Business Skeptic

The subprime crisis is becoming a field day for our society’s addiction to the blame game. I am not going to heap additional fodder into the cannon of public opinion. While questionable acts and motives abound in this situation, they did not cause the crisis but are an artifact of the real reason behind the collapse. The chilling fact is, the crisis would have occurred regardless, because it was engineered to fail from the very beginning.

A free market, whether mortgage backed securities, structured investment vehicles or coffee, is a dynamic system that is stabilized by feedback. A free market is defined by feedback. The process of negotiating a price, the force pushing a market or transaction to equilibrium is feedback. It was the structural lack of systematic feedback which caused the crash.

There are three essential characteristics for feedback to effectively stabilize a system. These are:

Relevant Information: The feedback signal must be directly related to the feed forward momentum of the system.

Timeliness: There must be a minimum of delay between the information feedback and forward signal. Too much delay causes the system to become unstable and it becomes increasing out of sync with the controlling information.

Amplitude: The strength of the information. Basically is the feedback signal strength strong enough to be heard over the noise and strong enough to effect the system process.

Structured investment vehicles, for which I am including subprime mortgage backed portfolios, where constructed in a manner which precluded effective feedback. In a structured investment vehicle, the base transaction (the feed forward signal) was dissected into multiple components. Repayment risk was decouple from credit risk, which was decoupled from interest rate risk, which was also decoupled from base asset value risk. Now under the mathematical laws of associative commutation, the whole is just the sum of the parts, and hence nothing related to the underlying base transaction is affected by this dissection.

The first notice of caution should have arisen at this point. Specifically, the reason for the dissection was that the parts could be sold for more than the whole (this is due to different risk / return profiles of the different buyers of the parts). One should ask at this point, whether there is a financial equivalent to the Second Law of Thermodynamics, the conservation of energy. Ask yourself a simple philosophic question. I take a pie and if I cut the pieces just the right way, I end up with more pie. Don’t think so, but this is a philosophic argument. The actual math of valuing structured investment vehicles does work and I don’t want to get into that here. It is the system dynamics regarding feedback which are broken.

What essentially happened is that by dissecting the base transaction, we decoupled the parts from the information flow about the whole. Information about the underlying asset could not be so precisely partitioned. Hence, each part had a market but it did not have relevant information feedback, because the information market was not and could not be partitioned and parsed along the same mathematical rule of the SIV.

In addition to the lack of relevant feedback, the partitioning of the base asset resulted in large time delays in information flow between that which effected the base asset and its parts. Part of this was due to the loss of information relevancy, context and fidelity and also because of the long and many hands that the parts had passed through. Image you are at an open air market negotiating for a hand woven rug. Each time you counter offer, your offer is broken in different pieces of information and each piece of information has to go to another city for an answer. Your counter price goes to a city 10 miles away, your delivery desires yet to another city and the warranty yet a third. Not only is this highly inefficient, the lack of relevancy and context of each information piece is likely to cause valuation problems.

The last aspect of broken feedback is amplitude. The strength of the feedback signal declines both because the signal is divided into parts and secondly because it begins to dissipate and lose its strength as it travels the long distances to the owners of the various parts.

The subprime and other Structured Investment Vehicles were designed to fail because they were engineered in a manner that seriously compromised the necessary feedback that systems rely on to be stable.

The amount of correction is a function of the three broken variables. As the time delay gets longer, the amount that the part values can diverge from the base asset’s value grows exponentially. As the relevancy of the information declines, the feedback declines in inverse proportion of the loss of relevancy. Lastly the reduction in amplitude, due to signal loss, reduces the feedback by the gain factor of the system which is proportional to the risk adjusted (almost a oxymoron in this context) compounded rate of return over the maturity of the base asset. Stated in somewhat mathematical terms, a structured investment vehicle such as subprime mortgage backed securities can diverge from its correct or feedback stabilized value by the following equation:

dV = 1/ a RIR * (TD)**et*(1/(A)**eM)

Where:

dV = diverged value of parts compared to base asset.

a = proportionality constant

RI = Relevant Information Ratio (Less than one)

TD = Time delay. This is a multiple of market trading speed.

t = time between initial investment and calculation.

AL = Amplitude. This is always less than one because of signal dissipation.

M = time to maturity.

In a perfectly free market with transparent information and almost instantaneous transactions, the calculated dV (divergence value) is unity. Or the sum of the parts equals the whole. In feedback compromised systems, there can be considerable value divergence. However, like quantum mechanics, this probabilistic divergent value function must eventually collapse to unity at either maturity or upon inspection. Hence the “created” value must collapse to zero. Welcome to the now.

A second principal for effective and successful capitalism is the need for an educated consumer. Adam Smith’s capitalism assumes that consumers will act in a rational manner and attempt to maximize individual utility. Rational buying behavior requires an educated consumer, knowledgeable with regards to the domain and specifics of the transaction.

Unfortunately the practice of “educating” the consumer is more notable in its breech than its practice. The sub prime mortgage market is great example. The consumers lured into purchasing homes they could not afford were certainly not educated by the mortgage bankers. People need to attend school and pass exams to earn the right to drive an automobile, but no competency is required to go into debt for hundreds of thousands and risk one’s economic future. Capitalism cannot nor should it protect people from their own stupidity, but neither should it take advantage of it. An uneducated consumer should be helped and educated, not seen as a target market and exploited.

This goes back to the founding principal of Adam Smith’s “Wealth of Nations”. Capitalism must be build upon a solid foundation of cultural morality. Many notorious rip-off’s have hidden behind the defense of “the free market”. But think about it. Like selling mortgages to people who could not afford them, should be we marketing pharmaceuticals or health savings accounts directly to consumers that have no medical training. Watch advertisements and see if the seller is trying to educate you or overtly keep you from being “rational”.

The freedom to decide is a strength and virtue of our society and economy. However, along with such freedom comes responsibility. Do the right thing.

I am perennially concerned when management list’s growth as both a corporate objective and strategy and certainly there is tremendous pressure from Wall Street to show growth. However management must be cautious because growth is a metric, an indicator of the effectiveness of a strategy, not an objective. The important task is to define and manage a strategy which achieves the market and business objectives related to the unique strengths, assets and value proposition of the firm. If you focus and effectively manage strategy, then the growth metric achieved. In this context, growth is an indicator of the effectiveness of both the strategy and the execution of same. If the growth is below expectation, management must the analyze and contemplate 4 things:

1. The growth metric.. Is the growth metric consistent with a well executed strategy? Or are we trying to achieve something which the strategy cannot support.

2. Is the strategy sound.

3. Execution. Assuming the strategy is sound, are we executing effectively.

4. Time frame. Are we measuring on a time scale inconsistent with the effective execution of a sound strategy. Effective execution of a sound strategy might take longer than the measurement period.

The trap that many companies fall into is attempting to manage growth directly rather than using it as a metric and guidance. If growth rates are below expectation, immediate action is taken to achieve that growth, which might be both at odds with and disastrous to executive strategy execution. Specifically, compromises and inefficiencies are made to manipulate the metric rather than to address either the ineffectiveness or the mismatch between the metric and the strategy.

While these maneuverings may achieve the metric in the short run , because they ineffectively apply or divert resources and de-focus management from the primary mission, that of strategy development and execution, the growth even if obtained will not be sustainable. More importantly, focusing on the metric rather than understanding what the metric is telling you about your strategy and execution, will permanently weaken the firm and the market opportunity will be ceded to the competitor that stays focused on strategy and execution.

Many executives believe that growth is the elixir of success. That growth will protect them and their companies. Growth, used inappropriately, as an objective rather than a metric, can result in the opposite.

Growth is not an antibiotic it can be anaesthetic.

I am concerned that too many companies and executives take a mechanical view of capitalism. Just because something is legal, it sells and is profitable, does make it ethical, right or moral. It is instructive to go back and reread the original doctrine of Adam Smith.

Adam Smith was a philosopher and not an economist as most people believe. A major prerequisite for the success of his economic philosophy; “the invisible hand”, was that capitalism must be built upon a strong foundation of cultural morality. The engine that keeps capitalism vital and productive, is integrity and ethics, which form the framework and scaffold by which investment and resource allocations are made.

In many ways, Adam Smith’s capitalism contained a strong flavor of market paternalism.

Today’s capitalism often appears to be based on the philosophy, that as long as it not explicitly illegal, then anything goes and let the market decide. These shadow capitalists even use the US Constitution in defense. “Freedom of Speech” etc. Bust ask yourself, Does the economy really need sex and violence on television? Violent and disgusting movie trailers during prime time family viewing? In a country with an epidemic of childhood obesity, do we really need to be pushing nutrition free, sugary breakfast “foods” directly to children? How about marketing pharmaceuticals directly to consumers that have no medical education? What about companies that market totally ineffective nutriceuticals and homeopathic remedies? The economy is filled with products and services that are ineffective and destructive, but profitable.

It’s not just the sellers of goods that should take a moment and reflect. Media companies, talk show hosts and even news reporters tout “stories” that help to market products that are wasteful, fallacious and in fact down right dangerous. This is not capitalism, but exploitism. Capitalism is the engine of productivity and productivity is the only way in which a society, economy and an individual attains greater wealth. By allowing and encouraging consumers to spend resources on ineffective and destructive products and time wasting endeavors, the entire economy suffers. I am not advocating legislation, governmental control on any other “anti-free market” intervention. I am simply asking for business leaders to simply be leaders and stand up and defend true capitalism.

The business press is awash in books on leadership. One of the most important aspects of leadership is doing the right thing when under pressure to make the numbers, and focus on the wealth of the shareholders. Business leaders should constantly be asking themselves; “does this product or service really benefit the consumer and society”, not simply, “will it increase earns per share”.

Just because something is legal does not mean it is right. Just because you can sell something, does not mean the world will be a better place because you produce it. Have some backbone and lead. Say, “I could, but it’s not right, therefore, I won’t”!

My favorite quote and a personal guiding thought is: “Manners are more important than Law”.

Respect the consumer, the economy and the core tenet of capitalism. Do what is right.

I recently received an email regarding the article on Solution Selling, asking me to comment on Customer Centric Selling. First, Customer Centric Selling is just the most recent and renamed version of Solution Selling, so there’s not a lot to talk about. Solution Selling was coined by Michael Bosworth in his book of the same name. He later sold his stake in the Solution Selling company he founded and subsequently repackaged “Solution Selling” into “Customer Centric Selling” (now CCS because I am tired of typing the entire thing). While I lambasted the lack of definition for Solution Selling in a previous article, CCS as a name at least contains some semantic logic. If you consider the 3 words, and acknowledge there are just two parties to a sales transaction, the seller and the buyer,;then CCS merely means that in selling you should focus on the buyer. No great revelation there. I guess the reason we need to be reminded of this is because “sales people” are too self centered and egotistical to focus on the customer. Wise advice and such reminders are always welcome and helpful, although they shouldn’t be necessary.

Other than reminding sales people to focus on the customer, CCS is just the newest revision of Solution Selling. It contains some minor refinements and additional tips, but nothing truly new. I find the book CCS incomplete regarding managing the entire sales process. The book lacks useful information on prospecting, which is the most important aspect of sales. The most successful sales people are great prospectors.

CCS assumes that “asking questions” is prospecting. While asking questions is very important and powerful in determining a buyer’s needs, pains and goals; you just can’t start pummelling an executive with questions. It’s disrespectful. You first need to present a clear and concise value proposition that is meaningful to the executiive and addresses something urgent  on the executive’s radar screen. If you do not have a compelling value proposition for the target executive that can make a substantial positive impact on his P&L or Balance Sheet, or some other item on the radar screen, you will be delegated down.

The other weakness in CCS is the lack of meaningful help in lead and account qualification. Understand that a sales person basically sells their time. They cannot afford to waste time selling to people who aren’t going to buy. Solution selling is about selling a vision of a better future against the current state of the present. The future is unknown and risky, but there is always tomorrow to make a decision. The present is known, and they know how to deal with it. Unless something really bad is going to happen if they don’t consumate the sale, then the sale is unlikely to close anytime soon. One of my favorite qualifying questions is “What will happen if you don’t do this project”? If the answer isn’t something really bad, such as “I will get fired”, “I will go to jail” or something similarily catastrophic; the sale is likely to take a nauseatingly long to close, if ever.

Also, don’t fall into the ROI trap.  ROI’s don’t sell. They are a gate to get through after the decision has been made. The ugly fact is that a company typically has 8 times more investments opportunities with acceptable ROI’s then they are capable of or desire to implement. It is not for a lack of capital, but organizational bandwidth, alignment with strategy or the executive just doesn’t care. Business investment doesn’t work like investment portfolio’s or MBA Corporate Finance. Addressing an urgent need and avoiding a painful consequence is more important than ROI.

Customer Centric and Solution Selling are power and important sales techniques. I personally use, manage and teach them. But because they are incomplete, I caution organizations adopting them to make sure they fill in the gaps regarding prospecting and qualifying.  To fill in the those gaps, I recommend “Value Forward Selling” by Paul DiModica. www.digitalhatch.com

Thank you for your comments and I look forward to your response.

One of the greatest attributes of marketing is the creation of words and phrases that sound great and instill a feeling of virtue and professionalism, yet are undefined and often meaningless. Solution Sales is one of my favorites. Ask a professional sales person to define a solution sale and he or she will define it either by exclusion, “it is not a commodity sale which is based on price”, or define it recursively, “it is when you are providing the complete solution” (obviously a solution is a solution; just as A=A) or by adjectives, qualitative or relativistic descriptions such as;
Complex
Network
Encompasses both product and services.
Difficult
Long sales cycle
Etc.
You see the problem! No one seems to be able to define a solution sale. For example, how complex does it need to be to qualify as a solution sale? It is interesting to note, that we have entire libraries of books and training classes on solution selling, yet can’t define it. This is not to say that those books and training classes are worthless, quite the contrary, as a sales management quack (oops, I mean consultant) I even teach this stuff. But it really bothers me that it is undefined…..Until now.

So here is the definition of a solution sale. “A solution sale is when the sales person has greater domain knowledge than the buyer.”

This has some profound implications. It implies the following:
1. Any sale can be a solution sale or a commodity sale based on the circumstances.
2. The type of sale, whether solution or commodity, is a sales tactic that can be determined by the sales person.

Ok you are probably scratching your head about all this. Let’s look at an example.

A 200 ohm ¼ watt resistor. Most people would say that this would be a commodity sale, since it is a commodity product. It is cheap, there are many suppliers and can be picked up off-the-shelf. Certainly to an electrical engineer designing a circuit, he knows exactly what is required. To him, it is a commodity sale, because he possess the greater domain knowledge, having designed the circuit. Now let’s consider someone holding a wire. They have a problem. Everytime they plug this wire into a device, it smokes and damages the device. They are not an electrical engineer, do not know about resistors, voltage and current. What do they need? A resistor! This is a solution sale, because the domain knowledge rests with the sales person. Ok this is a silly and possibly nonsensical example, at least to us engineers (yes I was an engineer), but it illustrates the point that the type of sale is not determined by the product or service but by the circumstances and the strategy of the sales person.

Consider a manufacturing automation sales person. He is selling automation to the engineering manager of manufacturer whose strategy is to be the lowested priced player in the market, runs on razor thin margins and whose business success depends on highspeed automated manufacturing. This conversation is likely to be very focused on specifications, features and price. Basically a commodity sale. Later this same sales person visits the manufacturing engineering manager of a pharmaceutical company that has product gross margins of 94% and whose business success depends on research and marketing. This conversation is likely to be completely different, with the sales person possessing more manufacturing automation domain knowledge than the customer. Hence a solution sale.

So a sale cannot be categorized as solution or commodity aprior. While the circumstances initially define the sale type, the sales person may elect to change the sale type in order to improve their selling position. To shift a commodity sale to a solution sale, the sales person needs to expand the scope of the conversation and deliverable to the point where they posses greater domain knowledge than the prospect. This is particularly effective when you are in a price competitive situation and cannot be the lowest priced player.

Conversely, if you are the lowest priced supplier, you might want to “commoditize” a solution sales situation if you are competitively weaker, by convincing the prospect to reduce the scope of the domain to the point where your competitor is no longer the domain expert.

OK, I hope I have convinced you that there is a definition for Solution Sales. Now throw it out the window. If a solution is the resolution to a problem, then any sale is a solution sale. Your tactics simply depend on how you and the prospect mutually agree to define the problem.