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Getting the Timing Right

New titles explore business strategy, classic arbitrage.

It's a lot easier to swim with the tide than against it. But many companies are so focused on "micro" level issues that they forget about the economic ocean they're swimming in. When recessionary "waves" ride ashore, they're caught utterly unaware.

That, says, UC Irvine business professor Peter Navarro, is precisely what happened to Cisco CEO John Chambers. This once-vaunted leader ignored unmistakable signs of weakness in 2000 and 2001—thereby leaving Cisco with $2 billion in inventory write-downs, and a plummeting stock price.

In his new Wharton School Publishing book, The Well-Timed Strategy, Navarro makes a powerful case for more fully integrating business cycles into your strategy—and shows exactly how to do it.

Integrating Business Cycles Into Strategy

Inventory is one obvious issue. Navarro's advice may not be so self-evident, however. The standard wisdom, of course, is to keep inventory turns as fast as possible, to maximize cash flow. If you're doing your job consistently well, that implies a flat inventory ratio throughout the business cycle.

But Navarro recommends "macromanaging" turnover ratios: tactically increasing them (by trimming inventories) when forecasts signal recession, and decreasing them (by raising inventories) when indicators signal expansion—so you can deliver fast, as soon as customers ramp up ordering.

As the latter example shows, managing to business cycles isn't only about mitigating risk, says Navarro. It offers significant opportunities for competitive advantage.

Case in point: hiring. Late in an expansion, labor becomes scarce, and wage pressures rise. When that happened to Isis Pharmaceuticals, the firm began relying more heavily on temporary workers and postdoctoral students. When a recession hits, wage pressures abate, and talent pools deepen. That's when Isis hires aggressively, "cherry picking" talented workers at far lower cost.

Similarly, when Xilinx saw a recession coming, it implemented sophisticated tactics for preserving valuable intellectual capital. Among other elements, the program offered knowledge workers a year-long sabbatical with a small stipend if they returned to school or worked for a non-profit. By avoiding the $250,000 investments required to hire and train each new engineer, Xilinx saved $35 million. And when the recovery started, Xilinx was able to offer innovative new products far more rapidly than its competitors.

Another case in point: M&As. While Nortel was burning up $75 billion in shareholder value through bad acquisitions, the well-known credit scoring firm Fair Isaac exercised "ruthless patience" through a three-year hunt for HNC.

HNC's predictive software offered powerful strategic synergies when Fair Isaac first considered acquiring it in 1999. But the price was too high. HNC then spun off a business unit, reducing its valuation. Fair Isaac looked again, but still couldn't justify the acquisition as accretive to earnings. Finally, in 2002, after the tech stock crash, Fair Isaac pounced. In the first year after the acquisition, Fair Isaac's revenue jumped 60%—but more important, its net income per share more than quadrupled.

Navarro shows how an awareness of the business cycle can also impact your marketing and product mix. Fast-food chicken franchiser El Pollo Loco found itself facing recession in a dangerous position: all of its growth was coming from price increases. Solution: an aggressive shift towards lower-cost dark meat, including a "Leg and Thighs" deal that drove profitable volume, even in tough times.

Centex, a leader in the hugely volatile home-building industry, responds to the first signs of economic cooling by raising the proportion of lower-cost homes it builds. The firm has developed a highly sensitive mechanism for sensing economic changes. All 55 Centex divisions scrupulously track local trends, in tandem with comprehensive "macro" data on jobs, housing starts, and building permits.

Which raises a crucial point: Navarro's techniques assume that you can predict business cycles with reasonable accuracy, and know how to intelligently evaluate the economic forecasts you're being given.

To that end, Navarro introduces three sets of tools: leading economic indicators, from stock and oil prices to the "ECRI dashboard" of growth and inflation indicators; more complex forecasting models; and daily signals from economic reports.

At the top of his list, an indicator that's been getting plenty of attention lately: the yield curve—the spread between short- and long-term interest rates. "Inverted" yield curves have signaled five of the last six recessions. The yield curve inverted a full 12 months before the 2001 recession, and was promptly ignored by most of corporate America, much to its regret.

In January 2006, the yield curve inverted again. Whether you plan to follow or disregard it this time, you'd better know what you're doing, and why. Which makes this book especially timely.

Demystifying Arbitrage, Identifying Mispricings

Arbitrage is the common thread that binds together much of contemporary financial thought. You'll find it at work in corporate risk management, derivatives analysis, asset pricing, portfolio management, and beyond. The underlying goal of arbitrage seems simple enough: identifying fleeting "mispricings" of assets or portfolios, and exploiting them for profit. But many managers, financial professionals, and investors would benefit from a far deeper understanding of arbitrage than they possess.

The subject has attracted more than its share of mystification. On one hand: breathless, low-content articles about enigmatic hedge fund traders and secretive currency speculators. On the other hand: intensely mathematical treatments that daunt all but the most technical.

Into the breach rides Randall Billingsley, associate professor of finance at Virginia Tech's Pamplin College of Business. In Understanding Arbitrage, newly published by Wharton School Publishing, Billingsley aims to give readers a strong intuitive understanding of classic arbitrage.

Billingsley brings exceptional experience to this assignment. He's spent 14 years teaching CFA candidates about derivatives and risk management. His case study on equity valuation was designated as assigned reading by AIMR (now the CFA Institute), the organization that awards the CFA designation.

Students find arbitrage slippery, he notes, because it's often presented in arguments that are "long on technical detail but short on economic intuition." To remedy that, he focuses on a wide array of examples. That allows him to compare and contrast, and to illuminate elements common to all. Instead of touching just "one part of the elephant"—say, M&A—Understanding Arbitrage offers an integrated picture.

This book begins where any treatment of arbitrage must: with the Law of One Price, which posits that investments with identical payoffs, however structured, should be priced the same; when they aren't, arbitrageurs' transactions rapidly eliminate the differences.

Billingsley captures the essence of arbitrage with one of the simplest examples imaginable: What happens if gold's trading for $10 more in Hong Kong than in New York? Why might that happen? Is it sustainable? How can it be exploited?

He demonstrates what happens when you incorporate asset valuation models into arbitrage, e.g., CAPM and APT. Then, using scenarios involving silver and interest rates, Billingsley shows how the cost-of-carry model can reveal arbitrage opportunities arising when spot and forward or futures prices don't accurately reflect the value of time.

Next, he turns to international arbitrage and currency exchange, showing how to assess cross-border differences in interest rates and inflation, and walking through the specific steps needed to arbitrage rate differentials. (Many readers will recall that George Soros "broke" the Bank of England: Billingsley explains how that was accomplished.)

Understanding Arbitrage carefully explains the relationships amongst call, put, exercise, and stock prices; time to expiration, and risk-free rates—and shows how these relationships are used to create synthetic securities. Billingsley then turns to an area where the power of arbitrage is "particularly compelling and elegant": options. This material is indispensable. In addition to generating two Nobel prizes, arbitrage-related options pricing touches business decision-making constantly: from determining whether to expand a profitable new business line, to valuing executive stock options.

In his final chapter, Billingsley addresses capital structure: especially the revolutionary Modigliani-Miller theorems. He begins by noting that just as "cutting an extra-large pizza into eight rather than six pieces does not increase the amount of pizza you can eat for dinner," neither are capital structure decisions relevant to a firm's valuation. (Modigliani himself used this analogy, quoting Yogi Berra as his source.)

Working with an idealized example, readers walk through measuring the effects of financial leverage, arbitraging misvalued capital structure, and analyzing capital structure from the standpoints of bondholders and equityholders.

What's missing from this book? For one thing, the advanced math: Billingsley focuses on nuts-and-bolts transactions and the intuitive side of arbitrage instead of advanced financial analysis. Second, Billingsley focuses primarily on "classic" approaches to arbitrage that are riskless and self-financing. He'll prepare you to encounter other forms—such as tax, regulatory, or index arbitrage—but you'll have to look elsewhere for detailed discussions. (He does, however, offer a cogent two-page precis of the Long Term Capital Management affair, and LTCM's far-from-riskless strategies.)

Billingsley is an elegant, careful writer with deep knowledge. He's insightful enough to focus on what's important, well-tuned to newcomers' questions, and comfortable using real-world metaphors to humanize his subject. If you keep bumping up against arbitrage—and you keep intending to get your arms around it—he's written the book you've been waiting for.