Reading through first quarter earnings reports has reminded me of a funny exchange between Tampa Bay football coach John McKay and a sportswriter following a very disappointing loss by the Buccaneers. The writer asked Coach McKay what he thought of his team's execution. Without missing a beat, McKay replied, "I think it's a good idea." Be careful how you phrase the question...
What the sportswriter meant was... The other definition of execution - the style or manner in which something is carried out or accomplished. And it is this definition that is more pertinent to what is happening in the equity market. In this context, execution was the differentiating factor in the recently released first quarter earnings reports. Virtually across the board, top-line revenues fell short of expectations, reflecting the weak overall economy. However, at the bottom line, there was significant variation between companies within most industries, as many companies were able to produce positive earnings surprises. With top-line growth soft, companies focused intently on expenses, strategic acquisitions, productivity, restructuring, product innovation, and marketing initiatives to drive earnings growth. Managing all these driving forces on a day-to-day basis is our definition of execution.
Typically, investors seldom reward companies that drive earnings growth through cost cutting and other means that are seemingly one-time in nature. Investors, generally speaking, prefer earnings growth generated by exciting new products or new business ventures. But sometimes that is not possible, which is largely the case in these trying economic times. So, companies are forced to adapt to grow.
Back to the gridiron... Prior to moving to Tampa Bay, John McKay was a legendary coach at The University of Southern California. One of Coach McKay's famous plays at USC was called "Student Body Right." This involved a sweep around the right end led by two pulling guards. Essentially, the objective was to out man the defense at the point of attack. It wasn't a very sophisticated play but it was effective. Perhaps it helped to have two Heisman Trophy winners carrying the ball (Mike Garrett '65 and O.J. Simpson '68). Student Body Right worked well until the defense shifted. Then McKay would run "Student Body Left."
Enough football... Effective execution requires a Student Body Left adaptability, a willingness to change course in order to take full advantage of the different environment and opportunities. As we saw in the first quarter earnings reports, some companies are better at adapting than others. Changing course may seem to be a no-brainer at times, but it is rarely that easy. Inertia can be a significant hurdle to over come, especially for large organizations.
Back to execution... Can CEOs make necessary changes in an effective manner? Or will CEOs stubbornly adhere to the old ways of doing things? Beyond that, will organizations promote a culture that encourages change or will it shrivel into a stifling bureaucracy? In many ways I do think it is that fundamental.
Regime change... It will be interesting to see how much change we'll ultimately see at top companies which have stumbled during this challenging economic period. Disgruntled shareholders, politicians, and the academic community have all called for regime change, especially at some of the leading financial services companies. Should a CEO, who was at the helm during the financial meltdown, be given the chance to right the ship? If so, how much time, exactly?
Building war chests... Meanwhile, several large companies, like Cisco Systems and Exxon Mobil, continue to build enormous amounts of cash in order to take advantage of future acquisition opportunities. While these moves do not come with out integration risk, companies can dramatically improve their competitive position by making timely strategic acquisitions during periods of market and economic weakness. Essentially, running Student Body Left when the world expects Student Body Right. At the same time, other companies have adopted a bunker mentality and see only risk not opportunity.
In the last two months the market has rallied about 25% from its low point, driven by signs that the economy is gradually improving and increasing sentiment that the worst is behind us. Despite this hope, many pundits remain bearish and fear that the rally has gone too far, too fast. That is a tough call, but in the meantime, it makes more sense to us to concentrate on individual companies and the competitive battles within industries. If the recession lingers owning proactive companies that are strengthening their competitive position seems to make a lot of sense. And if the economy has in fact bottomed, these same companies should continue to out perform.
From a sector perspective, several industrial stocks have driven the out performance of our core portfolio so far this year, despite the recessionary environment. Given the relative performance of cyclical stocks tends to be a leading indicator, perhaps this is a sign that the economy really has in fact bottomed. We shall see.
