’s operation in current times. Some of the risks noted in Home Depot’s 10-K include:

“state of the housing, construction and home improvement markets, rising costs, a reduction in the availability of financing,” – We all know what is going on these days. But if numbers have their say, we can probably say that markets are improving and home sales are increasing. This can positively affect Home Depot’s performance in the coming year.

“fail to identify and develop relationships with a sufficient number of qualified suppliers” – Though this is mentioned, unless we see any strained vendor relations in the past, we can say that the management is competent enough to maintain its supplier relationship. Research pertaining to exclusive relationship and its survival rate in the past can be a good indicator of the seriousness of this risk.

“ability to obtain additional financing on favorable terms” – Financing should be available in today’s market as government tries to fuel the economy by providing low lending rates.

“inflation or deflation of commodity prices could affect our prices, demand for our products, sales and profit margins.” – O yes! Gas prices have been fluctuating recently and so are the commodity prices. This can very well affect the transportation, procurement, and maintenance costs and can have a big impact on the business. Investors should pay close attention to this risk.

“ability to attract, train and retain highly qualified associates.” – At least for the near future, this shouldn’t be a problem if Home Depot plays its cards right. There are many talented folks looking for job these days.

“Increased competition could adversely affect prices and demand for our products and services and could decrease our market share.” – Because of high entry cost, Home Depot can be safe from new players. But needs to closely monitor existing competitors and be proactive in implementing it’s own strategies.

“If we cannot successfully manage the unique challenges presented by international markets, we may not be successful in expanding our international operations.” – Home Depot operates only in China apart from nearby countries. It does not have a lot of experience managing expansion internationally. So if it tries to open in other countries, close watch needs to be maintained on its performance, market share, and sustainability. Even a company like Wal-Mart had to leave Korea. It’s not easy.