Wall & Main


My perspectives as an investor and consumer

Stressing out the banks


One of the programs created under the TARP is the Capital Assistance Program (CAP).  The CAP was designed to promote confidence in the financial system by ensuring that the nation’s largest banks have sufficient capital cushion against larger than expected future losses.  A stress test, called the Supervisory Capital Assessment Program (SCAP),  was crafted and implemented by the Federal Reserve and the Treasury to aid them in assessing said capital cushion.  Details of the stress test were released to the public by the Federal Reserve on April 24th, through a 21-page white paper.  I present here a synopsis of the white paper.

All domestic bank holding companies (BHCs) with year-end 2008 assets exceeding $100 billion were required to participate in the SCAP.  According to ProPublica, 19 firms fell under this requirement.  They are listed in the second table below.  These 19 firms hold 66% of the assets and 50% of the loans in the US banking system.  They were asked to project their losses, and available resources for absorbing these losses, for 2009 and 2010 based on two economic scenarios — a baseline scenario and an adverse alternative.  The table below lists the components of the economic scenarios and the effect of the baseline and adverse conditions on each of them.  The supervisors, then, assessed whether their capital was adequate for them to function during this period.


Step 1: Loss Projections. BHCs were asked to project losses for 2009 and 2010 for 12 separate categories of loans held in the accrual book, for loans and securities held in the available-for-sale (AFS) and held-to-maturity (HTM) portfolios, and in some cases for positions held in the trading account.  The losses were to be consistent with the economic outlooks in the baseline and more adverse scenarios.  The BHCs were instructed to estimate forward-looking, undiscounted credit losses, that is, losses due to failure to pay obligations (“cash flow losses”) rather than discounts related to mark‐to‐market values.  The required assessments were broadly classified as:

  • First and Second Lien Mortgages: institutions provided detailed descriptions of their residential mortgage portfolio risk characteristics – type of product, loan-to-value (LTV) ratio, FICO score, geography, level of documentation, year of origination, etc.
  • Credit Cards and Other Consumer Loans (e.g., auto, personal, student): portfolio information included FICO scores, payment rates, utilization rates, and geographic concentrations.
  • Commercial and Industrial Loans: based on the distribution of exposures by industry
  • Commercial Real Estate Loans: included loans for construction and land development, multi-family property, and non-farm non-residential projects.  Information such as property type, loan-to-value ratios, debt service coverage ratios, geography, and loan maturities was provided.
  • Other Loans: farmland lending, loans to depository institutions, loans to governments, etc.
  • Securities in AFS and HTM Portfolios: majority are public-sector securities such as Treasury securities, government agency securities, sovereign debt, and high-grade municipal securities. Private-sector securities include corporate bonds, equities, asset-backed securities, commercial mortgage-backed securities (CMBS), and non-agency residential mortgage-backed securities (RMBS).  Supervisors focused on evaluating the private-sector securities.  Loss estimates were based on an examination of 100,000 of these securities.  Loss estimate, and subsequent “write-down” to fair value, for each security was determined based on credit loss rates on the underlying assets, consistent with loss rates for unsecuritized loans listed above.
  • Trading Portfolio Losses: estimated by applying market stress factors to the firm’s trading portfolio based on actual market movements that occurred between June 30 and December 31, 2008.
  • Counterparty Credit Risk: the risk that an organization is unable to pay out on a credit-related contract when it is supposed to, which directly impacts a firm’s earnings and the value of its assets.  The action taken by the firm to account for this risk is referred to as credit valuation adjustment (CVA).  Supervisors focused specifically on a firm’s loss estimates for mark-to-market losses stemming from CVA associated with market shocks applied to assets in trading books.

Step 2: Resources to Absorb Losses. Institutions were also instructed to provide projections of resources available to absorb losses under the two economic scenarios.  These include the pre-provision net revenue (PPNR) and the allowance for loan losses over the two-year horizon.

  • PPNR is the income after non-credit-related expenses that would flow into the firms before they take provisions or other write-downs or losses.
  • BHCs supposedly had some allowance for loan and lease losses at the end of 2008.  They were required to estimate what portion of this allowance would be required to absorb potential future credit losses on their loan portfolio under each economic scenario.  This calculation could either result in depletion of the year-end 2008 reserves (if there is adequate allowance) or indicate the need for building the reserves (if the allowance is inadequate).

Step 3: Determination of Necessary Capital Buffer. Supervisors examined two main elements as indicators of capital adequacy – pro forma equity capital and Tier 1 capital.

  • Pro forma equity capital was estimated by rolling tax-adjusted net income (PPNR minus credit losses minus reserve builds) for the two-year horizon through equity capital.
  • Tier 1 capital is composed of common and non-common equity, with the dominant component being common stockholder’s equity.

The initial assessment of the capital adequacy, or lack thereof, was conveyed to the BHCs in late April and is expected to be released to the public on May 4th, 2009.  As yet it is uncertain whether the publicized results will reveal much about the banks.

Filed under: Business, Economy, Government, , , , ,

Understanding the PPIP

davidellis-flow1-07sOn March 23, 2009, the Treasury Department released details of the Public-Private Investment Program (PPIP), which is one of the programs under the TARP aimed at restoring financial stability.

The details of the program were complicated enough to elicit a standalone post.

The Problem. According to the Treasury, one of the problems plaguing the financial system is that of legacy assets – real estate loans held directly by the banks (“legacy loans”) and securities, or tradable financial instruments, backed by loan portfolios (“legacy securities”).  The true value of these assets has been brought to question. As a result, there is uncertainty surrounding the balance sheets of the institutions holding these assets.  Markets don’t like uncertainty as is evident from their performance, especially that of bank stocks, over the last 12 months.

Proposed Solution. The program’s intent is to repair the balance sheets of these institutions by moving the legacy assets off the hands of banking institutions and into the hands of investors.  Cleaner balance sheets could make it easier for banks to raise capital and increase their willingness to lend.

Principles of the Proposal. Treasury will use $75 – $100 billion in TARP money to become co-investors with the private sector, with backing provided by the FDIC and the Federal Reserve.  The “investment partnership” will, thus, be able to purchase $500 billion to $1 trillion of toxic mortgage assets (both residential and commercial) from banking institutions that currently carry them.

There are two separate approaches, one for legacy loans and the other for legacy securities.  Initially, Treasury will share its $75 – $100 billion equity stake equally between the two programs with the option of shifting the allocation towards the option with the greater promise of success with market participants.

  1. Legacy Loans Program: Suppose a bank has a pool of mortgages with $100 face value that it wants off its hands.  It approaches the FDIC, which determines whether it wants to leverage the pool at a 6-to1 debt-to-equity ratio.  If it decides to go ahead, the pool is auctioned by the FDIC.  Several private sector investors are hoped will bid.  The private sector bidder with the highest bid would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.  Let’s say the highest bid is $84.  Of this purchase price, the FDIC would guarantee $6 of every $7 in investment, or in this example, $72.  This is debt financing.  The remaining $12 is equity financing, which is shared equally by the private investor ($6) and the Treasury ($6).  The private investor would then manage the servicing of the pool of purchased assets.  The private investor and the Treasury would each be able to purchase $14 worth of assets for every $1 of their own money (14-to-1 leverage).
  2. Legacy Securities Program: Treasury will approve up to five fund managers for this program.  A fund manager, for example, submits a proposal and is pre-qualified to raise private capital.  The Treasury plans on being a joint-venture partner.  Let’s say a fund manager is able to raise $100 of private capital for the fund.  The Treasury will co-invest $100 in equity financing along side the private investor and will provide an additional loan of $100 (debt financing) to the “partnership” fund.  Additional requests for loans up to $100 will also be considered by the Treasury.  As a result, the fund manager has $300 – $400 in total capital for purchase of securities.  The fund manager has full discretion in investment decisions.  This program will be incorporated into the previously announced Term Asset-Backed Securities Loan Facility (TALF) whose original goal was to provide debt financing (non-recourse loans) to buyers of newly created consumer and small business loans.

The PPIP program has thus far met with lukewarm reception from the private sector, which is noteworthy given the necessity of their participation.  On a conference call to analysts and investors last Thursday, Jamie Dimon, the CEO of JP Morgan and, currently, the go-to guy for the US government on financial mergers/takeovers, said that they will not take part in the PPIP.  “We’re certainly not going to borrow from the federal government because we’ve learned our lesson about that,” said the Chief Executive.  Wells Fargo and US Bancorp are noncommittal.

It remains to be seen whether the Public-Private Investment Program will succeed in getting credit flowing again or further reveal corporate fear of business decisions driven a government that’s looking solely in the rearview mirror.

Filed under: Business, Economy, Government, , , ,

So you’re saying, “There’s a chance.”

zebraOne of the many funny scenes in the movie, “Dumb and Dumber” involves an exchange between Lloyd (Jim Carrey) and Mary (Lauren Holly).  Lloyd is wondering about the probability of a future with Mary:

Lloyd: What are my chances?

Mary: Not good.

Lloyd: You mean, “Not good” like one out of a hundred?

Mary: I’d say, more like one out of a million.

Lloyd: So you’re telling me there’s a chance.  Yeah!

The reaction of investors on March 18th seemed similar to that of Lloyd’s as they digested the statement by Ken Lewis, the CEO of Bank of America.  He stated that his company could pay back the $45 billion it received from the Troubled Assets Relief Program (TARP) by the end of 2009 or early 2010.  The price of the stock shot up 22% that day.

This got me thinking about “rhetoric” and the perception it creates in the minds of the audience.  Notice the use of the phrase, “could pay back.”  The intended effect here was that of using the phrase, “will pay back” without the negative legal and psychological ramifications of actually making such a definitive statement.

The reaction that such a statement generated in the stock price of Bank of America is what elicited this post.  Executives of corporations and politicians see it as their job to put as positive a spin on an issue as possible while staying within the legal bounds.  Corporate and political public relations (PR) departments are in the business of using the imagination of the audience and causing them to project what is possible as something that is probable or even highly probable.

What does this mean?  There is a distinction between possibility and probability.  Simply put, that which is possible may not be probable, while that which is probable has to be possible.  In other words, the likelihood of an outcome increases when you move it from the realm of the possible to that of the probable.

What does this have to do with rhetoric?  The intent of rhetoric in the world of business and politics is two fold:

  1. To get people to perceive that which is merely possible as actually being probable
  2. To minimize or eliminate liability from the statements that are made

Let’s take a look at a couple of examples, one from the corporate world and the other from politics:

Corporate.  Ken Lewis, the CEO of Bank of America says that the company could pay back $45 billion by the end of 2009.  This is actually within the realm of possibility.  But things that are merely within this realm do not provide enough actionable information for an investor.  I cannot make an investment decision based solely on this information because the company could just as well not pay back the money.  However, if the executive can make me think that this is highly probable, then I have something to build an investment thesis on.  It would go something like this…

The company pays back the TARP money.  They are excluded from discussions about banks that are going to be nationalized.  Management is, therefore, free to run the company in a manner that’s in the best interest of the shareholder as opposed to the government.  Bonuses for highly talented people are dictated by the company’s compensation committee, not the government.  This becomes a tool for poaching talent from other nationalized or semi-nationalized banks.  The company, as a result, is able to run a business that is more efficient than their nationalized counterparts.  As an investor, this would make the company a candidate for my investment dollars.  Therefore the spring-loaded effect on Bank of America’s stock price on March 18th.

If this does not pan out and the company is unable to pay back the money, they minimize their liability by saying that they never made a definitive statement to that effect.  It was only a possibility.  The company has succeeded in capturing current upside and minimizing future downside.

Politics.  Here is a case with similar intentions but contrasting results to the corporate example.  I remember even when the recession was underway, President George W. Bush and Senator John McCain were sounding like a broken record emphasizing that the fundamentals of the economy were strong.  Their intention was to keep the country, as a whole ,from going into panic mode.  It is possible that the country would not go into a deep recession, but probability showed otherwise.  They were trying to get the American people to project what was possible as that being highly probable.  If called to account, they would try to minimize liability by saying that the “fundamentals of the economy” actually referred to something like the integrity, optimism, entrepreneurial spirit, and work ethic of the American people.  However, as the popular saying goes, “The road to hell is paved with good intentions.”  The administration and Senator’s intentions were instead seen as ignorance, arrogance, and subterfuge and contributed significantly to the results of the subsequent elections.

Here are the lessons for consumers/citizens/investors:

  • Realize that it is the job of corporate executives and politicians to present any situation in a positive light.
  • It is not your job to receive it at face value.
  • The explicit statements may not contain much actionable material.
  • The interesting material is implicit as is the case with the work of art shown above by Victor Vasarely, considered by many to be the father of Optical Art (Op-Art).
  • Learn to read between the lines and be diligent about it.
  • Ask yourself questions like, “What is the real information here?” and “What is intended merely as a projection?”

“One in a million” could mean that you have a chance or very little chance.  Which one, as a consumer or investor, are you going to pick as being actionable?

Filed under: Business, Politics, Psychology, , , , ,

Use leverage to transform health care in the US

ailing_healthcare_by_frantzwahWe all understand to some extent that our health care system is in dire need of reform.  Do we know what its condition really is?  Allow me to paint a picture.

What is the current and projected state of health care in the US?

National Health Expenditure (NHE) is defined as the total health care spending in the United States.  According to Centers for Medicare & Medicaid Services (CMMS), which quantifies health spending on an annual basis, the NHE grew 6.1% to $2.2 trillion in 2007, or $7,421 per person.  In comparison, this cost was $75 billion or $356 per person in 1970.  Health care spending currently accounts for 16% of our Gross Domestic Product (GDP) and is projected to grow by an average of 6.2% per year between 2008 and 2018.  At that rate the NHE will have reached $4.5 trillion in ten years and account for 20% of our GDP.  Healthcare spending has exceeded overall economic growth (GDP) annually by an average of 2.5 percentage points since 1970.

80% of health care spending goes to hospital care (37%), physician and other professional services (29%), and drugs (14%).  Many doctors complain that the system is now turned on its head where more and more of each healthcare dollar goes to cover administrative costs associated with the first two categories than to pay professional fees.  The facilitator of the doctor-patient relationship has become the principal entity.  Meanwhile, the doctor-patient relationship is now there to support the facilitator.

Private health insurance and out-of-pocket payments accounted for the largest part of health spending (55%) in 2007.  Public programs like Medicare, Medicaid, etc., comprised 45% of NHE.  While worker’s earnings and overall inflation has increased ~30% since 1999, health insurance premiums have grown 119% during the same period.  This usually means that workers have to spend more of their income each year on health care to maintain coverage.  These effects may either be direct – through increased worker contributions for premiums or reduced benefits, or indirect – such as when employers forgo wage increases to offset increases in premiums.  I gather you’ll agree with me that neither of these options is ideal.

Due to the influence of the recession and the leading edge of the Baby Boom generation becoming eligible for Medicare, average annual spending growth by public payers is expected to outpace that of private payers.  As a result, CMMS projects that public programs will overtake private insurance and reach 51% of NHE by 2018.  Not only will it be necessary for us to allocate greater portions of our income to employer-covered insurance premiums and Medicare, there is no guarantee that it will be sufficient to bear the imminent burden on our health care system.

How can this problem be addressed?

Victor Fuchs, Professor of Economics and of Health Research and Policy at Stanford University, proposes tackling health care reform around four essential principles: coverage for the uninsured, cost control, coordinated care, and choice1.  According to him, any reform which does not cover these essentials is doomed to fail.  In addition, any reform plan that is not controversial is certain to be inconsequential.

Dr. Benjamin Carson has one such controversial and ambitious plan.  Dr. Carson, who has served in a medical advisory role for both President Clinton and President Bush, suggests the idea of a medical endowment where ten percent of the cost of health care be set aside annually in an endowment fund2.  The interest from the endowment would be used initially to cover health care expenses for the uninsured and underinsured, the first C of Prof. Fuchs principles.  He envisions growing the fund to such a size in 15-20 years that it can cover most of the country.  He has initiated a pilot program at Johns Hopkins Medicine.  The fund, called the Benevolent Endowment Network fund, will be started off in pediatric neurosurgery, expanded to all of neurosurgery with the hope of eventually covering the entire hospital.

On the corporate side, Wal-Mart is slowly positioning itself to be a force in health care through a controversial plan for tackling the second C – cost control.  I call it controversial because Wal-Mart tends to elicit a visceral reaction from many people, who view the company as “pure evil.”  I merely present the company as one of the potential forces necessary for true health care reform to be accomplished.  In September 2006, the company introduced $4 30-day prescription pricing for 291 generics in the Tampa Bay, FL area, which was available to the uninsured.  It has since expanded the program to 49 states covering 350 generics and 1000 over-the-counter medications.  Pricing now includes an option for a 90-day prescription for $10.  Several pharmacy chains, including Target and K-Mart, were forced to follow suit.  Anecdotal evidence from my pharmacist friends, who work for other chains, suggests anger at this move.  Meanwhile, many consumers applauded the move.

The company is now looking to shake up Pharmacy Benefits Management (PBM).  It announced a pilot with Caterpillar to provide 2500 prescription drugs to 70,000 of its employees, spouses, and retirees.  If successful, it is sure to try expanding the deal with other employers.  This, in turn, could help employers cut their costs related to prescription drug coverage.

The third leg in Wal-Mart’s stool is electronic medical records (EMR).  According to an article in the New York Times, Wal-Mart has decided to team its Sam’s Club division with Dell and eClinicalWorks to market hardware, software, installation,maintenance, and training to physicians’ offices.  They will be mainly targeting small physician groups where 75% of the nation’s physicians practice.  Another initiative in the works for Wal-Mart is telemedicine in collaboration with NuPhysicia, LLC.

Michael Porter, University Professor at Harvard Business School and Director of the Institute for Strategy and Competitiveness, has a plan for tackling the third and fourth C’s – coordinated care and choice.  He proposes a value-based health care delivery system where players strive to create value for patients rather than capturing more revenue, shifting costs, and restricting services.  The centerpiece of this strategy involves bundled reimbursement for an entire care cycle instead of individual services like doctor visits, MRI scan, radiologist consultation, biopsies, etc.  He provides examples of institutions such as The Cleveland Clinic and MD Anderson Cancer Center where disease-based integrated practice is bearing fruit.

Despite the various forces working to address the four C’s, one important issue that I see missing is that of preventive medicine.  I proffer this as the most important piece for the long term viability of any health care reform that’s implemented.  Most reform ideas center around the reduction of current health care burden which are all remedial in nature.  In fact, our entire nation’s health care focus seems to be on treating the disease.  Even the preventive measures mainly target regular screenings.  The assumption here is that some type of disease is inevitable; so let’s try to nip it in the bud through screenings.  What about the notion that many diseases may be prevented if we actively engage in a lifestyle that’s healthier this year than it was the last?  A friend of mine (hat tip CJC) made a statement recently which I believe to be true:

No health care reform or plan in the world can bear the burden of overweight and obesity and the complications that arise from it.”

According to the National Institutes of Health, two-thirds of us are overweight and one-third are obese.  Overweight and obesity are known risk factors for several diseases.  Certain diseases can trigger other complications and multiply the cost associated with treating them all.  For example, people with diabetes spent $190 billion for health care in 2004, nearly seven times the $28 billion they spent specifically to treat diabetes.  A sizeable portion of the total spending for these people went to the treatment of conditions that are common complications of diabetes3.  So leverage, in this case, works against us and multiplies the burden on the health care system.

However, leverage may be employed to our advantage, as well.  What if we take personal responsibility for our long term health through healthier eating and more physical activity?  We may be able to reduce conditions of overweight, and obesity and diseases like diabetes, heart attack, stroke and other related disorders.  As a result, we will find ourselves making fewer doctor visits outside our regular check-ups.  Fewer complimentary services are ordered by our primary physician.  All of this reduces the burden on our health care system.  Health care providers can, in turn, focus on patients with diseases that are out of their control and provide better value.  Meanwhile, consumers may be willing to apply some of the savings from their reduced insurance premiums to cover the uninsured and underinsured.  The four C’s have a better chance of success in providing coverage for all of us because less strain is put on by each of us.  And the best part: this leverage monetarily costs us next to nothing.

All it requires is one question and small steps to answer it: How can I live healthier this year than I did last year?


1 Health Reform: Getting the Essentials Right by Victor R. Fuchs

2 The vision of the Benevolent Endowment Network fund by Dr. Ben Carson

3 Roehrig C., et al. National Health Spending by Medical Condition, 1995-2005.  Health Affairs.  Volume 28, Number 2 (2009): pp 358-367.

Filed under: Business, Economy, Government, Health, , , , , , , , , ,

As the pendulum swings…

the_pendulumThrough my experience as an investor, I’ve learned to look at the market as a collective expression of fear or greed. Webster’s dictionary defines greed as a selfish and excessive desire for more of something than is needed.  Fear, on the other hand, is an unpleasant often strong emotion caused by anticipation or awareness of danger.

The market tends to swing between these extremes in reaction to various factors.  What’s peculiar to me is the timing of these emotions.  We are most fearful when we should be aggressive and most greedy when we should be cautious.  I use the words “aggressive” and “cautious” purposefully because I don’t think we should ever be making decisions based on fear or greed.

Part of the reason for collective emotion is due to the human tendency for groupthink.  Groupthink is an exhibition of consensus without critical thought or analysis.  It requires minimal effort, is not caustic, and appeals to our desire for a comfortable buffer.  If an idea fails, at least we’re not the only ones failing.  There is a certain level of comfort in failing or being mediocre as a group.  Unfortunately a successful idea under groupthink does not bear a lot of fruit because the participants, by design, are too late to the game.

Independent thought, on the other hand, requires maximal effort.  You find yourself having to do most of the research and analysis, and drawing your own conclusions.  These ideas differ from the “group;” so criticism is inevitable, which over time, can wear emotions down.  Besides, there is always the danger of failing miserably with no one to fall along with you. Once we take these factors into account it’s no surprise that many of us unintentionally pursue the path of least resistance.

The emotional pendulum had swung to the side of greed during the historic housing boom:

  • as home values appreciated, the idea of quick and large profits gained momentum
  • our wrongful association of material wealth with happiness found new life
  • homes inappropriately became ATM’s due to easy access to home equity loans
  • financiers saw an opportunity to take advantage of groupthink participants to juice up their bottom lines
  • as our perceived “ATM’s” got bigger, we allowed ourselves to suspend the simple, yet profound, notion of spending less than we earn

Kyle Bass serves as an example of a person who resisted groupthink during the greed phase.  Mr. Bass runs a hedge fund out of Dallas, Texas.  In 2005 he started doing his own research into the mortgage-related securities that were being packaged by Wall Street and sold worldwide.  He asked the tough questions.  According to him, Wall Street was putting lipstick on a pig and selling it to people who did not understand what they were buying.  The lynchpin to the groupthink assumption was that home values would never come down.  Bass came to the conclusion that the trend was unsustainable and the unraveling would be vicious.  He and his partners predicted early on that the amount of troubled loans would hit $1 trillion.  He even shared his concerns with risk managers on Wall Street.  No one wanted to listen.  He then made the tough decision of putting a substantial portion of his own capital and that of his investors behind his conclusions even as the herd was thundering the other way.  His fund reported a return of 400 percent in 2007.

The pendulum now finds itself swinging to the other extreme — that of fear:

  • people are pulling out of the stock market after seeing half the value of their portfolios vanish into thin air
  • those nearing retirement are worried that they will have to work much longer to make up for the lost value in their retirement accounts
  • the housing-led recession is fully afoot
  • those who have lost jobs are wondering if they’ll find one soon
  • those who still have their jobs are fearful of losing it any day
  • the decline in home values hasn’t abated yet (remember the lynchpin?)
  • the foundations of many banks are crumbling leaving people wondering if their money will be safe
  • ……….

Fear seems to control our decisions these days.  Unfortunately, the economy will not see an improvement until this emotion subsides.  One thing I know for sure…this too shall pass.  As Solomon, the wise man, once said, “To every thing there is a season, and a time to every purpose under the heaven.”   There are enormous opportunities for people who recognize this, resist groupthink, make tough decisions, and take some risks.  As sure as Kyle Bass earned his profits working against the market’s greed, there will be those who reap great rewards working against the market’s fear.  Sadly, most of us will only hear about it after the fact.

Filed under: Business, Economy, Psychology, , , ,

Mr. Softy’s becoming a retailer?

apple_store_smallMicrosoft is pursuing its ambitions in retail by planning store operations of its own.  It has hired David Porter to spearhead its efforts.  Mr. Porter was most recently the head of worldwide distribution for DreamWorks Animation SKG.  He also brings 25 years of experience from Wal-Mart.

Critics are already shoveling dirt over the perceived grave of said effort.  I’m withholding  judgment till I see it played out.  Their reasoning behind such a push is really what piques my interest.  As you may recall, Microsoft had once ventured down this path in 1999 through a large store in the Metreon center in San Francisco.  The doors were quietly shuttered within two years.

Fast forward ten years and we have another effort by Microsoft to operate its own stores.  Why does a company that has 90+% of the worldwide PC market need to enter into the brick-and-mortar retailing business?  How much more can it gain through sales at these stores?

I think discussions around marketshare miss the point.  The real issue is consumer mindshare.  Although Microsoft has tried to expand into areas such as search, gaming, music, mapping, etc., its cash cow still remains the operating system and Office suite of applications.  The latest incarnation of its operating system, Vista, has not received the acceptance that Microsoft had hoped.  When it comes to innovation, companies like Apple and Google are capturing consumers’ attention.  Microsoft, although ubiquitous, finds itself falling off consumers’ radar.

Here are a couple of charts to illustrate my point:

The first chart was produced using Google Trends.  aaplvmsft_search_volumeYou can use their tool to compare the frequency of occurrence of your term/s relative to the total number of Google searches.  The results are expressed as “Sales Volume Index” which is the volume of your search term relative to total search volume.  Although these results would not pass the test of scientific rigor, they do provide interesting insight.

I compared the terms “Apple” and “Microsoft.”  The green line represents Microsoft while the orange line represents Apple.  The chart shows results of  searches conducted worldwide over the past five years.  Of interest here is the steady loss of mindshare, expressed through search, that Microsoft has suffered relative to Apple.

Now take a look at the second chart which compares the relative market cap of the two companies.  aaplvmsft_mkt_capThe numbers are normalized to Apple’s market cap in January 2004 of $8.4 billion.  Microsoft’s market cap in 2004 was 36x that of Apple’s.  You’ll notice that the general trend since then has been similar to that of the Sales Volume Index.  While Apple’s market cap has increased 1000% in the past five years, Microsoft’s relative market cap has seen a 50% decline.  One of the reasons for the decline is the steady erosion of Microsoft’s traction with the consumer.

With the next version of its operating system, Windows 7, Microsoft wants, and needs, to prove to the consumer that they can have a better experience with its products than they do with Apple or Google.  Maybe getting them into a  vertically integrated store is the solution.  Microsoft would control all aspects of the store and the experience.

Whether successful or not, Microsoft feels that it needs to try because consumer confidence, once lost, is enormously difficult to regain.  Just ask the Big Three auto makers.

Filed under: Business, Technology, , ,