Harvard College Investment Magazine Summer 2006 by Harvard College Investment Magazine

Harvard College

Investment

Magazine

SUMMER 2006

In this Issue Managing Harvard’s Money: Mohamed El-Erian Independent Investing: Joe Moglia, CEO of TD Ameritrade Investment Hero: Meet Warren Buffett Inside Islamic Finance

PLUS • Women in Business • WALMART: Past, Present, and Future • Rep. Michael Oxley on Corporate Governance And More...

The World of Investing

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contents 29

Summer 2006

Managing Harvard’s Money

An Interview with Harvard Management Company’s New CEO, Mohammed El-Erian Widely respected as an expert on emerging markets, El-Erian brings an exciting new outlook to the Harvard Management Company. By Alex Bayers and Jennifer Ying Lan

4 6

8 17

The Burst of the Bubble

By Stanley Chiang

By Donna Ivry

Romanian Finance

Karan Bilimoria: The Entrepreneurial Einstein

By Michael Lapsa

Meeting Warren Buffett: America’s Investment Hero By George Giannukos

45 2

An Interview with Dr. Daniel Daianu, Former Romanian Finance Minister By Alexandru Manaila-Maximean and Kuanysh Y. Batyrbekov

By Devina Shah

GLOBAL OUTLOOK

Get Rich Quick

Investment Opportunities in Eastern Europe

U.S. Firms Look to India’s Property Market for Risky Get-Rich-Quick Schemes By Vivek Kuncham

Wider than ever, Slovakia, Czech Republic, Poland and Hungary open their doors to investors By Jan Zilinsky

A Leader in Corporate Governance

An Interview with Congressman Michael Oxley

Consolidation in the Telecom Industry: What is Happening and Why? By Petros Andreou

Women in Business Gauging the Possibilities

By Nancy Saunders and Bob Cohen

INSIDE THE PROFESSION

Interview with Joe Moglia, CEO of TD Ameritrade

By Sergali Adilbekov

Looking for a Career Upon Graduation

By Roxanne Bras

Who Really Invented the CAPM?

The Wal-Mart Story

Helping Independent-minded Investors

Partnership Portfolio

INSIDE SCOPE

features From Red Neck to Blue Chip

Letter from the Editors

Flying Embraer

Oil Prices: Why Have They Soared So High?

Brazilian plane manufacturer ﬁnds success in the American commerical plane market By Kedamai Fisseha

By Hagop Taminian

Shar’iah Finance Investment Inside the Islamic World Rika Christanto

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

INVESTING TODAY

The Lost Pension Generation

The Savings Rate Myth

By Drew Davis

By Mimi Yu

HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

harvard college investment magazine

Letter from the Editors

Dear Readers, Welcome to another issue of the Harvard College Investment Magazine! This past year has seen HCIM grow at an astronomical pace. Our staff which consists of four different boards: Editorial, Business & Strategy, Publishing, and Design, has grown exponentially. Starting out in the early days with a staff of 12, HCIM has now grown to encompass almost 70 full-time staff editors, managers, designers, and executives. Accompanying our inner growth has been the outward extension of HCIMʼs Investment Partnership Network to other universities in the U.S., the U.K., and China. HCIMʼs network currently contains 18 premier student nancial and investment related associations at prestigious universities like Yale, UC-Berkeley, Northwestern, Texas A&M, Cambridge, University College London, Oxford, Beijing University, and Fudan University, etc. We invite you to learn about four of our most prominent partners featured in our new section ʻThe Partners Portfolio.ʼ By establishing our network, HCIM hopes to connect like-minded students and investment associations across the world in order to increase the opportunity for student participation in ad hoc joint ventures which complement the resources, and goals of the participating partner members. This Summer 2006 issue of HCIM features several articles written by contributors from our various partner schools. Continuing our acclaimed interview series which has in the past featured such prominent CEOs such as Ken Grifn of Citadel Investment Group, Dean Wilde of DC Energy and Dean & Company, and Jeff Bezos of Amazon.com, we at HCIM are proud to add the CEO of TD Ameritrade Joe Moglia and the President and CEO of the Harvard Management Company Mohamed El-Erian to the list. In addition to Mr. Mogliaʼs and Mr. El-Erianʼs interviews, we hope you will also enjoy our feature interviews with Warren Buffet, CEO of Berkshire Hathaway, Inc., and Congressman Michael Oxley of the groundbreaking Sarbanes-Oxley Act which changed the face of corporate governance forever. Additionally, our popular Global Outlook section will shed light on such pertinent issues as banking inside the Islamic world, purchasing real estate in Indiaʼs growing property market, and comparing emerging economies in Central and Eastern Europe. Furthermore, please nd intriguing articles on the astronomical rise of the Wal-Mart Corporation to the top of the retail world, the current theme of mergers and acquisitions in the telecommunications world, and valuable insight for pursuing a career in business in our Inside Scope section. As always, the success of our magazine would never have been possible without the amazing dedication and hard work of our incredibly talented staff. We sincerely hope that you will enjoy this issue of the Harvard College Investment Magazine.

Kuanysh Y. Batyrbekov Editor-in-Chief

Jennifer Ying Lan Editor-in-Chief

Harvard College Investment Magazine

hcim

Summer 2006

California Investment Association, University of California, Berkley

International Leadership Council, University of Chicago

Aggie Investment Club, Texas A&M University

Columbia Financial Investment Group, Columbia University

Presidents: Willson Deng and Anna Dickstein

President: Flomar Maurrasse

Presidents: Bryan Farney and Robert Wallace

President: Alex Verbuch and Nicklas Volbi

The California Investment Association, one of the biggest student investment associations on the West Coast, resembles a mutual fund, which starts with each member making an initial contribution. During a typical meeting, a team of members presents a company of their choice. The club then debates the strengths and weaknesses of the prospective investment. Finally, members vote on whether to purchase, sell, or hold the stock with the money from our club fund.

The International Leadership Council is a network of college students who share a passion for entrepreneurship and the ﬁnancial markets. Our two divisions, ILC Entrepreneurship and ILC Investment Management, seek to give students the exposure and skills necessary to be successful in their future careers.

The Aggie Investment Club (AIC) was established in 2000 and has become the premiere business organization at Texas A&M. The AIC was created to focus on “providing the nuts and bolts of building wealth” and recognizes that “you will need more than a degree to be ﬁnancially free.” The AIC facilitates knowledge to its members through three main avenues: Bi-Monthly speaking events, AIC Workshops, and our Crown Partnership for Global Leadership Development.

Columbia Financial Investment Group (CFIG) is a student-run organization aimed at cultivating a familiarity with the ﬁnancial markets and investment techniques. Whereas in the past CFIG was mostly concerned with educating students on ﬁnancial matters, CFIG of today focuses on actually building an equity portfolio that outperforms the market portfolio without taking on high risk.

Throughout the semester, CIA holds a virtual stock portfolio contest to help members become accustomed to selecting stocks. This is an opportunity for members to apply and practice the new investment strategies that they have learned in the club. Although the specifics of the competition change throughout the years to make the experience more dynamic, the contest is a fun and exciting way to supplement the actual investing that the club performs as a group. From the technology bubble of the late 90’s to the debacles of Enron and Arthur Anderson, the past decade has shown that the world of investing is often unpredictable and surprising. The dynamics of the stock market are constantly evolving, which makes successful investing an ever-changing art. Investing is a lifelong learning process and we believe that the best time to start learning is always now. Although visibility in the economy is always limited, we believe that smart investors can proﬁt in both bull and bear markets. It all starts with learning the investing fundamentals, being aware of the environment, and building a storehouse of knowledge.

ILC Entrepreneurship focuses on founding businesses, while also giving members the chance to participate in our current start-ups, Prepme.com and Collectica.com. Prepme is a website designed for our academic preparation programs. PrepMe provides an industry-leading online SAT preparation course written by the nation’s highest scorers. Our course for the new SAT has just been launched. The course for the new SAT combines our industry-leading strategies and techniques with special online tutoring and essay coaching from top scorers. Collectica is an innovative market and forum on the internet for people to advertise their various idiosyncratic collections. Members can: • • • •

Upload, organize and share your collections with everybody on the internet Look at other people’s collections Meet other collectors with common interests Join clubs, ﬁnd collecting events, enjoy news and ﬁnd buyers for your stuff

ILC Investment Management trains students to understand the ﬁnancial markets and macro-economy, giving them a framework to critically think about the markets. ILC is also able to leverage its network of contacts and give students access to real professionals in a wide array of industries.

Through our Bi-Monthly guest speakers, AIC brings in high caliber speakers to educate students on building wealth with systematic investing; how to invest for your own account, etc. The AIC Workshops provide an environment in which members learn by in-depth and hands-on experience through live case studies and projects. The AIC utilizes our strong network with established student organizations to host each workshop. We both develop and implement curricula founded on the methodologies of Harvard and Wharton, and seek to create a pedagogical setting that best promotes an interactive learning experience. Through our Crown Partnership, AIC members enjoy the opportunity to both learn from and mingle with some of the most powerful people in their respected ﬁelds. AIC members gain access to professional resume building, premier student investment symposiums, and strategic networking with business executives, successful investors, professors and potential employers.

CFIG’s meetings consist of analyzing personal presentations on corporations and voting on whether to add it to the CFIG fantasy portfolio. Meetings also include special speakers who are respected leaders in their financial fields. CFIG’s ultimate goal is to manage a portion of Columbia University’s endowment fund, in an effort to put some of the university’s money into the investment hands of its own students and to further the group’s significance on campus.

INSIDE SCOPE

Who Really Invented the

CAPM?

By Sergali Adilbekov The Capital Asset Pricing Model (CAPM) is the widely-known mathematical benchmark for estimating returns on assets in financial theory. In the sixties, this revolutionary concept first introduced the notion of quantifiable risk, which helps to determine the price of assets. It uses the common, non-diversifiable risk, to calculate a theoretically appropriate required return on an asset. Nowadays, CAPM remains the bestknown and most popular pricing tool, overshadowing the myriad of other theories such as Arbitrage Pricing Theory and the Three Factor Model. Because of its popularity, the intriguing history behind the development of the CAPM merits a closer analysis. What is discovered upon further research reveals only the shroud of mystery and aura of intense academic competition which surround the identity of the true inventor of the CAPM.

William Sharpe, John Lintner, and Jan Mossin are usually named as the creators of the CAPM. Nonetheless, it was only Sharpe who received the Nobel Prize for the creation of the CAPM. The rst person to actually publish the proposed model, Sharpe received his Nobel Prize along with Harry Markowitz and Merton Miller in 1990 for their pioneering work in the theory of nancial economics. Markowitz and Miller were honored for having developed the theory of portfolio choice and for having added fundamental contributions to the theory of corporate nance, respectively. However, in the description of the award, Sharpe was credited more specically for his contributions to the theory of price formation for nancial assets, the so-called, CAPM. At the time, various practitioners knew that three other economists had independently arrived at the same model as Sharpe in their research. Jack Treynor was actually the rst economist to start the study of Capital Asset Pricing Model. In 1981, American economist 8

Fischer Black wrote to Treynor, “You developed the Capital Asset Pricing Model before anyone else,” in a way, urging Treynor to take credit for his groundbreaking work. Treynorʼs revolutionary unpublished manuscripts “Market Value, Time, and Risk” and “Toward a Theory of Market Value of Risky Assets” which laid the groundwork for CAPM were not well studied until Robert A. Korajczyk published Treynorʼs mimeographed drafts in his Asset Pricing and Portfolio Performance: Models, Strategy and Performance Metrics in 1999. When Treynorʼs works were nally revealed to the public, many economic historians came to realize that maybe the Nobel Prize for the CAPM had been awarded prematurely. Four years later, in the Journal of Investment Management, an article appeared by Craig W. French, which claimed that Treynor was actually the rst inventor of the CAPM and had preceded Sharpe, Lintner, and Mossin. According to French, Treynor had been unfairly overlooked and not credited for his innovative work, which would later be

CAPM

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

When Treynor’s works were ﬁnally revealed to the public, many economic historians came to realize that maybe the Nobel Prize for the CAPM had been awarded prematurely. known as the “CAPM.” After this article was published, popular sources like Wikipedia.org began to cite Treynor as one of the independent inventors of the CAPM. Bernstein, in his book “Capital Ideas,” stated that Treynorʼs friends at the University of Chicago showed his work to Merton Miller, who in turn sent it to other colleagues. Therefore, speculation abounded in the academic world that the CAPM developed by Sharpe, Lintner, and Mossin could have been inuenced heavily by access to Treynorʼs earlier works. However, despite the controversy, Lintner and Mossin also deserve recognition for their contribution to the development of the CAPM. John Lintner, a native Kansan, taught at Harvard from 1946 until his death in 1983. Many nancial economists say that had Lintner been alive in 1990, he, too, would have shared the Nobel Prize with Sharpe. Unfortunately for Lintner, it was too late because the Nobel Prize Committee only gives awards to living scholars.

Jan Mossin, a Norwegian economist, developed his version of the CAPM in his doctoral dissertation at Carnegie Mellon University. In 1968, he was awarded the Alexander Henderson Award for the CAPM, which is presented to the best economic theory student at the Tepper School of Business. It is a common opinion that had Mossin lived longer (he died in 1987), he, too, would have received a Nobel Prize for his contribution to the CAPM. The recognition for the development of the ground-breaking Capital Asset Pricing Model does not seem to have been distributed fairly. In contrast to William Sharpe, the only man who won a Nobel Prize for it, Jack Treynor, John Lintner, and Jan Mossin were never ofcially acknowledged for their important contributions to the Capital Asset Pricing Model. Hopefully, the legacies of Jack, John, and Jan will one day be justiably readjusted in order to reect these menʼs invaluable contributions to modern nancial theory.

Bain Capital is one of the world's leading private investment firms, managing more than $38 billion of leveraged buyout, public equity and credit funds. Sankaty Advisors, the credit products and debt hedge fund business of Bain Capital, is a world-class team of over 40 investment professionals with extensive experience analyzing and managing high-yield investments. Representatives from Sankaty Advisors will be visiting campus throughout the year, speaking with undergraduate students about internships and full-time positions that will put your education to work on global, multi-million dollar investment decisions. Please look for us on campus in the coming months to learn more about the great opportunities we offer.

For information visit us at www.baincapital.com or www.sankaty.com HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

INSIDE SCOPE

From Red Neck to Blue Chip: From ruining the environment to continuing gender discrimination to single handedly destroying “mom and pop” stores, Wal-Mart has allegedly done it all. Yet behind the media hype, protests, and politics lies a company rarely examined for what it truly is, the most successful retail corporation in the world today. Combining cutting edge technology with oldfashioned customer service, Wal-Mart continues to gain market share at home while expanding its operations to cover the globe. Dominating its competitors at virtually every measure of achievement, Wal-Mart seems to be on the path of perennial success, but what is it that keeps Wal-Mart on top and how long can it expect to stay there? By Roxanne Bras History: The Making of a Dynasty Sam Waltonʼs life epitomized the American dream. Growing up during the Great Depression, he served in the Army in World War II before coming back and graduating from the University of Missouri and entering the retail business. First working as an associate at various retail companies like J.C. Penney and Ben Franklinʼs, Walton eventually opened his own store, a Five and Dime, on September 1, 1945. Sam, his wife, and his partners worked hard for years trying to perfect their competitive edge in the retail business. After almost twenty years in the business, on July 2, 1962, the rst Wal-Mart opened. Sam opened the rst Wal-Mart in Rogers, Arkansas. His primary goal for the store stemmed from the experience he had garnered at smaller retail companies—keep prices low. He operated like no other retail outlet had done before,by steeply cutting prot margins. Instead of continually marking up prices to earn more money, he drove them so low that he was guaranteed to beat his competitors; thereby, relying on consumer expenditure growth rather than prot margin for success. Walton would bypass the main distribution centers in mid-America and pack up his truck and drive out to meet the manufacturers himself on weekends. He would come

back with trucks full of merchandise which he could then sell at a lower per-unit price because he had cut out the middle-man fees. He also carefully led what could be described as ʻmilitarystyle reconnaissance missionsʼ to determine ideal locations for new stores and then tenaciously ensured their success by implementing revolutionary marketing ideas and impeccable customer service. Throughout the 1970ʼs, Wal-Mart continued to expand through the South and into the Mid-West. In 1983, the rst Samʼs Club, a bulk retail and grocery supplier, was opened. The 1990ʼs marked Wal-Martʼs expansion far beyond the South and the beginning of ʻWal-Mart Super-Centers,ʼ where groceries were added to retail. Today, Wal-Mart is the largest private employer in the world, operating in all 50 states and 15 countries worldwide. Number one on Fortuneʼs list of the largest corporations since 2002, Wal-Mart has grown from its humble beginnings to become the worldʼs largest retailer, raking in unprecedented prots and growing at astounding rates. Management: Sam Knows Best Leadership has been essential to Wal-Martʼs success, with Sam Walton setting the standard not just for the company, but for the entire retail industry. His humble charisma (he once danced the hula at high noon on Wall Street, making good on a promise after Wal-Mart reached its prot goal), untiring dedication, and unwavering commitment to excellence made Sam the perfect corporate leader. After his death in 1992, the company underwent some leadership changes, yet the management of Wal-Mart has largely avoided the scandal and corruption that has plagued other large corporations. The current president and Chief Executive Ofcer, Lee Scott, has held the ofce since 2000, but previously worked at Wal-Mart for over 25 years, managing logistics and transportation. An interesting aspect of WalSUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

The

Story Martʼs leadership is its lack of prestigious degrees. Instead of looking to the Ivy League for leadership as many corporations do, Wal-Mart relies on experience from within. More than seventy ve percent of Wal-Martʼs management staff began their careers in hourly positions. For example, a current Executive Vice-President of Samʼs Club began his career as a paid-by-the-hour cart pusher. Wal-Mart claims that this extensive grassroots experience is more valuable than degrees or outside experience because it builds foundation and dedication from inside the company. Business Philosophy: More Than Just Pop-Tarts Wal-Martʼs unique culture has drawn both criticism and praise from outsiders. After a trip to Asia in the early 1980ʼs, Walton came back to the U.S. with some groundbreaking ideas inspired by the Japanese and Chinese cultures of customer-service. If you walk into a Wal-Mart, the rst thing youʼll notice is the greeter. Since 1983, Wal-Mart has ensured that a “people greeter” meets all customers at the door with a smile and salutation. Then, there are the almost cult-like cheers that begin most workdays for the employees. From the “Wal-Mart Cheer” to “Samʼs Pledge,” Wal-Mart consciously develops team-work from the ground up. It also enforces customer service like no other retail store. It relies on its associates to ensure that each customer is personally assisted and satised with his shopping experience. “How may I help you?” is not just a question on the company smock, itʼs a manifestation of Wal-Martʼs business philosophy. Another distinguishing feature of Wal-Martʼs business philosophy is its emphasis on logistics. Short of the Pentagon, WalHARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

Mr. Walton doing the hula on Wall Street after losing a bet to his Wal-Mart employees.

“We’re all working together; that’s the secret. And we’ll lower the cost of living for everyone, not just in America, but we’ll give the world an opportunity to see what it’s like to save and have a better lifestyle, a better life for all. We’re proud of what we’ve accomplished; we’ve just begun.” – Sam Walton

Mart has the most advanced data processing center in the world. Having led the retail business in implementing a vast web of computer, laser, and satellite technology, Walton believed that this was the key to growth. In almost real-time, Wal-Mart processes each individual transaction that occurs in every store. It compiles this information to update its merchandise lists, re-supply stores, and spot purchasing trends before its competitors. Their logistical abilities shined brightly during the hurricane season of 2005. While other stores suffered enormous losses stemming from their inability to remain stocked or open, Wal-Mart was able to keep stores supplied up until hours before the storms hit, and then re-open more quickly than even the government agencies in the affected areas. Wal-Mart uses its sophisticated data processing to analyze specic situations such as these, and then translates the information directly into protability. For example, Wal-Mart discovered that prior to hurri11

INSIDE SCOPE

canes, customers consume more Pop-Tarts than normal (strawberry-avored, to be specic). This information was translated into larger supplies of Pop-Tarts for customers in the path of hurricanes, and when consumers snatched up the Pop-Tarts, larger prots reinforced Wal-Martʼs amazing ability to stay ahead of the retail game.

nounced bold new plans to expand into rural China, but the road to Chinese success has not been without several speed bumps, including clashes with cultural differences and unions. WalMart executives admitted that they thought they could transplant the American model into China and expect the same success, but small cultural differences translated into huge business blunders. For example, most Chinese households donʼt have washStocks: Even Wal-Mart Gets the “Blue Chip Blues” ing machines. When Wal-Mart stocked its stores with detergent, it faced dismal sales. Once realizing their cultural error, stores Being a successful company does not guarantee success- switched to hand washing detergent and it ew off the shelves. ful stock performance. Wal-Mart (ticker symbol WMT) has Unionization was another difculty, but one all too familiar to shown only a lackluster performance on Wal-Mart. Chinese workers expressed the New York Stock Exchange over the the desire to unionize but Wal-Mart was past ve years. This trend is not specic able to diffuse the situation with less SAM’S PLEDGE to Wal-Mart; rather, it is plaguing most public relations battles than it had in the large-cap American companies. Dubbed United States, where union leaders and From this day forward, the “blue chip blues,” equities of common sympathizers have effectively kept Walhousehold-name companies such as DisMart out of union strongholds like New every customer that ney, Intel, Microsoft, and Wal-Mart have York and Boston. comes within ten feet done virtually nothing since 2001. Currently trading around $45, WMT split ofEconomic impact: The Good, the of me, I’m going to ten during the decade of 1970-1980. Since Bad, and the Savings 2000, it has been uctuating between $40 look him in the eye, and $57, but has not consistently beaten Labor unions, environmentalists, and I’m going to smile, the Dow Jones Industrial Average. Since protectionists all claim that Wal-Mart has 2001, Wal-Mart has recorded an astoundnegatively impacted the economy, while I’m going to greet him ing 83.5% growth in earnings per share. business leaders, capitalists, and Walwith a ‘Good morning,’ Yet this growth has translated into a disMart itself insist that it positively affects mal fall of 1.2% in its stock price. AnaAmerica. Who is right? Although it has or a ‘Good afternoon,’ lysts expect this trend to eventually reverse been difcult to quantify Wal-Martʼs efor a ‘What can I do itself, assisted by the unprecedented level fect on the economy, several studies have of cash corporations such as Wal-Mart are tried. Most studies conclude that it has for you?’—so help me holding, but only after the economy begins created a net increase in jobs while sislowing down. When the economy slows, multaneously decreasing prices on the Sam! analysts expect investors to turn to familaverage bundle of goods a typical famiar companies who offer security, even if ily purchases. For example, an extensive the returns arenʼt fantastic. But until then, Wal-Mart has to face study by Global Insight in November of 2005 on the impact of some rather unhappy customers—its shareholders. Wal-Mart showed that from 1985 to 2004 there was a cumulative decline of 9.1% in the food-at-home prices. a decline of 4.2% in A Multinational Corporation: Rolling Back Prices commodity prices and a decline of 3.1% in the Consumer Price from Bentonville to Beijing Index. The report calculated that total consumer savings over the past ten years amounts to $263 billion. Additionally, WalGrabbing the top ranking on Fortuneʼs Global 500 list, Wal- Mart has improved the overall efciency of the economy by Mart is the largest corporation in the world. It rst began its 0.75%. As for the argument that Wal-Mart is bad for labor, the global expansion in 1991 by opening a store in Mexico City. 3.1% decrease in the Consumer Price Index was offset by a 2.2% Since then, Wal-Mart has entered 15 countries and has over decrease in nominal wages, but this still leaves consumers with 2,000 international locations. Its greatest presence is in Mex- an increase of 0.9% in real disposable income. As Americaʼs ico with 786 stores; the United Kingdom with 315 stores; and economy is approximately 70% consumption driven, this is a big Canada with 278 stores. However, Wal-Martʼs largest interna- boost to the economy as a whole. Sadly, despite this imprestional success has been in penetrating the typically protectionist sive empirical data, it appears that Wal-Mart will continue to be Chinese market. With 56 locations in China, Wal-Mart has an- judged more for its politics than its numbers.

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

Looking to Future: Cooling Down or Heating Up? With a Wal-Mart store in virtually every town, where else can they expand? Analysts point towards foreboding data showing a drop in same store sales by two percentage points when a new Wal-Mart opens in close proximity to an existing Wal-Mart. Wal-Mart executives seem to have the answer. Despite analystsʼ predictions that Wal-Mart will soon begin to cannibalize its own business by expanding in its own backyard, Wal-Mart insists that competition among its stores will pay off. Wal-Mart is faced with two options: continue expanding at the risk of cannibalization or grow in the only territories yet untapped, California and New England. The problem is that both areas are hostile to WalMart, and the obstacles of labor unions, government approval, and boycotts may not make the growth worth Wal-Martʼs effort. But not to worry, Wal-Mart has done the math and gured out a way to keep on rolling back prices and raking in prots even in its own backyard. If two stores each make $100 million in profits, and a third store is added, Wal-Mart calculates that the three stores will each make slightly less, to the tune of $80 million a store. Yet quick arithmetic shows that the prot of three stores at $80 million is more than that of two stores at $100 million.

So as long as Wal-Martʼs gets its math right, it looks like it will continue to experience the astronomical growth and prots of the past three decades. In all likelihood, Wal-Mart will continue to be the favorite target of assails from labor unions, protectionists, and liberal leaning politicians who depend on their constituencies. For its part, Wal-Mart has stepped up its public relations image as it attempts to counter these attacks by stressing its philanthropic actions (over $200 million in charitable donations in 2005), its “All-American image” (supporting military service members), and its new environmentally friendly initiatives (stocking its shelves with organic food). Yet, it seems that Wal-Martʼs biggest benet to America is largely ignored. Wal-Mart, with its 1.6 million associates worldwide, has provided jobs made possible only through Wal-Martʼs superior efciency. Each week, WalMart serves more than 138 million customers, providing them with unmatched customer service and unbeatable prices. These savings have translated directly into increases in real disposable income for the average American and subsequently, a higher quality of living. More jobs, unmatched levels of efciency, and astronomical consumer savings—what more could you ask for?

SATISFACTION IS GOOD.

PRIDE IS BETTER. Join Merrill Lynch and you’ll share in a sense of pride that runs throughout our organization. Pride in the world’s premier financial services brand. Pride in our continued leadership in products and services. And pride in our intellectual capital that continues to foster groundbreaking innovation. Know the exhilaration of working alongside some of the finest minds in financial services. Stretch yourself to reach for – and achieve – the success you dream of. And take pride in contributing your talent to a team that defines exceptional in every sense of the word. If you seek a truly outstanding employment experience, there’s never been a better time to join Merrill Lynch.

EXCEPTIONAL WITHOUT EXCEPTION ml.com/careers Merrill Lynch is an equal opportunity employer.

HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

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Looking for a Career upon Graduation Harvard College Office of Career Services

By Bob Cohen and Nancy Saunders Imagine you are at a meeting of senior executives who have gathered to talk about your company’s global expansion strategy. Your role is to deliver a plan that will successfully launch a new consumer product into a highly competitive market. Before this meeting, however, you have not done much research about what the product can do or who would be interested in buying it. Since you have little information about the market you have targeted, it is also unclear how you will position the product or what your strategy will be to sell it. How long do you think would you keep your job? If you answered “not very long,” you are right. Just like What is a “business career?” launching a product into the marketplace requires knowledge For many Harvard students, it may be surprising to learn that about how the product meets customer needs, everything you do about planning for and pursuing a “business career” is based on the term “business career” is actually misleading. It is also by two key pieces of information. What skills and experience can I no means limited to investment banking and consulting. While these rms typically represent a sizeable offer a prospective employer and how do number of employers who recruit on they match an employerʼs needs and recampus, they are not the only business quirements? In effect, you need to follow a Roughly 85% of career opportunities you can pursue. In planning process in order to come up with fact, there is no such thing as a “business the jobs available, your career “strategy.” career.” The term “business career” actuWhether you are just beginning to invesbetter known as the ally refers to a specic function within an tigate business careers by industry, research organization, or what you do in your job information about careers, or actively look “hidden job market,” every day. On the other hand, where you for an internship or job after graduation, are not publicized do your job refers to the industry your itʼs important that you assess your interemployer is in and covers an incredibly ests, personality, values, and skills to idenanywhere and must wide assortment of work possibilities. tify the career path, industry, and type of be found through employer that most closely matches these Deﬁning your “product” qualities. You also want to have some clear alternative methods. ideas about how your experience and skills Where do you start? meet an employerʼs needs. Developing a career plan is not about So, how do you get this information? Well, one place to look is the Ofce of Career Services. We are choosing one job title or career direction at the exclusion of othnot just a place you go to for jobs. We also offer information and ers. It is about knowing who you are what works for you, and guidance about careers, industries, and organizations. You can where you want to do it…for now. You are the constant; everyalso meet the advisors to talk about related subjects such as fel- thing else – what you cannot control – is the variable. Once you are clear about your values, interests, personality, and skills, it lowships as well as work abroad opportunities. 14

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

is a matter of picking the “playground,” or industry, where you want to apply them. Your priorities and needs may change, but moving from one career path to another – based on your choice or necessity – is expected and will certainly be a matter of how well you understand and apply the career planning and job search skills you are hopefully learning now. Deﬁning your “market” Once you have generated some ideas about what kind of work you would like to do, you need to develop and reality-test your “career hypothesis.” One of the best ways to accomplish this is

you have identied your target industry and potential employers, you want to choose a variety of different approaches to pursue jobs in these markets. The more resources you use, the greater the likelihood of interviews. Most job seekers rely on third party resources, such as on campus recruiting, employment ads, or the web. Bear in mind, however, that these resources only account for only 20% of the total job market! The resources listed here are intended to be a complement to, not a replacement for, your own job search efforts. While it may be tempting to rely on the web because of time constraints or other commitments, studies continuously show that some form of contact development or networking remains the most productive way of looking for a

Developing a career plan is not about choosing one job title or career direction at the exclusion of others. through informational interviewing. Informational interviews give you the opportunity to talk with people working in a specic industry or job. Because of their experience, these contacts are the real experts who can give you insight into various jobs. One of your best resources for contacts is the Harvard alumni network, Crimson Compass. By taking the time to adequately research, you will gain important “informational condence” in your potential career and work goals. While you may be tempted to “keep your options open,” you will be far more productive by exploring careers that truly correspond to your personal criteria and for which you are realistically marketable.

job. Networking

Looking for a job is a numbers game. Studies continually reinforce the common sense idea that the greater the number of interviews, the greater the number of offers. Reports from schools throughout the country suggest, however, that only 20% of the students who participate in on campus recruiting actually get jobs through that program. While the average hiring rate at Harvard is probably higher, that still leaves a signicant percentage of students without employment. It is common knowledge amongst Developing your “strategy” industry professional that the positions advertised through third party resources such as newspapers, job search rms, the web, Putting together a strategy for your job search is no different than and on-campus recruiting programs only represent fteen perlaunching a new product into the marketplace. It is a process, cent of all the jobs that are available. This means that roughly rather than a formula. There are no one-size-ts-all approaches 85% of the jobs available, better known as the “hidden job marthat apply to everyone because each job hunter is unique. Once ket,” are not publicized anywhere and must be found through alternative methods. Networking is simply using people you know as a resource to help develop contacts or obtain information. Most importantly, A word about using networking is an extremely useful way to web resources... nd out about non-publicized job openings. Networking is also a way to develop specic Certainly, the web has contacts or strategies to approach employgrown in popularity as a recruiting tool for employers and a job search resource ers of interest. By process, however, it is no for applicants. However, Meg Riley Dikel - one of the leading experts of how the different than how you might try to nd out Internet plays a role in the job hunting process - clearly admonishes users that information about a course or instructor. You the web, like any other third party resource, should not replace strategies like ask around and, eventually, someone knows networking when looking for employment. The Riley Guide - which has an online somebody who knows the information you tutorial for how to use the Internet in your job search - and Dick Bolles’ The Job need. Hunter’s Bible are considered to be two of the best web sites for their overall Remember, you are not directly asking value as both a research and job hunting resource. In addition, employers spefor a job, merely for ideas and tips. Asking ciﬁcally interested in Harvard students who do not necessarily recruit on campus for a job could end the conversation once the post their internship, term time, or full time positions on MonsterTRAK. contact does not have an available position. Your rst objective is to develop leads and HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

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2004

career

to gain information about the employers that you have targeted. Use networking to learn as much as you can. Learning about career opportunities within your eld of interest will prepare you for actual job interviews. Be sure to ask if your contact knows anyone else with whom it might be helpful for you to talk. Be certain to follow up on every lead you receive and acknowledge by letter your appreciation for the assistance that you have received. If you do not include networking in your job search strategy, you are putting yourself at a disadvantage by excluding a whole group of opportunities that are uniquely yours. Avoid conducting informational, referral, or actual interviews over the telephone unless it is geographically impossible. Meetings in person are most successful, because the employer can get a better sense of who you are and what you have to offer. Once you have identied your target industry and type of employer, you must decide what approaches to take to pursue opportunities in these markets. The more resources you use, the greater the likelihood of interviews. However you choose to slice the pie, there is just so much time in the day. Having a good strategy needs to include how much time you plan to spend on each approach you plan to take. Statistics show that most people who are successful in obtaining employment do so through a process called “networking” or contact development.

� Cingular acquires AT&T Wireless � Sprint gains control of Nextel

2005

•

Employer and Industry Research

Now that you are ready to implement your marketing strategy, it will take more than just library research to successfully develop a targeted approach to your overall game plan. Before hunting for background information about a potential employer, rst decide what type of information you need, and then determine where to nd it. Approach this research project systematically and allow yourself plenty of time. Dig deeper into information than you think you need to. For example, you may know that Ralston Purina makes pet food, but are you aware the company also makes cereal for humans, owns a major tuna sh company, and operates resorts and restaurants? You may be talking with a subsidiary of a much larger company and not realize it if you do not do your research. The most “targeted” research efforts focus on clearly identifying where opportunities exist and in what ways your “product” meets the needs of those potential customers. Some suggestions to develop a market-based approach to your research include: • Put together a regular reading program of books, magazines and periodicals such as The Wall Street Journal, Time, Newsweek, Forbes, Business Week, Inc., or any industry, trade or professional publication. • Investigate some of the web-based resources that provide comprehensive employer, industry, and geographical market information. The Career Resources by Field section of the OCS web site at www.ocs.fas.harvard.edu

•

is an excellent place to start. Interview bankers, investment analysts, accountants, and economists about emerging trends through professional association membership directories, newspaper clippings, faculty referrals, and industry reports from banks, accounting rms or investment rms. Develop a target (prospect) list of companies which, through your research and contacts, are most interesting to you and offer the best chance of gaining employment. Segment these companies into primary and secondary target markets based on your level of interest, the degree to which these organizations meet your career requirements and your opportunity for success. Decide on a strategy for each segment based on the time, energy, and resources you can afford to devote to each and your likelihood of success.

Classiﬁed and Web Ad Responses Be prepared to answer any ad that appeals to you based on your interest and ability to do the job. Follow all the appropriate publications for your eld of interest, industry or functional area. If you are looking outside of the immediate market, arrange to receive any newspapers that cover the locations of specic interest to you. • There are some approaches for responding to ads that you might consider: • Read the ad several times. First to get the general idea, then to get specic details. • Underline key words or phrases that identify the companyʼs specic needs. • List these needs on a separate piece of paper. • Identify what skills or accomplishments in your background match up to these needs. • Draft a response but, in the case of print ads, do not mail it on the day the ad is published. Wait a few days so that your response arrives after most replies have been received. SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

� Sprint Nextel strikes a deal with the country’s four biggest cable operators: Comcast, Cox, Time Warner and Advance/ Newhouse � France Télécom acquires Amena � Telefonica gains control of Cesky Telecom � Telecom Italia buys Liberty Surf

2006

� Telefónica buys O2 � AT&T acquires BellSouth

The Burst of theBubble Consolidation in the telecom industry: What is Happening and Why?

he telecommunications industry was meant to change drastically after the nineties. Deregulation in the nineties was followed by a rapid expansion in the telecom industry, primarily due to the enormous projected demand for internet services. As a result, both new entrants in the telecom market and also former national monopolies in Europe and regional operators in the United States built enormous networks to carry the projected demand for the internet. More specifically, according to Andrew Odlyzko, a researcher at the University of Minnesota, the capacity of fiber-optic cable networks between 1998 and 2001 increased five hundred times. Unfortunately, consumer and business demand for internet increased only four times in that period. Telecom companies ran into huge debts and the telecoms bubble inevitably burst. But telecoms did not only overestimate the increase in internet demand. In general, they overestimated the speed by which consumers are able to adapt to new technologies. As a result they over-invested and ran up big debts without increasing their revenues as expected. For example, European companies invested over €100billion ($90 billion) for 3G networks for wireless telephones but the expected increase in demand never came about. By Petros Andreou By the turn of the century, share prices plummeted and more that half a million employees were laid off in the telecom industry between 2000 and 2002.

HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

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CONSOLIDATION & RECOVERY: A Timeline of Deals After 2002, when the initial shock had passed, and investors regained condence, we witnessed a wave of mergers, acquisitions, and agreements in the telecoms industry, both in Europe and in the United States of America. At rst, analysts were troubled at the sight of the increased activity in the telecoms industry. Nobody expected such a rapid recovery. Some colossal telecommunication companies were created in the process and deals were taking place at a frequency the industry had never before witnessed. (Figure 1 depicts the new scene in the telecommunications industry.)

REASONS FOR CONSOLIDATION Regulator’s Standpoint Were antitrust regulators satised by the wave of mergers and acquisitions? The most likely answer is “yes.” The tide had turned around and the telecommunications industry needed to consolidate for the benet of the consumers. After the burst of the telecommunications bubble, the Federal Communications Commission (FCC), Americaʼs antitrust regulatory body for telecommunications, became more lenient regarding antitrust issues. Experts recognized that a consolidated telecommunications industry would be more benecial for consumers than a fragmented and struggling telecommunications industry with many small competitors. This fact should not be a surprise. There are many economies of scale in the telecommunications industry which are not being taken advantage of, especially after the fragmentation of the industry which followed the deregulation of the nineties.

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A Wave of Mergers UNITED STATES 2004 Cingular acquires AT&T Wireless. Sprint gains control of Nextel. 2005 SBC acquires AT&T. Verizon Communications buys MCI. Sprint Nextel reaches a deal with the country’s four biggest cable operators, Comcast, Cox, Time Warner and Advance/Newhouse. 2006 AT&T spends $67 billion to buy BellSouth. Under this deal, AT&T gains control over Cingular, the largest wireless service provider in the U.S.

EUROPE 2000 France Télécom acquires orange for €40 billion. 2004 In Belgium, Telenet, a cable operator strikes a deal

with BASE, a wireless operator, according to which Telenet will be able to offer wireless service.

2005 France Télécom acquires 80% stake of Amena, a large

Spanish wireless service provider for €10.6 billion ($12.7 blln). KPN and Telfort merge in the Netherlands. Ireland’s Eircom gains control of Meteor, a wireless service provider. Denmark’s TDC acquires Sweden’s Song. Telefonica spends €2.7 billion ($3.3 billion) for a 51% stake of Cesky Telecom, the Czech Republic’s biggest phone company and then increases its stake to 69% by buying from minority shareholders. Cablecom, a Swiss cable company, teams up with Sunrise, a wireless provider. Telecom Italia acquires LibertySurf, the French internet service provider, from Tiscali. 2006 On January 26th, Telefónica completes a £17.7 billion ($31.5 billion) all-cash acquisition of O2, one of the largest wireless-service providers in Britain, Germany and the Republic of Ireland and the sixth largest in Europe.

For one thing, average advertising costs decrease for a telecom company that offers multiple services. Since brand name is very important in the telecom industry, when a customer signs on with one aspect of a brandʼs service, that customer is more likely than not to also sign up for the other Figure 1. Ranking of Telecoms by Market Capitalization features the company offers as well. But most importantly, there exist operational economies of scale where the merged companies take advantage of each otherʼs networks and client base. Indeed, the integration of the back ofce staff and of the varying corporate cultures might be difcult at rst. But in the long run, the elimination of duplicated tasks reduces the operational costs signicantly. For example, Telefónica estimated that its acquisition of O2 will reduce average costs by €293 million ($353 million) per year by 2008 as a result of taking advantage of these operational economies of scale. A more consolidated industry could take advantage of these economies of scale, thus beneting both themselves and consumers. Furthermore, Source: Reuters a fragmented industry is problematic since com-

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

panies often go bankrupt and seek Chapter 11 protection. Due to the ability of companies under Chapter 11 to lower prices, we usually witness the beginning of vicious cycles where more companies who are unable to compete with the lower prices also going bankrupt. The FCC thus considered a more consolidated industry benecial across the board. More Services Necessary The recent perception that telecommunications companies need to offer more services has been responsible for the heavy market activity in mergers and acquisitions. This notion comes partly from the telecomsʼ erce competition with cable companies. Cable companies have begun to offer land-line voice services, internet access and TV services. Given that consumers may like buying complete packages of services, telecommunications companies have begun to offer a package of services as well. This search for “the complete consumer package” has created many mergers among companies who offer differing products and services. For example, France Télécom acquired Amena, a Spanish wireless provider. In addition to wireless service, France Télécomʼs Spanish activities will include xed-line services through Uni2, which is owned by France Télécom and operates in Spain, and internet service through Wanadoo. France Télécom had previously offered a similar package in Poland, the United Kingdom, Belgium, France, and the Netherlands but is only now expanding into the Iberian Peninsula. Generally, the various new telecommunications companies are able to offer packages which consist of products like xedline and wireless phone service, broadband internet access, Voice over Internet Protocol (VOIP), and even TV and video service through Internet Protocol Television (IPTV). These new de-

soon enough, “Voiceline service will very rapidly cease to become a major revenue generator for all telecoms operators, xed Telefonica is Spain’s former and mobile.” national monopoly and is now As a result, teleone of the biggest telecomcommunication rms munication giants in the world. are now trying to limit Telefonica was created in 1924 their dependence on and was state owned until 1997. voice services. Due to In 2005, Telefonica spent €2.7 the rise of VOIP, they billion ($3.3 billion) for a 51% need to offer other stake of Cesky Telecom, the Czech Republic’s biggest phone communication sercompany and then increased vices in order to dilute its stake to 69% by buying their vulnerability to from minority shareholders. On declining revenues. January 26th, 2006, Telefónica Furthermore, not only completed a £17.7 billion ($31.5 xed line voice activibillion) all-cash acquisition of ties are affected by the O2, one of the largest wiredevelopment of VOIP. less-service providers in Britain, Wireless telephones are Germany and the Republic of Ireland and the sixth largest in also affected since new Europe. Today, Telefonica has WiFi cell phones allow operations in more than thirteen consumers to use VOIP countries, mainly in Europe and services while on the Latin America. move. Arguably, cellphone providers could eventually prove to be more vulnerable to VOIP since the majority of their revenues come from voice services. Cable companies, on the other hand, have not been relying

The search for “the complete consumer package” has created many mergers among companies who offer differing products and services. velopments in consumer telecommunication packages are now constantly taking place amongst these deals between the large providers of each service Emergence of VOIP In particular, demand for VOIP has risen sharply. VOIP providers allow voice conversations over the internet for minimal costs or even free. The cost to consumers is only that of their home internet connection. However, how has the increase in VOIP subscribers (as shown in gure 2) caused an increase in the merger and acquisition activity in the telecommunications market? For one thing, the demand for voice-line services offered by telecommunications companies is declining. “VOIP will destroy simple voice-line revenues faster than most analystsʼ models predict,” according to Cyrus Mewawalla of Westhall Capital. Mewawalla predicts that HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

on voice services as a major source of revenue. They had served as internet service providers amongst other things, and now the development of VOIP now allows them to offer calling services to their repertoire. Mergers between wireless and cable companies, then, seem to hold large potential as a result of their complementary services. Standalone wireless operators offer limited Internet service, while demand for internet connection is being given a boost with the development of VOIP. At the same time, cable 19

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Idiosyncratic Reasons

band services, are still controlled by these former monopolies. For that reason, consumer groups are uneasy at the prospect that the telecommunication industry will once again consolidate around former monopolies someday. Nevertheless, this time around, the concern that the consumer will be hurt as a result of monopolistic practices is not very realistic. The emergence of various outlets for cable, VOIP, and wireless communication services will ensure a tough ride for former monopolies.

Some deals are not explained by simple trends that are hap- The “Communications Supermarket” pening in the telecom industry. A primary example is the deal between Sprint and Nextel which took place in 2004. It is also doubtful whether the concept of a “complete telecomNextel had been operating under a system called iDEN, which munications package” is sound. The transformation of telecom was very popular amongst its clients because of its “Push to companies into communication supermarkets where consumTalk” walkie-talkie feature. However, their ers can satisfy all of their communication network was unable to upgrade to higherneeds is very reminiscent of the ”nancial “Voice [services] will speeds like rival Global System for Mobile supermarkets” in the 1980s. Communications (GSM) networks had At that time, Citigroup and Amerivery rapidly cease been doing at the time. On the other hand, can Express were pioneers of the “nancial to become a major Sprint was operating with Code Division supermarket” idea which emerged in the revenue generator for Multiple Access (CDMA) networks, which early 1980s. The varying nancial products had the potential to be upgraded. When upof these nancial giants were aggressively all telecoms operators, graded, CDMA networks could accommoadvertised and the idea of the “nancial suﬁxed and mobile.” date the “Push to Talk” walkie-talkie feapermarket” where a consumer could nd ture. With Nextel needing a better network everything they needed in the nancial --Cyrus Mewawalla of which Sprint had, and with Sprint needing world at one bank was highly publicized. Westhall Capital a stronger client base which Nextel had, the Yet, the cross-selling of nancial products acquisition of Nextel by Sprint was thus upset consumers and the incorporation of reasonable in many respects. Each compavarying nancial services into one company nyʼs strengths were the otherʼs weaknesses and the two created a did not prove to be efcient. Citigroup ended up being forced to much less vulnerable (and bigger) wireless operator. spin off its travelerʼs life insurance unit, and American Express split from its nancial advisory business. As an indication of the failure of the “nancial supermarket” concept, in February 2005 when American Express announced its decision to split from its advisory sector, its stock price rose by 6%. There Is No Turning Back Nonetheless, it may be true that someday all consumers will want to buy their communication services from one large Concerns are “communications occasionally raised supermarket.” Figure 2. VOIP Access Lines in the US (in millions) that the consolidaHowever, could it Source: TIA & Wilkofsky Gruen Associates, -May2004- eMarketer.com tion trend will result be that this recent in the return of the telecom consolipre-deregulation era dation trend was where a few large just the product of companies monopoa awed concept lized the telecomand will soon cremunications indusate nancial disastry. The copper wire ters and eventually networks, which be reversed? Only are instrumental for time will tell. land-line and broad-

THE FUTURE

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

Joe Moglia

CEO of TD Ameritrade

Helping Independent-minded Investors HCIM: What are some of the advantages of the recent merger with TD Waterhouse?

tions. This merger will allow TD Ameritrade to reach more investors with better service. By Stanley Chiang

Moglia: There are ve primary benets of acquiring TD Waterhouse. First, we are gaining valued TD Waterhouse customers. The merger also eliminates pretax costs, which will increase the protability of the company. Second, the merger will attract long-term investors. Ameritrade offers “Amerivest,” a service which helps an individual invest by factoring in risk tolerance with long term nancial goals, whereas TD Waterhouse focuses on mutual funds and xed income sources; the combination of both tools should attract a wide range of long-term investors. Third, TD Ameritrade will give investors strong analytical tools and will be particularly helpful for independent advisors to perform research. Fourth, with the acquisition of TD Waterhouse, TD Ameritrade can form a strategic relation with TD Bank Financial Group, the Canadian commercial bank. TD Ameritrade can gain most of the benets of being a bank without the cost of actually being a bank. Lastly, Ameritrade will have a greater physical presence by acquiring TD Waterhouseʼs branch loca-

HCIM: How do you see the role of the individual investor change over the next few years? TD Ameritrade offers more and more investors the ability to invest their money online easily. Also, TD Ameritrade gives investors plenty of independent research tools that could make investors dependent on analyst calls. Do you think that these two factors will result in greater speculation, like the investor attitude that caused the dot com bubble?

MOGLIA

companies are unable to offer wireless services and they aspire to offer a more diverse service. This is the economic rationale behind deals such as Sprint Nextelʼs (a wireless operator) agreement with Advance/Newhouse, Time Warner, and Comcast(all cable companies), and the repeated attempts by NTL (a UK cable operator) to acquire Virgin mobile (a wireless operator).

An Interview with

INSIDE THE PROFESSION

Moglia: First of all, one of our main goals is to educate investors. For example, most investors do not know about Exchange Traded Funds, which I think are wonderful investment tools that should be incorporated into investment strategies. We want investors to have a disciplined and diversied portfolio strategy. After the internet bubble, I think that investors have become educated and more investment savvy; they are less willing to speculate and take risks after going through the pain of the losing their money in the bubble. TD Ameritrade will help investors

Having coached college football for over sixteen years, one day Joe Moglia decided to switch careers. Slowly climbing his way up the corporate ladder, using the skills in management and leadership which he exercised on the field, Joe Moglia eventually became the CEO of TD Ameritrade, one of the largest online retail brokerages in America. Under his guidance, Ameritrade has recovered from the bursting of the ‘dot-com’ bubble to become a leader in online brokerage. What started off as a small discount brokerage firm in 1975, Ameritrade eventually grew into one of the largest brokerages by innovating investment tools for clients. Joe received a B.A. in economics at Fordham University in 1971, and later continued to the University of Delaware, where he received a Master’s in secondary education and social sciences. In addition, he coached high school football while attending school. He went on to coach in the college arena, where he was the defensive coordinator for the Dartmouth College football team. In his last three years, from 1981 to 1983, Dartmouth was able to tie for the Ivy League Championship twice. Coach Moglia then decided to switch paths, and joined Merrill Lynch in 1984. In four years, he became the top broker at Merrill Lynch, where he managed investment products, insurance, and 401(k) funds. In 2001, Joe left Merrill Lynch to take the position as CEO of Ameritrade. He inherited a company which was suffering from the ‘dot-com’ bubble and in financial difficultly because of the weak stock market. However, Joe believed that Ameritrade could become the leader in the industry by consolidating other online brokerages and leveraging the firm’s strengths in technology. He started by acquiring National Discount Brokers and Datek Online Holdings, which then made Ameritrade the largest online brokerage in America, in terms of online trades per day. In 2004, Ameritrade continued its aggressive merger policy by acquiring Bidwell & Co., MyDiscountBroker.com, Inc., and parts of BrokerageAmerica LLC, Investex Securities Group, and JB Oxford & Co. More recently, Joe rejected a $2.3 billion buyout offer from E-Trade because he believed that Ameritrade had healthy and sustainable profits. In early 2006, Ameritrade acquired TD Waterhouse to become TD Ameritrade. Joe has also authored several books and articles on football and investing, including his latest book, Coach Yourself to Success: Winning the Investment Game. Recently, Harvard College Investment Magazine had the pleasure of sitting down with CEO Joe Moglia and discussing his vision for TD Ameritrade and how his various beliefs and goals have come into play during his long and successful career.

HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

INSIDE THE PROFESSION

After the internet bubble, I think that investors have become educated and more investment savvy; they are less willing to speculate and take risks after going through the pain of the losing their money in the bubble. learn about investment strategies by offering them more education tools and independent research. Tools, such as Amerivest, will give investors greater ability to think about long term goals and taking risks. When investors use independent research, they must be aware if there is a potential conict of interest on part of the analyst. There are a lot of sources of investment advice, and investors must be able to lter out the advice that could be problematic. Most importantly, investors should never blindly accept advice.

HCIM: You have a very unique background for a CEO. You were a football coach for 16 years before you went into business. How do you relate sports and business?

Moglia: There are so many parallels between sports and business. I have applied the same thought processes that I used as a football coach to any decision that I have made in business as a CEO. The main traits that you need in both football and business are organization and discipline. If youʼre messy in football, youʼre going to lose the game; if youʼre messy in business, HCIM: Last year, Ameritrade rejected an acquisition offer from youʼre going to lose money. I also learned that the most imporE*Trade, and now E*Trade is one of TD Ameritradeʼs largest tant thing in football and business is performance. If you canʼt rivals for online brokerage. How do you think this competition win a game in football, youʼre out of a job. Likewise, if you will affect investment services? canʼt give clients long term growth, youʼre out of business. I am a better businessman because of my job as a Moglia: Competition is almost always good football coach. By the way, Dartmouth was for the individual investor. Competition puts 3-0 against Harvard when I was the defense There are a lot pressure on companies to provide the right coordinator. of sources of products, tools and goals for investors. Investors will be able to demand more tools HCIM: As a business executive, you have investment advice, for lower prices. TD Ameritrade is different hired many people. What do you search for and investors from E*Trade because we focus solely on in employees and what sort of preparation online brokerage and dedicate ourselves to do you suggest for a career in business? must be able making sure that investors have a good experience. What investors care about is havMoglia: What I tell students is to have less to ﬁlter out the ing a reliable brokerage, and they donʼt mind background and more passion. If you love advice that could paying a few more dollars of commission for what you do, it becomes a career, otherwise that better service. Here at TD Ameritrade, it becomes a job. Students should nd somebe problematic. we are going to build that trust by improving thing that they truly love rather than for othInvestors should their online experience. We offer tools that er reasons. When I was at the Merrill Lynch give investors insight into investment deciTraining Program, out of 26 people, 25 were never blindly sions so that investors will be better educatMBA graduates, and I was the only football ed about investments. coach. People in every eld will succeed in accept advice. business. It doesnʼt matter what your backHCIM: What is the next step for TD Ameriground is, as long as you have passion. trade? Are there any plans to try private equity or expand internationally? HCIM: As a CEO, you must have a lot a pressure from various groups within TD Ameritrade. How do you manage to implement Moglia: For now, we are just focusing on achieving those ve your ideas amid different interests? goals that I mentioned before we try anything else. We want to establish the reputation as an excellent online brokerage and gain Moglia: As a CEO, I have the responsibility to come up with the client trust by working to make sure all ve goals are completed. strategic vision of the rm and to implement it. My responsibilWe donʼt have any plans for expanding internationally. We are ity is for two main groups: clients and shareholders. The clients focusing on expanding our reach domestically, and one of our want more and more for less, and shareholders want greater regoals is to establish an even greater client base here in the US. turns. I answer to both by implementing those ve goals that The problem with expanding internationally is that we donʼt I mentioned. There is not necessarily a conict because sharehave a competitive advantage in foreign countries like we do in holders want more prot and clients want more tools. Both can the US. Here in the US, we know what investors want, but inves- be achieved by working on our ve main goals because costs tor needs may be completely different in other countries because are reduced while providing greater service. I can balance both of different cultures and nancial systems. interests by doing what is right. 22

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

Women in Business Gauging the Possibilities

ver the course of the past few decades, the role of women in the business world has changed dramatically. As potential opportunities shifted from the primarily secretarial work of the past to more senior positions in higher-level management, women have consistently adapted to t their new roles. However, even now, the playing eld is not entirely level. The U.S. Equal Employment Opportunity Commission recently reported that women represent only 32.6% of ofcials and managers in investment banks. More strikingly, 51% of women in the nancial services industry report that they are paid less than men for doing similar work. Even while considering these well-known inequalities, it is tough to gauge the actual difculties a woman might encounter in the workplace. Nonetheless, women entering the nance industry today have the benet of role models and mentors—women who have blazed their own trail to success despite all the barriers around them. Knowing that the potential for career growth exists however can still prove to be a heavy burden as women strive for the top. The skewed ratio of men-to-women in top positions limits the opportunities for women as they climb the corporate ladder, which begs the question: exactly what difculties and successes can women expect for their careers in todayʼs everchanging society and economy? Internship In recent years, competition for entry-level positions has spiked and thus, exponentially raising the importance of summer internships to the point that a career in the nancial industry appears to start the summer prior to graduation. The recruitment HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

By Donna Ivry

of minorities and women is a top priority for large banks. Once hired, the treatment of female interns does not appear to differ from their male counterparts. Yue Zhou, Harvard College Class of 2006, interned in the private equity fund group at Citigroup, where she dealt with clients who were experiencing difculty in raising funds. Working to assist the salespeople, her daily tasks included market research and fund valuation. The private equity fund group is primarily project-oriented, and projects were divided between her and the male intern in the group. “Whenever there were deals coming up, they would e-mail both of us and ask who was available. They never gave him more deals just because he is male,” Zhou said. Generally nding treatment equitable at the hands of management, Zhou felt that the women salespeople outperformed the males, particularly excelling in communication. She found that female salespeople participated more in the client aspect of the business. “[The women in the group] were really proactive. They can really talk to the client, progress the conversation, and convince the client in a very patient manner. Basically, female salespeople create a very credible image for people. They donʼt have a temper. That is why they are really successful,” Zhou said. She found that both a female director and managing director were especially successful in terms of their sales performance. However, Zhou pointed to one of the stereotypical weaknesses of women in business: a lack of toughness. She related one incident in which a client was pushing the group to sell his fund more quickly, but the fund was especially difcult to sell. Zhou recalled how the male and female salespeople differed in their response. “All the male salespeople went their own way: ʻyou cannot push us. It is not the right pace. We know how to control the pace.ʼ The two female salespeople were worried: ʻthe client 23

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demanded that we do this so we have to really push hard and [that she] didnʼt really know what this world was all about, but expedite our pace.ʼ The women remained very client-oriented. this is what [she] wanted to do for the rest of [her] life.” She took They knew that it was not possible to push the fund, but they a junior summer internship with Goldman Sachs and eventually could not confront the client,” Zhou said. accepted Morgan Stanleyʼs full-time offer the next year. After When Zhou considered her own future in business, she found working in investment banking and equity research with Morgan herself unsure if it were her ultimate goal. She considers the ste- Stanley for four years, she decided to return to business school. reotypes of women to be her biggest challenge—along with fears Her decision to return was fueled by her realization that she of acting according to her gender role. wanted to become a higher-level man“The challenge is the stereotype. When ager. After her acceptance into business others view you as a woman and assume school, Halphen was offered a position “The challenge is the that you are docile, that you are not tough on the research management team–constereotype. When and that you cannot carry out your responrming the “value [she was] going to get sibilities, that is the biggest obstacle. Some out of [her] MBA.” others view you as a women become frustrated and some womHalphen acknowledges the difculty woman and assume en cannot make it through. However, the in returning back to business school, but that you are docile, women who can overcome the stereotype sees it as a non-gender specic issue. also overcome their internal fears. What I “Making the decision to go to business that you are not worry about most for my full time position school is a really big investment—both tough and that you is how proactive I should be as a woman. from a time perspective and a nancial Will I be viewed with bias? Nonetheless, I perspective. So whether you are a man or cannot carry out your believe that when you overcome your inwoman, you have to believe that if you responsibilities, that is ternal fears, you also overcome peopleʼs are going to business school, you will the biggest obstacle.” biases, and then you can be successful.” make some sort of return on that investment,” Halphen said. --Yue Zhou Business School In regards to specic strengths espoused by women in the business environment, Much like high-level participation in the Halphen sees it as a diversity issue–parcorporate world, female enrollment in business schools ticularly in regards to raising diversity among an industry known stagnates around 30%. The Princeton Review at- for its “old-boy” framework. “I think diversity brings strength to tributes the low female attendance to the any team. I think teams are better at making decisions… when time conict between business school they are a diverse group. So whether you are talking about age and starting a family which raises range, gender, socioeconomic background, cultural differences, the high opportunity cost of the racial differences, I think teams and organizations that foster that MBA degree and the general sort of diversity across the gambit tend to be more successful,” fear of the intensely quan- Halphen said. titative nature of business With statistics reporting fewer top-level roles for women, school. the opportunities available to women are called into question. Isabelle Halphen, However, Halphen believes that this discrepancy might be beHarvard Business cause “a lot of women start to make lifestyle choices like startSchool Class of ing a family. There are men who make lifestyle choices as well. 2006, began her There are guys who say ʻI did banking for four years, ve years; career in nance at Iʼm not going back to that. I am not spending that kind of time Bank of America at the ofce anymore.ʼ But I donʼt think there is a difference in with a commer- the opportunities open to men and women; I think the difference cial banking in- resides in the choices that people make.” ternship during Halphen will be returning to Morgan Stanley next year. Her her sophomore expectations of her career can be explained by an exercise from year at MIT. her rst year leadership class, in which students were asked to She said that write a narrative of their own future. When reecting upon what she “com- she wrote then, Halphen stated that “when you think about your pletely fell in future, itʼs perfect or it should be, right? When you are at this love with it stage, you have to believe that the world is open to you and I and decided do believe that. To me, yes, I want to have a family and yes, I 24

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

want to make time for that, but I donʼt see a professional goal as unattainable right now because of any of my future decisions. I am prepared for whatever might actually come down the road, but again if I were to write about my future today, it would be perfect.” Managing Director and Beyond

back and asks ʻwhat has Janet Hanson been doing for the last twenty-ve years?ʼ it would be making sure that I pulled women up with me and that I always used my position, my platform, and my ʻvoiceʼ to help other women around me do the same thing,” Hanson said. Hanson sees women as an invaluable resource in any occupation. “Women,” said Hanson, “are extraordinary at being able to multitask, although the word ʻmultitaskingʼ would not pay full respect to everything I think women bring to the workplace. They can juggle so many different elements of their careers and lives and then integrate all those different pieces. They make brilliant consultants. They make brilliant bankers. They make brilliant re-

Undoubtedly, the upper levels of many investment banks are predominantly male, but more and more women are being given the opportunity to join the top ranks, and they have shown themselves more than capable. These examples demonstrate to younger women that success in the business world is possible, irregardless of gender. This then translates into fuel for the young- Women CEOs Among the FORTUNE 500 er generationʼs desire for advancement. Company Leading the way for women in business is Janet Hanson. CEO Hanson was the rst woman in Goldman Sachsʼ history to be Claire Babrowski RadioShack promoted to sales management. Since leaving her successful Brenda C. Barnes Sara Lee career at Goldman Sachs, Hanson founded Milestone Capital Dorrit J. Bern Charming Shoppes Zale Management, launched the 85 Broads network, and is now a Mary E. Burton PC Connection Patricia Gallup managing director at Lehman Brothers. Her busy day is split beReynolds American Susan M. Ivey tween her responsibilities as Senior Advisor to the President of Avon Products Andrea Jung Lehman Brothers, continuing in her role as Founder and ChairAnnTaylor Stores Kay Krill man of Milestone Capital (which today manages over $2 billion Jack in the Box Linda A. Lang in institutional assets), and overseeing the 85 Broads network, an Kathleen A. Ligocki Tower Automotive online global community which encompasses over 13,000 active Anne Mulcahy Xerox members. New York Times Janet L. Robinson When Hanson left Goldman Sachs to raise her two children, Paula G. Rosput Reynolds Safeco Lucent Technologies she felt “a complete disconnection from [her] professional life.” Patricia F. Russo Rite Aid Mary F. Sammons She started at Goldman Sachs at the age of 24, after attending Golden West Financial Marion O. Sandler Columbia Business School, and found herself dening her own Banta Stephanie A. Streeter identity in terms of her career. “That was the person I knew, so eBay Margaret C. Whitman once that identity was stripped away, I really struggled badly. Citizens Communications Mary Agnes Wilderotter I asked myself why anyone should nd themselves in a posi- Dona Davis Young Phoenix tion where they feel so disconnected and absolutely cut off from their professional identity and relationships. That was the pas- Source: FORTUNE (2006) sion and impetus behind launching the 85 Broads network,” said Hanson. The network provides a unique platform for women to connect with each other at every stage of their careers and lives, so that “no one will ever actually completely disconnect from whatever world they had been a part of,” regardless of their career focus, personal goals, background, or age. Hanson had few female mentors in her academic and early professional career, as she found “literally no one ahead of [her]”; consequently, she has made it her conscious effort to promote and support other women. She has always been grateful for her own advancement and makes the effort to start and end everyday by thanking those around her. Hanson has dedicated her career to helping other women nd their own passions and dene success on their own terms. “If anybody looks HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

Rank 423 111 641 715 992 280 281 786 692 551 142 557 339 255 129 326 940 458 768 666

25 25

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search analysts. They make brilliant anythings.” “are not going to accept a system that says you have got to wait Hanson suggested that two impediments to a womanʼs suc- ten or twenty years before we are going to give you signicant cess result when: “the men who most likely are in a position of leadership responsibilities. You are too smart, you are too dedipower or authority do not celebrate the unique characteristics cated, and you are not going to be willing to play the game of and talents that women bring to the table, failing to develop and ʻI am going to spend the next ten years in the mines just so that help ʻsponsorʼ their careers as they would with men” and when I might be in line to be promoted.ʼ” There is a serious “talent “women who are in a posidrain” out of the rms where there is a still tion to help other women a great imbalance between “traditional” cado not make the effort.” reer paths and a more integrated solution to Hanson believes strongly womenʼs professional and personal futures. “that while there are many “Women are going to vote with their feet. things companies can do They already leave to start their own busito better support women, nesses at a rate far higher than men. Your women themselves can level of tolerance for not realizing your full and should take many professional potential, not making personal positive steps to do this for decisions that are best for you, and not being themselves.” treated with respect for the value you are creCompanies overall are ating for your rm or organization is close to still trying to understand zero, and that is the way it should be.” how best to create a positive working environment The Frontier for women. Financial and professional service rms In todayʼs nancial industry, unlike prein particular, with grueling vious generations, women are being given demands and long hours the opportunity to succeed. The consensus, in many of their business however, seems to suggest that the level lines, need to focus on how reached by any woman in that environment this can be done within is based on her own drive—internal motivatheir organizations while tion is absolutely necessary for still achieving desired women, as well as their male More and more women are business results. “Creating counterparts, to succeed in the a positive working envifast-paced world of nance. Tobeing given the opportunity to ronment where both womdayʼs women have shown themjoin the top ranks, and they en and men can make the individual selves to be very capable of that choices that make the most sense for success. Twenty of the Fortune have shown themselves more their careers and personal lives is 500 companies currently have than capable. critical for rms in banking and law women CEOs, an increase of and medicine. This goes way beyond nine from last year. As that numbasic human resource policies and ber continues to grow, women programs. It has to become part of the cultural fabric and leader- will be motivated to strive for those top positions and to mentor ship values of the company. You have got to support your people those that follow them, creating a snowball effect that is bound in every single stage of their lives and careers, both women and to change gender equality in the workplace. men –women are still for the most part the caregivers and they It now appears that women can attain any role that they detypically make many more transitions in their careers than their sire, but what will really revolutionize the gender statistics in the male counterparts. They are the ones that are most likely to drop nancial services industry is when companies change their own out after having kids,” Hanson said. “Staying strongly connected practices to facilitate the careers of women. Providing simple with women throughout their careers, even after they leave their services as childcare would ease the conict between family and jobs or companies, is a challenge but also an imperative for these career. Not seeing a career and a family life as a tradeoff will altypes of rms.” low more women to enter the business world, knowing that they Although Hanson does not believe that equal representation do not have to compromise any of their life goals, be it business of sexes in the banking industry is something which can happen success or a family. Success for women, in contemporary sociin the immediate future, she remains optimistic about womenʼs ety, is really dened by choice, choosing your future knowing roles in business. In her opinion, women today are smarter and full well that no matter what you choose, you can achieve it. 26

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

A Leader in Corporate Governance An Interview with Congressman

Michael Oxley By Michael Lapsa

HCIM: What was the motivation for the Sarbanes-Oxley Act? Oxley: It started with Enron and then cascaded with the effects of WorldCom, which was four times larger than Enron in terms of bankruptcy cost. The horror that came out of Enron was huge. Large segments of the population viewed it as unfair that Enronʼs senior management knew to sell their shares before trouble began, while small shareholders held stock as the company fell apart. Many of these small shareholders lost their entire life savings in the collapse. There was a public outcry as a result of this, and Congress responded to the outcry. HCIM: Evidence suggests that this was a bipartisan initiative. Was it hard to get support for the act? Oxley: No, not at all. The bill passed the House Committee on Financial Services by a 3-1 margin, and then went on to pass Congress by the same margin. Furthermore, the Senate passed the bill by a vote of 97-0. Everyone realized that something had to be done. The seriousness of the scandals and the loud public outcry were enough to warrant a response from a great majority of Congress.

HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

Congressman Michael Oxley, a Republican representing the Fourth Ohio district, was first elected to the United States House of Representatives in 1981. Since then, he has served twelve consecutive terms and is currently the Chairman of the House Committee on Financial Services, which is responsible for overseeing Wall Street, commercial banks, and insurance companies. Originally a lawyer, Congressman Oxley chose to enter state politics first as a representative in the Ohio General Assembly. After serving nine years in Columbus, Oxley emerged victorious from a special election for the United States House of Representatives in 1981. Congressman Oxley has sponsored numerous legislative proposals regarding the way business is done in America since his first year in the House. For the 106th Congress, Oxley introduced the successful bill aimed at reforming the unfair and anti-competitive practices in the professional boxing industry. During the following congressional session, Oxley supported a bill designed to combat the financing of terrorism and other financial crimes. However, his most famous piece of legislation to date is the Sarbanes-Oxley Act, or more formally, The Public Company Accounting Reform and Investor Protection Act of 2002. Passed in the wake of the serious corporate scandals, like Enron and MCI/WorldCom, which rocked America’s business community from 20012002, the Act created stricter regulations for accounting and other corporate governance processes in an effort to improve investor confidence in capital markets. While the act remains popular with many investor groups, there have been serious complaints from small businesses across the United States. Small capitalization companies have cited the excessive costs of compliance as a serious problem with the new legislation. The most important part of the Act establishes a public agency, the Public Company Accounting Oversight Board, which is in charge of regulating accounting firms in their positions as auditors of public companies. The SOX Act also covers auditor independence, corporate governance, and enhanced financial disclosure. SOX is widely considered by some as one of the most significant changes to United States business and financial laws since the New Deal in the 1930s. More recently, Congressman Oxley sponsored several bills designed to amend confusing aspects of previous federal business legislation. During 2005, Oxley introduced a groundbreaking bill which clarified the permissible real estate brokerage activities under the Bank Holding Company Act of 1956. Congressman Oxley recently agreed to an interview with the Harvard College Investment Magazine during the 2006 Redefining Investment Strategy Education (RISE VI) Forum at The University of Dayton, where prominent members of academia and the business community met to discuss issues affecting the financial services industry.

INSIDE THE PROFESSION

HCIM: How much opposition did Sarbanes-Oxley face from small business owners?

ture? Oxley: Yes, I am worried, but not terribly worried. We have to remember that some of the differences in savings rates between Oxley: None, they basically caved on the issue. The busi- countries results from the way in which we measure savings. The ness community laid down, and that is regrettable to some ex- measurement does not account for the equity that is held in pritent. While the Senate was debating the bill, they passed many vate homes, and seventy percent of American equity is within amendments that should not have been allowed, and many of homes. The Japathese amendments passed because the business community nese on the other did not put up a ght. They should have worked to stop some hand hold their of these amendments, but everyone savings in more was so nervous after the scandals liquid forms. As that they were willing to let almost a result, accuWe have to remember any amendments pass. rate comparisons that some of the across countries HCIM: Do you think that Sarbanesare not necessardifferences in savings Oxley has restored investor conily possible from dence? the measurerates between ments that we countries results from Oxley: It has been a factor in restorhave taken. ing investor condence. In speaking the way in which we with investor groups, I have heard HCIM: You have previously addressed nancial measure savings. The them actually quantify the increase education. Do you think more economic and in condence. Additionally, many nancial literacy should be encouraged at the [low U.S. savings] CEOʼs have acknowledged that primary and secondary level? the law has made their companies measurement does not more transparent. This is denitely Oxley: Big time. Practical knowledge of nance account for the equity a good thing for restoring investor is huge. People who do not go beyond high condence. school need to know about the basic stuff like that is held in private balancing a checkbook. People as a whole are homes, and seventy HCIM: Do you think more has to be ignorant about basic economics, and ignorant is done to protect shareholder rights? the right word. If I were King, I would make evpercent of American eryone take Economics 101, but I am not going equity is within homes. Oxley: Yes. Like I mentioned earto be king so that is not going to happen. lier, the Sarbanes-Oxley Act has increased shareholder protection— HCIM: In looking at the recent Dubai port deal, however, there is much more work there seems to have been a conict between free to be done. For the most part though, these changes will be im- markets and the national interest. What level of government inplemented by the Securities and Exchange Commission (SEC). tervention should be allowed to protect the national interest? At this point, Congress needs to defer to regulators with regard to any additional reforms. Oxley: Well, I do not know if I would completely agree with that formulation of the conict. Since 9/11, security versus trade and HCIM: Some small business owners have complained that the foreign investment has been a tough debate. I think that the procost of oversight under the law is too high. Could you address cess works well as a whole; however, I was in the distinct minorthis? ity that did not agree with the controversy surrounding the port deal. The whole debate was a result of misinformation. Many Oxley: It is true that the costs have been high for small cap people did not understand the details of the deal. The Dubai rm companies. Probably though, the SEC is going to address this was only managing the ports, not owning them. We send a very through the small business committee. bad signal to the rest of the world by not allowing foreign rms to do business in the United States. Now, we run the risk of missHCIM: Are you worried about the low level of savings in the ing out on foreign investment, and the last thing we need to do it United States, and the effect this could have on the countryʼs fu- discourage foreign investment. 28

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

Managing Harvard’s Money An Interview with President and CEO of the Harvard Management Company,

Mohamed A. El-Erian By Alex Bayers and Jennifer Ying Lan

HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

n June 2005, Harvard University’s endowment rose to a record high $25.9 billion, making it the largest endowment of any educational institution in the world. To put this number in perspective, Harvard controls more money than many countries’ national income. Harvard’s bank accounts have over four times the size of the Bahamas’ GDP of $6.3 billion and slightly over Syria’s GDP of $25.7 billion. In the Spring 2005 issue of the Harvard College Investment Magazine, we interviewed Jack Meyer, the former President and CEO of the Harvard Management Company (HMC). Mr. Meyer’s recent departure generated a lot of interest regarding the inner workings of the HMC. Additionally, the controversy surrounding Harvard’s investment in PetroChina, who was accused of doing business with the Sudanese government in the midst of concerns of genocide, raised the public proﬁle of HMC to new heights. 29

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In early 2006, Mohamed El-Erian took over as President and CEO of the HMC. Originally established in 1974, the HMC’s primary goal is to manage the continuous growth of the approximately 10,700 different funds established under the university’s name. Most of the money which Harvard takes in through donors and investments is then reinvested again in order to solidify a continuous cycle of long-term growth for the university. Mr. El-Erian brings an exciting new outlook to the HMC, having previously spent years at the International Monetary Fund (IMF), Salomon Smith Barney, and the Paciﬁc Investment Management Company (PIMCO). Widely respected as an expert on emerging markets in developing countries, El-Erian hopes to continue HMC’s investment in these markets which “now have a larger impact on the global economy as a whole.” Having published on a wide range of economic and ﬁnancial issues, El-Erian’s expertise and investment performance landed him on Fortune Magazine’s illustrious “Real Mutual Fund Dream Team.” Recently, Harvard College Investment Magazine had the chance to sit down with Mr. El-Erian to discuss his experience with the HMC thus far and his vision of the future for Harvard’s endowment.

HCIM: Mr. El-Erian, you have an interesting background compared to your typical money manager. How was your career unfolded? El-Erian: I joined the IMF after my post-graduate studies in the UK. Being populated by PhDs, the IMF was a natural extension of my academic endeavors. But it also had an important practical side because the institution interacted with policy issues impacting the development of markets and the private sector. Next, I went to Solomon Smith Barney, now Citigroup, in a research position advising both internal and external investment managers. Then, I went into direct investment management at PIMCO, starting exclusively in emerging markets and then gradually encompassing other segments of the nancial markets. It was thus a natural step to go to HMC, which is an investment management rm involved in a broad set of asset classes. Indeed, the really exciting thing is that this move also completes a circle. Coming back to the academic world was a real attraction for me. The big shift in my career was going from an international public insti30

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tution to the private sector, and then moving from the sell-side to the buy-side, so going from Solomon to PIMCO. At Solomon, I tended to advise people on investments. By contrast, on the buyside, youʼre fully accountable for your decisions. You take full responsibility and ownership for the P&L--the prot and loss of every trade you come up with and execute. The move from PIMCO to HMC was not that different because the two institutions share important common characteristics. They are both large in their elds. PIMCO, at over $600 billion of assets under management, is one of the largest investment managers in the world; Harvard, at $26 billion as of June 2005 is the biggest university endowment in the world. They both have long-term investment horizons, are patient investors, and are full of very smart people. So, that move was less of a structural shift than the move rst from the IMF to the private sector and then from the sell-side to the buy-side. HCIM: Do you enjoy being able to broaden out and work with more types of investments and in more areas than just the emerging markets? El-Erian: I enjoy being able to work with more asset classes and doing so with colleagues who are specialists in each of these asset classes. Indeed, HMC has excellent people in timber, in private equity, in public equities, in real estate, etc. Itʼs a joy working with really smart people. Itʼs also a joy to interact with the broader Harvard community. Today, for example, we brought in professors to talk about issues we face in investment management and we received brilliant academic insight from them. HCIM: Do you see more of an attempt to broaden out to students in the future? El-Erian: Weʼre looking for smart insights wherever we can get them. Investment management is a difcult business. One of the advantages we have here is to be able to tap a smart community. SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

In addition to bringing people to HMC for discussions, the teaching that I am intending to do will afford me the possibility of also interacting periodically with students. Initially, the teaching will be at the Harvard Business School, with occasional events with undergraduates. HCIM: You mentioned being able to be a long-term investor. Can you comment on the pressures that might hurt other managers, and can you give some examples of Harvardʼs long-term investments?

HCIM: What trends do you see right now reected in Harvardʼs investments? El-Erian: This is a very uid world, and Iʼve talked in the past of how many traditional relationships no longer explain well whatʼs going on in global economic and nancial conditions. In this uid world, we see opportunities internationally going from the public markets—stocks and bonds—to what we call the private markets, where markets are still developing. So opportunities related to commodities and real estate in developing countries, helping companies go public in developing countries are all opening up as a larger number of countries climb up the quality ladder. At the same time, there are risks. Valuations are stretched in some areas and correlations are unusually high, so weʼre trying to take advantage of the opportunities and manage risks.

El-Erian: I think that the world itself is getting more short-term. The signicant ow of money into hedge funds, which tend to be more sensitive to monthly or weekly performance, has meant that the market as a whole is shortening its investment horizons. Hedge funds, as you know, are known in the industry as “fast Many traditional money,” and youʼve had a signicant shift HCIM: As you move over to investments of capital to that segment. in private markets, how do you make the relationships no So the industry as a whole is becomdecision to invest? ing more short-term, which means that longer explain well for institutions like HMC, that has by its El-Erian: We do it in the following way. what’s going on in construct a long-term focus, we can afford We rst identify an investment theme. to be on the other side of these short-term We then nd opportunities associated global economic and oriented trades. We can be the patient inwith that theme. We then ask the quesvestors in an increasingly impatient world. tion, “Do we have the expertise to do ﬁnancial conditions. That has resulted in our ability to exploit this internally?” We prefer to do things a number of opportunities that have eninternally for two reasons. One, itʼs much hanced the value of the endowment. For cheaper and, second, it provides greater example, weʼve established the best expertise in timber, and that transparency for risk management purposes. is inherently a long-term investment activity. You buy the forWe are now going through a period of transition followests, you cultivate the trees, and when it comes time, you sell ing the departure last year of highly talented internal managers either the trees or the forest. However, you have to be willing and who spun off from HMC to create a successful hedge fund called able, when you go into this area, to hold your investments for a Convexity. We are rebuilding. And as we do so, we will be using long time. You cannot suddenly decide to sell it overnight. There more external managers during the transition. are many areas like that which have served the endowment well. We take advantage of the fact that we have a long-term vision in HCIM: Do you see the alumni pressure to shift management a world thatʼs increasingly short-term. externally and operate more like Yale has, using outside funds, as overblown? HCIM: Does that relate to your criticism of various fund managersʼ focus on certain indices? El-Erian: We operate under the direction of our board, which is appointed by the Harvard Corporation. Itʼs very clear what our El-Erian: Thereʼs a danger in the industry of blindly following mission is. It is to maximize the return on the endowment in the an index. After all, several indices are arbitrary constructs, rep- most cost-effective way, taking into account risk considerations. resenting a snapshot of the world as seen by some. Many do not That is whatʼs guiding us day in and day out. In seeking to detake into account structural changes. If you look at the history liver on our mission, we ask “Whatʼs the best way of executing of HMC, one of the reasons why it has been able to deliver on this investment?” If we can do it internally where it is more costits mission of producing superior returns for the endowment is effective and transparent, we do. If we cannot, or do not have the because HMC has been ahead of the trends. Harvard went global expertise, we will hire external managers. well before it was fashionable to go so. Harvard went into the commodities well before it was fashionable to go there. HCIM: Ultimately, will this hiring process return HMC to where By denition when you go early into an asset class, it is not it was before? reected in the index because it hasnʼt been fully accepted by the industry as a whole. The danger of hugging the index is that you El-Erian: Part of what weʼre doing is rebuilding; part of what end up investing looking through the rear-view mirror. weʼre doing is reinventing. Itʼs going to take time to get back to HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

INSIDE THE PROFESSION

a situation where weʼre fully equipped to generate the returns of the past. After losing 33 people in connection with the Convexity spin-off, we initially identied ve senior hires that are central to the transition process. Once each comes in, they are expected to develop their teams subject to overall HMC quality considerations. If you look at the breakdown of the ve positions, three of them come under the rubric of strict rebuilding—i.e., replacing expertise that we had before. One is in domestic xed-income, one is in international xed-income, and one is on the external side. These are positions that existed beforehand. We also have the reinventing side of the transition. Indeed, as we are positioning the institution for the next 5-10 years, we examined which activities would become more important as the world evolves. These are new positions for HMC. For example, we went out and hired a foreign currency portfolio manager. This is a reection of the reality that international investments have become an important part of the endowment and are going to continue to be important as the world changes. HCIM: You have a lot of experience with investing in Latin America. Can you comment on the resurgence of nationalism and its effect on that regionʼs investment prospects? El-Erian: Itʼs becoming even more difcult to generalize about Latin America as there are two broad trends. The rst trend, which covers countries such as Chile, Mexico, and Brazil, involves orthodox economic policy management with emphasis on the social sectors and institution building. In the case of Mexico, it is being followed by a right-of-center government while, in other cases, like Chile and Brazil, it is being instituted by left-ofcenter governments. . The second trend, which is visible in countries such as Bolivia and Venezuela, incorporates less orthodox economic policies and a different approach to institutions. Then you have countries in the middle, and you can ll out the spectrum. For example, Peru is closer to the rst group and Ecuador closer to the second.

The countries that fall in the rst group, which have more predictable economic policies and more robust institutions, are offering HMC and other investors a greater set of investment opportunities at this stage. While on the topic, it is also important to note that, at HMC, we tend not to think in terms of regions. Instead, we come up with an investment theme then seek to identify where the enabling conditions prevail in terms of industries and countries. As a result, we end up being less region-driven and more driven by the set of opportunities. HCIM: What opportunities do you see for students upon graduation? El-Erian: They are growing as new parts of the world come into the mainstream, and as new instruments opportunities arise. Indeed, students now face the prospect of a greater spectrum of interesting activities in the nancial sector. And they call for interesting mixes of expertise. Indeed, when we look to hire people at HMC, we assess the extent to which a potential new hire would also contribute to our understanding of new issues, drawing on their training and their education. Harvard students are exposed to a wonderful toolset while at the university, thus enhancing their opportunitys in a uid world. HCIM: Are there any unorthodox skills that are not associated with nance that you nd yourself looking for in candidates for various positions? El-Erian: Finance has become even very complicated. It is not just an issue of identifying an activity and analyzing. It also involves structuring and rened instrument development and selection. To excel in such a world, you need to have four qualities: a solid grounding in micro and macroeconomics; strong skills in math and statistics; solid grounding in legal issues; and nally, street smarts. Building a successful organization is combining these four skills. You hardly ever nd all four in one person. The key issue is to combine all four.

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

An Interview with Dr. Daniel Daianu, Former Romanian Finance Minister

INSIDE PROFESSION Romania’s former Finance THE Minister and current Professor of Economics Dr. Daniel Daianu is a graduate of the Harvard Business School. As Finance Minister during 1997-1998, a period when Romania underwent some of its ﬁrst and most important democratic reforms, Professor Daianu helped oversee groundbreaking changes to the Romanian economy. Between 1992 and 1997 Dr. Daianu was Romania’s Central Bank Chief Economist, Deputy Finance Minister (1992), and Chairman of the Organization for Security and Cooperation in Europe (OSCE) Economic Forum (2001). Currently, he is an economics professor at the School of Political and Administrative Studies in Bucharest, the Chairman of the Supervisory Board of BCR (the largest Romanian commercial bank), and a distinguished member of the Romanian Academy. Among other things, Dr. Daianu has taught at the Anderson School of Management (UCLA) and UC-Berkeley. He is also a former President of the European Association for Comparative Economic Studies (EACES). One of his most recent publications is “Ethical Boundaries of Capitalism” (Ashgate, 2005), which he co-edited with Radu Vranceanu.

ROMANIAN FINANCE HCIM: Professor, what were your responsibilities as the Minister of Finance and what were the major economic changes which you undertook? Daianu: I began my mandate in December 1997 when the economy was plunging. The GDP had gone down by 6.6% in 1997 and fell even further by 5.4% in 1998. Let me put in a nutshell what lay behind that dynamic. At the end of 1996 (an election year) the monthly ination rate reached almost 10% and the reserves of the Central Bank (NBR) were circa 700 million USD (less than one month of imports). Although Romania had borrowed more than 1.5 billion USD in the past 18 months, the budget decit and the current account decit were rising menacingly whereas there was a lot of rot in the banking system. The new government, which was formed in December 1996, had to undertake a series of painful reforms –such as price liberalization, the cut of subsidies, and a much freer foreign exchange market, in order to stem the depletion of central bank reserves and limit external decits. It is true that the “medicine” delivered to the patient was quite sour, and I concur with the view that the monetary program could have been designed better; but, in retrospect and having in mind the crisis that engulfed many Asian economies in the late 90ʼs it appears that that program helped Romania avert a very bad nancial crisis. For there is a hell of a difference between having about 700 million USD as central bank reserves at the beginning of the scal year compared to the more than 2.5 billion USD that the NBR had in the second half of 1997. The program of liberalization and very tight monetary and budget policy led the economy into a downfall, which continued for several years. My major concerns were to construct a realistic public budget, in spite of constant bickering among the coalition partners, and maintain a working relationship with the International Financial Institutions (IFIʼs). I said no to several major HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

projects proposed By Alexandru Manaila-Maximean and Kuanysh Y. Batyrbekov by my government, including the acquisition of a multitude of military aircraft from Bell Helicopter, though an off-set component gave the misleading feeling to most that it was not a terribly costly project. Actually, that purchase would have cost Romania more than 2.5 billion USD. The payment was not to be done instantaneously, but at a time when my country was put on a watch list by rating agencies (because of heavy external payments due in 1998 and 1999 and the fallout from the Asian crisis), a less prudent stance would have been irresponsible on my part. I did oppose the opening of the Treasury Bill (T-bill) market to foreigners for I considered that premature. Both as an NBR ofcial and, later, as a Minister, during discussions with IMF people, I voiced my disagreement to opening Romaniaʼs capital account at that stage. I would remind people that that policy move, which was favored by the IMF and international nanciers at the time, proved to be fatal to some Asian economies. The IMF itself had to revise its stance on this issue later on. I did strengthen the dialogue with the National Bank for the sake of a more coherent macroeconomic policy. I fought granting state guarantees to all kind of deals which would have clobbered the public budget. My demarche was to harden the budget constraints in the overall economy as much as possible, for both public and private companies. Last but not least, I tried to bring new blood in the Ministry, to instill a new sense of public service and the conviction that enlightened and effective public policy needs a solid intellectual base. I had the aim of enhancing economic policy ownership at a time when intellectual dependency on IFIs among domestic policymakers was, frequently, overwhelming. I fostered a candid dialogue with media, so that my fellow citizens were informed correctly about our policy. Unfortunately, I did not benet from sufcient political sup33

INSIDE THE PROFESSION

port and, arguably, I did rufe many feathers around. Ultimately, I was forced to quit the Government. HCIM: What have the growth patterns of Romania been like during the last 16 years, and where do you think Romania is going economically and politically in the context of EU integration?

INSIDE THE PROFESSION

lenient when it comes to a string of weaknesses: corruption and functioning of the judiciary, security of borders, protection of the environment, food safety, and agriculture. Since then, some progress has been achieved, but still much has to be done. The EU offers Romania a historic chance to overcome the trap of backwardness. I say this because sustained rapid econom-

The EU offers Romania a historic chance to overcome the trap of backwardness. Daianu: Local late-Stalinism, in tandem with a lower level of economic development compared to other Central European countries, had an important bearing on Romaniaʼs transition, on public policy and the functioning of public administration, and on the performance of political elites. This is mirrored by economic dynamics. Romania went through two boom and bust cycles during the past decade. The transformational recession in the very early 90ʼs was a common feature among European post-Soviet command economies, but the second downturn in Romania could have been avoided had proper policies been put in place. I am not talking here about ideal policies, for nobody is infallible. But, better and more consistent policies could have been implemented. I should mention that all other Central European transition economies avoided a second boom and bust cycle. Romania relies on heavy remittances in nancing its trade decit; more then 1.5 million Romanians work abroad and they send over three billion euro back home yearly. These fellow citizens are the counterparts of the many millions of Spaniards, Italians, Serbs, Croats, Portuguese, etc. who worked all over Western Europe in the decades after the second World War. They are the proof of the benets of European integration. Thus, de facto, Romaniaʼs labor market is integrated in the European Union, in spite of the Boelkenstein Directiveʼs restrictions. Infrastructure is a developmental bottleneck. Together with insufcient spending on education, it will hinder longer term growth. There are substantial EU funds and privatization receipts, but these resources need to be capitalized on by good projects and good practices. The logistics of the utilization of EU funds is a formidable challenge for the Romanian government. The years of 2007 to 2013 is, probably, the period with the largest EU budget funding potentially available to Romania. The Lisbon Agenda constraints plus the tensions between donor and recipients countries will likely reduce the funding after 2014. Unless Romania proves that it can absorb EU funds adequately, long term prospects for nancial assistance will worsen. HCIM: In your opinion, what impact will the EU reforms have on the Romanian economy? Could you discuss some of the major economic and political reforms imposed on Romania? Daianu: Romania will join the EU as one of its poorest members and as an emerging economy with pluses and minuses. The EU country report of October 2005 states that Romania has a functioning market economy and a quintessentially liberal democratic polity. It acknowledges substantial progress in most of the areas which make up the Acquis Communautaire. But the report is not 34

ic growth, or what is called ʻcatching-upʼ in current economics parlance, is a rare phenomenon. In Western Europe, Ireland is the most interesting case. However, its case should not be overstretched. Spain and Portugal saw positive, though less spectacular, developments after the end of the Franco and Salazar dictatorships (Spainʼs case, in my opinion has more relevance for Romania, including its exceptional absorption of EU funds). The so-called miracle economies of some Southeast and East Asian countries provide notable lessons as well. In general, the experience of economic development demonstrates that the “catechism” of post-communist transformation - privatization, liberalization, and stabilization - is not sufcient enough to explain nor ensure sustained rapid growth. I should stress, too, that the EU has been going through hard times for several years now, and that the skies are not clear ahead; there is mounting resentment in the western part of the EU vis-avis new entrants and their conspicuous economic dynamism. It is worthy to notice that Central and Eastern European economies have GDP growth rates that have averaged above 5% annually in this decade, whereas the EU15 growth rates have been, on average, below 2%. Demographics and sclerotic welfare systems in many of the old EU member states, where bulging budget decits exist, concoct a bad cocktail for combustion regarding the Unionʼs overall dynamics in the years to come. In addition, we witness the extraordinary economic rise of Asian economies (China, India, etc.) that is bringing about tectonic shifts, though gradually, in the world economy. When the French economist Jean Paul Fitoussi talks about “Impotent Europe” (Lʼ Europe de lʼimpuissance) he does not have in mind the US economy only as a benchmark, but implications of the rise of the new Asian heavyweights as well. Against this changing international background, Romania is to join a Union that is vacillating, in several regards; a Union that is seeking an exit from seemingly un-tractable social and economic gridlocks and a Union that is facing the challenge of managing increasing complexity. Romanian public policy has to be clairvoyant and pragmatic. We need to be able to understand the variable geometry of the Union, its current and future problems. Likewise, Romania has to understand that the world does not start and end at the gates of the Union. Looking at Romaniaʼs EU accession prole, one notices some very particular features. Romania has a per capita income that is roughly 30% of the average in the EU (in purchasing power parity terms), while the population (circa 22 million) is large as to the average nation in Central and Eastern Europe. There is an unusually high percentage of rural population (35% of the total) and share of farming in overall economic activity; the costs SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

of upgrading the energy sector and of environmental protection region? plus the costs of overhauling the social security system are also pretty high. Additionally, Romania needs to achieve an adequate Daianu: Greece, Italy, and Austria (in particular) are major ecodegree of nominal convergence (according to the Maastricht cri- nomic players in Southeast Europe. As a matter of fact, Austria teria) which is supported by continuous real convergence. All is the largest investor in Romania, with big stakes in strategic these tasks require effective public policy, which in turn depends sectors –such as oil and banking. Austrian banks are very aggreson good public administration and sustained economic growth. sive all over the Balkan region and leading companies from BalBut, as Romaniaʼs transition indicates quite clearly, public admin- kan countries intend to be listed on the Vienna Stock Exchange. istration itself is in need of deep reform. Hopefully, the EU can Whether Bucharest could turn into a nancial hub for the region assist Romania in this area as well. Here, another note of caution is an open question; the answer depends on Romaniaʼs future is warranted: transformation and development could be easily economic development, inside the Union. Sustained economic solved if policymakers and private entrepreneurs could simply growth, overall modernization, nancial deepening, and growing plant adequate, progressive institutions in economic ties with the neighbors would unfavorable environments; thus, changing enhance such a status. social and organizational networks and inWhether Bucharest could frastructures almost overnight. HCIM: What are the prospects for Investturn into a ﬁnancial However, institutions cannot be “purment Banking (particularly M & A and hub for the region is chased,” nor can they be assimilated inIPOs) in Romania? stantaneously. They are in themselves a an open question; the local socio-historical outcome. And still, Daianu: Joining the EU and economic answer depends on being in the Union can make a tremendous ʻcatching-upʼ involve an ongoing process difference, for the general good. As the of restructuring and of corporate “blendRomania’s future economic Earth draws its energy from the Sun, so ing.” Think about the emergence of redevelopment, inside the could Romania draw upon the energy of gional companies in Central and Eastern the Union (however weakened it currently Europe in an area of the European Union Union. is) in order to modernize its institutions that will continue to be its most dynamand economy. Growth theorists would call ic for years to come. Make a guess why it jumping on a superior development path and joining a superior Unicredit, Raiffeisen, Erste Bank, etc. have made big inroads in cluster of societal aggregates. Romania. These are strategic investments that are underpinned by great prots (take a look at return on equity numbers for most HCIM: Do you think that joining the European Monetary Union of these investments). Investment banking has an obvious role and accepting the EURO will prove to be benecial for Romania? to play here. What are the positive and negative aspects of joining EMU? HCIM: What advice would you give to a student or young profesDaianu: There is some ways to go until Romania can join the sional who wishes to pursue a career in public service? Euroland. First, the Maastricht conditions have to be observed, although some of them are disputed among economists. For in- Daianu: One must be very solid professionally. Learn not to sucstance, very low ination rates are very hard to achieve in econo- cumb to paradigmatic fundamentalism. Be pragmatic and keen mies where the Balassa-Samuelson effect is substantial –espe- to learn from more experienced people. Understand also that cially in these so-called ʻcatching-upʼ economies. Some of the economics has to be embedded socially –as Marc Granovetter Maastricht criteria (budget decit, size of public debt) can easily would argue strongly. A good mastery of graduate textbooks is be met by Romania: our decits have been below 1% of GDP in ne, but is not sufcient in order to become a good public policy the last couple of years and the public debt is around 25% of GDP. practitioner. On the other hand, good professionals do not earn On the other hand, Romania still has too high of an ination rate handsomely in the public sector when looking at the pay in the (though in the single digits) and high interest rate differentials. private sector. Consequently, there is an additional ingredient for Romania has to reveal a solid record of macroeconomic stabil- those who decide to spend time in the public service, apart from ity and the ability to weather powerful adverse shocks before it gaining some inside knowledge. It is the desire to help your felcan contemplate joining the EMS. Unless domestic markets are lows, your country. This is a lofty moral value which, unfortusufciently exible and productivity gains adequate, a premature nately, is increasingly scarce in our societies. Let us hope that accession into the EMU would cause much pain. The case of more than a few young individuals do have the power and the Italy showed this amply enough. 2012-2014 is the time frame dedication to shun cynicism and obnoxious egocentrism and mathe National Bank of Romania has in mind regarding when to terialism. I do see bright Romanians who return home, though join the EMU. the number of those who leave is pretty high. This gives me the optimistic hope that Romania will not stay as a large and poor HCIM: Since Romania is the largest country in the Balkan re- periphery country on the outskirts of the European Union over gion, do you see Bucharest becoming a nancial center for the the long run. HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

INSIDE THE PROFESSION

His License Plate Says My quest to learn from America’s billionaire investment hero,

Warren Buffett hat do Fidel Castro and Warren Buffett, the worldʼs second richest man, have in common? Probably nothing, but if it were not for Fidel Castro I would have never have had the idea of setting up a trip for 33 students to meet with Warren Buffett, Chairman of Berkshire Hathaway Corporation. Prior to spring break one year, my cousin proposed the idea that we visit Cuba, one of the last remaining Communist countries in the Western Hemisphere. He asked something that piqued my interest: “Why donʼt we try to meet with Fidel Castro?” Meeting a dictator? Interesting, but I replied that I rather meet someone like, well, Warren E. Buffett. If you are passionate about music, you would probably want to meet Aerosmith. If your thing were motion pictures, you would probably want to meet Steven Spielberg. My interest is business and, in particular, investing. The process of researching a business and learning what makes it better than its competitors — and in the process, making a couple of dollars as the stock price increases — is something which is fascinating. After a few e-mails to Buffettʼs staff, I was amazed to nd myself standing in his lobby in Omaha, Nebraska, waiting for him to see us. I looked to my cousin and said, “What do we say?” Being helpful, he responded, “This is your thing.” But before I could react, Warren Buffett popped out and said, “Aww…the Aggie invasion.” We all laughed that Buffett knew Texas A&Mʼs students are known as the Aggies; but more importantly this took a little of the nervousness out of the air – on our part at least. After that initial meeting, who would have thought he would invite us back, along with 30 of our fellow students? That November, we headed to Omaha for a whirlwind 24-hour trip that opened my eyes to the world of a humble, thankful man whose license plate reads “THRIFTY” — the same man whose investment strategies have made him the second wealthiest man in the world. Integrity Not only did we meet with Buffett, we also met with people 36

from the Berkshire Hathaway companies, Nebraska Furniture Mart and Borsheimʼs (the largest single-store independent jeweler in the nation). One of the biggest themes we were inundated with was the critical essence of integrity and how important it is to the culture of Berkshire Hathaway. As Susan Jacques of Borsheimʼs told us, “It takes 37 years to build your reputation, and you can lose it in 37 seconds.” She said she thinks about this every time she is about to make an important decision. While we students were eating lunch with Buffett that day in his favorite steakhouse in Omaha, Goratʼs, he told us what he tells all of his managers: only make decisions that you wouldnʼt mind reading about in the newspaper the following day. He said to act as if an unbiased reporter stood next to you as you made your decisions. He guaranteed that we would avoid most of the problems that plagued todayʼs white-collar criminals if we thought like this. He sure does!

Q: What do you stay away from when valuing a company? Buffett: What I donʼt understand. Get a x on your own limitations of knowledge. Ted Williams [the only Major League Baseball player to hit .400, or a 40% success rate, over an entire season] divided the strike zone into 77 areas. You only swing at the pitches you can hit with an average of .400. Also, I donʼt want to know the price of a stock as I value it. Knowing the price anchors your thoughts. Q: What is the more valuable area of academic study, accounting or nance? Buffett: Accounting is the more valuable. It is the language of business… A number of CEOs donʼt understand accounting. Some people have an intuitive grasp, [but] some people will try to cheat you and lie to you. Q: Explain your business evaluation criteria.

Thankfulness Itʼs funny. Buffett, with his loads of wealth, was able to make a bunch of cash-strapped college students feel just as wealthy as him; albeit, in a different kind of way. As we were walking out of Goratʼs, Buffett said he really wanted to show us his car. Immediately, the students began thinking: What kind of car does Warren Buffett drive? The newest Hummer or a limo waiting to pick him up? Not exactly. Buffett drives a simple Lincoln Town Car. What he wanted to show us was his license plate, with the word “THRIFTY” emphasizing his philosophy. It is quite amazing that someone with his wealth and power realizes just how lucky we, as Americans, are. You might think that someone of his social stature is careless with his material possessions and nancial status. Not Buffett. As he said, “If I were born in Bangladesh 200 years ago, I would have been

Graphic: YiDing Yu for Harvard College Investment Magazine

By George Giannukos, Texas A&M University

someoneʼs meal.” Buffett strongly believes that his ability to allocate capital and manage valuable businesses would be worthless in another country at a different time. As he likes to say, we won the “ovarian lottery.” According to Buffett, his odds of being born in the United States in 1930 were 50 to 1. Buffett explained that when we were born, we pulled quite a valuable lottery ticket: We live in a

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

Buffett: Where is this business going to be in 5 to 10 years? What is the moat? What protects it? With Coca-Cola, the moat is the brand name in the mind. Seeʼs Candies [a Berkshire Hathaway company] owns the boxed chocolates business in California and has been there since 1921. A boy buys a box of chocolates, and she kisses him: We own him. Other examples of moats: Microsoft operating systems; and Meg Whitman [CEO of pioneering online auction company eBay Inc., who] has all of the buyers and sellers. Businesses with moats are easy to value. How do you knock off Wrigley? — the Internet doesnʼt change the way people chew gum. Q: What biography would you recommend? HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

society where we have equal human rights, educational opportunities, and the invaluable chance to make it big. Business Advice What would our visit with the worldʼs best businessman be without business advice? He did not offer us any stock picks, but I we left with great great advice. Buffett told us to invest “within our circle of competence.” The idea is simple, but makes a lot of sense. Many entrepreneurs and investors will invest in unfamiliar industries. Warren believes that the inherent risk in investing comes from not knowing what you are doing, not the volatility of the stock price. Buffet tries to reduce this risk by staying within his circle of competence. As Buffett says, “Itʼs not important how big your circle is or how many industries you are familiar with but that you dene and know where the perimeter is.”

Buffett: The question is, who are your heroes when you are 15? This is a strong indicator of future success. Katharine Grahamʼs autobiography is very honest and very interesting. She ran The Washington Post. She had a strong will…and felt it was important to succeed. Q: What other books do you recommend? Buffett: “The Intelligent Investor,” chapters 8 and 20 provide the framework. Also, read about a lot of businesses. Philip Fisher is another good author [ “Common Stocks and Uncommon Prots and Other Writings”]. You need to like reading annual reports and related information. Look for businesses you understand. You need to know enough about the business to be a good scorekeeper. Q: What is your denition of a capitalist? Buffett: A capitalist lives off of prots, not labor. If I was born in Bangladesh or 200 years ago, I wouldnʼt have been successful. Imagine yourself 24 hours before your birth. A genie comes to you and says, “John or Joan, you will be bright and fair-minded. I will let you design the world into which you will be born — the economic and social conditions for you and your descendents.” John or Joan replies, “So, whatʼs the catch?” The genie then states, “From the jar pick a ticket. There are six billion possible tickets.” The tickets have information on them such as male or female, U.S. or Bangladesh, physically t or crippled, nurturing parents or abusive parents. Your lottery ticket matters. Take the example of the sport of boxing. In the 1930ʼs, Madison Square Garden held 30,000 seats. Now, due to cable TV, 190 million people can watch the boxing match. The boxers benet due to the size of the audience — i.e. [the lottery of] when they were born. 37

INSIDE THE PROFESSION

We won the ovarian lottery. In 1930, the odds were 50 to 1 against being born in the U.S. I was also born to parents who cared about me, given good health and a good mind. Q: What is your view on social responsibility? Buffett: In 1790, there were 3.9 million people in the United States, 100 million in Europe and 190 million in China. We succeeded because we had a better system, not because we have better morals or are smarter. The talent prole of the population does not t the job requirement prole. People in the right place should take care of people who canʼt succeed. Q: Explain your take on tax fairness. Buffett: I spend $2.2 billion on the federal government [annually]. What should tax policy be? The “haves” should pay the lionʼs share. I have the same tax rate as my receptionist when you include social security. I am wired a certain way and I get benets. I do not agree with [President] Bush at all. We [the wealthy] donʼt need any more favors. Bill Gates also agrees with me. I prefer liquor store robbers with hungry kids to companies that locate offshore to avoid U.S. taxes.

One way to lead is to work harder than anyone else. A good rule is that the ofcers eat last, and the enlisted eat rst. Air Force General Curtis LeMay said, “I will y the lead plane, and I will court martial anyone who wonʼt y.” The leader takes the biggest risk but demands compliance. Q: How will business fare in the stock market over the long term?

Buffett: Four to six percent is the typical range for corporate profits as a percentage of GDP. This is unlikely to change. Over the last four or ve years, the market has returned six or seven percent. Over the last 35 years, it has returned ten percent annually. Seven to thirteen percent is pretty much the expected range. The market returned between seven and thirteen percent exLeaders should actly one year over the last 35 years. [I] have a passion conclude that investors are much more volatile than businesses.

for their

business... That people are

Q: Whatʼs your view on the capital asset pricing model (CAPM)?

Buffett: CAPM is still taught in schools. The weakness is that it assumes efcient markets. The popularity is fading, but it a leader implies still persists — priesthoods are like this. that the leader is It was very acceptable in the 1960ʼs: Allocate capital, what is the most atcompetent. Q: Who should have stock options? tractive thing to put our money in? If the smartest thing isnʼt that smart, then Buffett: Charlie Munger [vice chairman of we donʼt play. We donʼt want to give up Berkshire Hathaway and close associate of Buffettʼs since the cash exibility. Good businesses offer offensive decisions; bad 1970s] and I are the only employees who should work for stock businesses offer defensive decisions. Switch to offensive busioptions. No one else has control over the company strategy. nesses for a signicant edge.

willing to follow

Q: What qualities do you look for in business partners and coworkers? Buffett: I misjudge them sometimes, but rarely. It is easy to recognize the extremes; I can tell the outright crooks. You want to develop the qualities you like in other people. Consider which of your classmates would you choose to go long on [buy] ten percent of their earnings? The one with the best grades? — Probably not. You will probably pick the person who is the most generous and the most honest. Conversely, think of who you choose to go short [sell] ten percent of their earnings. Q: How does someone become a good leader? Buffett: Leaders should have a passion for their business; they need to be able to energize people to march with you because they believe in you. I like Arnold Schwarzenegger as a leader. Berkshire Hathaway has a strong and unusual culture… That people are willing to follow a leader implies that the leader is competent. 38

Q: Any advice for students entering the workforce? Buffett: What train are you getting on: U.S. Steel or Microsoft? Donʼt work for somebody whoʼs crummy. Q: Who are the right heroes? Buffett: My heroes are: My dad — parents are everything in the formative years; Melinda and Bill Gates; in raising three kids, my wife; Tom Murphy, who ran Capital Cities ABC [Murphy purchased ABC in 1985 with Buffettʼs backing]; Ben Graham [co-author, “The Intelligent Investor”]; somebody who makes you behave better. George Giannukos ʻ06 is an Accounting major at Texas A&M University. He started investing at the age of sixteen. He aspires to build an empire and told Warren Buffett that he hopes to have a mini-Berkshire Hathaway some day. With a greater interest in making beans (than counting them), he hopes to break into the nance industry after he graduates. SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

Bilimoria: The Entrepreneurial Einstein The story of Cobra Beer as told at the Said Business School, Oxford.

he link between academia and successful entrepreneurship has notoriously been an insubstantial one. Indeed, most of the worldʼs most thriving businessmen have come from the lower echelons of society attaining very mediocre school grades. Yet, these men have ended up commanding international billion dollar enterprises. We only have to look at the case of Sir Alan Sugar who left school at the age of sixteen and started out selling products such as cigarette lighters, intercoms, and TV aerials. Now Sugar is the owner of Amstrad, one of the biggest providers of consumer electronics which at its peak achieved a stock market valuation of £1.2 billion and is now the famous face of the hit-UK show version of ʻThe Apprentice.ʼ Yes, the case for non-academic aspirations grows stronger, yet fear not my fellow soon-to-be poor college grad pseudo-Einsteins. There does exist a man who has managed to get the best of both worlds… Recently, Oxford Uni- Bilimoria’s Tempranillo wine the Silver Medal versityʼs Oxford Entrepre- isat awarded the prestigious Monde neurs (OE) brought one Selection 2005, Brussels of their founding patrons, Karan Bilimoria, the Founder & CEO of Cobra Beer to the Said Business School to talk about his journey as an entrepreneur. On that fateful day, upon entering the Said Business School, a large, intimidating building, there was a large crowd of smartlydressed students and smatterings of conversation which mainly consisted of ʻDo you think weʼll get free beer afterwards?ʼ We all entered the lecture theatre where Bilimoria was to give a talk on the inspiring and life-changing work he was doing with beer. After the President of Oxford Entrepreneurs, Rajeeb Dey, made an introductory speech and welcomed Mr. Bilimoria to take the oor, we got our rst glimpse of Mr. Bilimoria. When you rst catch sight of Karan Bilimoria, you may not immediately conclude that he is a man who has achieved the apparently impossible feat of conquering both the academic and business worlds, but rest assured, he has. Mr. Bilimoria was born in Hyderabad, India in 1961 as the son of a Lieutenant in the Indian Army. He attained his rst degree in business before the age of nineteen and then immigrated to the United Kingdom to try his luck and improve his fortunes. He obtained a diploma in accounting from London Metropolitan University and then joined Ernst & Young as a trainee chartered accountant in 1986. Not surprisingly, the tax and audit ofce HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

By Devina Shah, Oxford University could not contain him and his desire for learning propelled him to return to full time education and to read law at Cambridge. After graduating as a lawyer, Bilimoria decided that despite his intelligence and highly-regarded qualications which all seemed to be pointing to a professional career in law or banking, he was going pursue his longtime ambition of running his own business. He returned to India to spend some time with his family, and after some unsuccessful attempts at importing and exporting random non-beer-related items, Karan founded Cobra Beer Ltd in 1990. To this day, Bilimoria stresses the importance of passion in a successful business but then again, it does not really seem that difcult to be passionate about any kind of alcohol. What fueled Bilimoriaʼs desire to produce a new kind of beer was his recognition of an increase in a new kind of food: curry. Curry houses and Indian restaurants alike (although they really are not alike), were fast becoming the most frequented places to eat out in England. Bilimoria possessed the ingenuity to recognize that there was an opening in the market of a country where people loved both beer and curry but did not digest them together. The result was a vision of an Indian lager that would not only complement Indian cuisine but also due to its unique chemistry, appeal to ale drinkers. When Karanʼs parents discovered that their son was going to quit the profession of law before he had even started, they were inevitably shocked. Yet, he pursued his vision. Bilimoria described the strenuous rst few years of his business as involving him physically transporting crates of Cobra Beer and attempting to sell it to various Indian restaurants in Birmingham and London where Asian communities were particularly populous. 39

INSIDE THE PROFESSION increase in prots in the rst year after the successful television commercials, but which also took the marketing world by storm through its artsy, fun and witty vibes. Karan Bilimoria, who is intimidatingly tall and stocky, was as amiable and charming face to face as in his speech. He took an active interest in what students were saying about the importance of shedding cultural conventions which seem to tie down many bright young minds to stable and professional city jobs. So, what is it about academia that so often does not lead to glory and billions? Is it the fact that as academics, we are too analytical and not practical enough in our thinking? Does too much information impede on the fragile senses of intuition that so many great entrepreneurs attribute their success to? Sitting in a room surrounded by intelligent and creative peers, these questions which Karan Bilimoria had raised were of no slight signicance. Judging from Mr. Bilimoriaʼs advice, it seems that an academic mind-set is always needed no matter oneʼs age; however, when situations call for taking leaps and following it up with hard work, maybe it is worth it to make that jump. Devina Shah ʻ08 studies English Literature and French, Joint Honours at Wadham College, Oxford University. This upcoming school year, she will split her year between Paris and Lyons. Currently, she is considering what she would like to pursue upon graduation and her options are disparate, including journalism, investment banking and postgraduate studies in the US.

Quantitative Equity Analyst MDT Advisers is seeking a few very talented individuals to join its core investment management team. These individuals will contribute to all aspects of our investment process including software development, investment research, and portfolio management. Qualifications:

• A recent bachelorʼs degree from a top school with an outstanding record of academic achievement. • Solid background in several quantitative disciplines such as finance, economics, statistics, computer science, and operations research. • Strong programming skills. Experience solving complex problems in the C language a plus. • Excellent oral and written communication skills. We offer an extremely competitive compensation package, an intellectually stimulating work environment, and a convenient Boston area location. This is an outstanding opportunity for individuals with a willingness to work hard and a genuine desire to excel in the investment management business. For additional information, please visit our website www.mdtadvisers.com. Please forward resumes or questions to Kelly Patel at careers@mdtai.com.

R B ussian

usiness

ummit

Once in a lifetime opportunity for students to interact with Russian executives at the top of their fields Explore Hidden Opportunities Expect the Best Find Yourself in Russia MOSCOW JUNE 2007 For More Information:

RBS@harvardinvestmentmagazine.org SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

GET RICHQUICK US Firms Look to India’s Property Market for Risky Get-Rich-Quick Schemes By Vivek Kuncham

Growing Demand for Property Investment Whether in the political capital of Delhi or the informationtechnology hubs of Bangalore or Hyderabad, the property market in India is fast emerging as a lucrative investment opportunity. Long overshadowed by the ʻdotcomʼ boom, the underdeveloped property market in India is beginning to attract institutional investors, particularly foreigners. According to a recent study done by The Economic Times, Indiaʼs leading nancial newspaper, the current market demand for property is estimated at over two billion dollars. The renewed appeal of Indiaʼs property market has been driven by three factors. The rst cause of this enormous demand is the rising afuence of Indiaʼs middle class within Indiaʼs growing consumer market. Nationwide consumption has grown with increasing wealth and low interest rates, which has led to a higher demand for shopping malls, movie theaters, and entertainment centers. Moreover, annually 200 million homes are needed when only 179 million currently exist, leaving a shortfall of over 20 million homes. Each year, approximately 4.5 million new homes are constructed, but this number is only enough to barely cover new demand and does nothing to relieve the existing shortage. Providing work space for the two million new university graduates this year will also require an estimated 100 million square feet of additional ofce and industrial space.With this rapidly growing population and developing education sector, demand for housing and ofce space has never been so high. The second cause of growth in the property market is Indiaʼs booming economy, which is growing at a remarkable rate of 8% per year. Indiaʼs evolution into a focal point for global outsourcing has increased the demand for industrial and ofce space to cope with the expanded production facilities and the millions of new jobs which have been generated. Economic growth in India appears sustainable, and according to a United HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

Nations report in March, it should last for at least another two years. Further demand for investment, specically foreign investment, comes from a change in the general attitude of Indian rms. Firms are now looking not just for capital but also for technical knowledge and foreign expertise. Many regionally centered rms are also looking to branch out with the aid of foreign capital. The greater inow of foreign direct investment has particularly affected real estate rms since they previously received only a relatively small proportion of foreign investment. Complications: India’s Legendary Red Tape So, why havenʼt foreign seized this opportunity to if demand

companies already invest in India is so high? One reason is that strict property laws have made it difcult for foreign investors to undertake any desirable projects. These property laws were passed in response to the 1997 economic crisis in Southeast Asia, where excessive and unmonitored investment in Thailandʼs property market ushered in the nancial collapse. However, in February 2005, a desperate need for foreign capital nally caused the government to modify these laws to make foreign investment more welcome. An important change was to reduce the minimum size of foreign projects from 100 acres to 25 acres for housing and to 50,000 square meters for commercial space. This easing of property restrictions has increased international interest, yet Indiaʼs inefcient bureaucracy continues to make foreign investors hesitant. Overall, Indiaʼs property market is underdeveloped and unorganized. According to a World Bank report, India ranks 116th of 155 nations on a survey ranking the relative ease of doing business. Poor foreclosure laws, tedious property registration processes, and cumbersome state-specic laws and tax regulations have all contributed to this fragmentation in the market. Gagan Banga, a director at Indiabulls Property, says that ownership claims are very poorly dened, and therefore there is a high

Graphic: YiDing Yu for Harvard College Investment Magazine

Because of Bilimoriaʼs determination and ingenuity, today Cobra Beer is one of the fastest growing brands in the U.K. and has been exported to over 30 countries around the world. Cobra Beer now has operation sites in India, the U.S., and South Africa. Bilimoriaʼs success can only be encouraging for the students of today who aspire to be the CEOʼs of tomorrow. Indeed, this businessman of booze stressed the importance of ʻlife-long learningʼ throughout his talk. He stated that “just because you are running your own business doesnʼt mean you turn your back on continuing educational development.” He stated that one of the turning points in his career was attending the business growth program at Craneld School of Management at Craneld University in the U.K... Bilimoria truly believes that education is a life long process, and event today, he still regularly attends courses at the London Business School and at Harvard Business School. What makes Bilimoriaʼs story fascinating is not only the charming way in which he tells it but also the sense of myth and mystery that surrounds it. In his speech, the word ʻvisionʼ recurred frequently. He emphasized the importance of having a vision: not just a goal, but an intense picture of your ideal business and what you want that business to represent beyond dollars and pounds. Coming across as very humble, he made no pretences about having worked hard at points in his life when he actually owed his successes to luck. Furthermore, he was particularly engaging and interactive when describing his ʻingeniousʼ marketing ideas for Cobra Beer which not only lead to a considerable

GLOBAL OUTLOOK

risk of litigation for new developments. These pervasive problems with Indiaʼs property system pose major risks for foreign investors; rms are deterred by the prospect of dealing with the Indian bureaucracy. Thus, potential foreign investors have been at a standoff, with each rm waiting for another to test Indiaʼs red tape before committing to the risky nancial venture. If one rm is able to steer through the bureaucracy, then other rms will have higher hopes of achieving success as well.

beginning of investment in India. Morgan Stanleyʼs property management branch plans to pour over one billion USD into India over the next ve to seven years. As a result of Morgan Stanleyʼs investment, analysts predict a spurt of foreign activity. Investment bank Lehman Brothers, in light of recent soaring share prices and rapidly increasing prots, has also announced its plan for signicant investment in Asia. On the other hand, private equity rms such as Warburg Pincus, Blackstone Group, and J.P. Morgan, have decided India presents an Taking the Plunge not to raise funds to invest in Indian propextremely compelling erty and to sacrice a higher return rate On March 1, 2006, Morgan Stanley for a safer one. Michael McCook, head investment story and chose to invest approximately $68 milof property investment for the California [is expected] to be lion in Mantri Developers Private, Ltd., a Public Employeesʼ Retirement System Bangalore-based real estate development (CalPERS), believes “The guys who go a long-term investor company, single-handedly making Morgan in rst to China and India and get 30% Stanley the largest foreign stakeholder in returns deserve it because they help crein the real estate a single company in India. As a minority ate laws. They pave the way to let the sector. partner in Mantri, Morgan Stanley intends rest of us come in afterwards to get 15% to build much-needed middle class homes, or 20%.” shopping centers, and hotels. Sonny Kalsi, Thus, early investors like Morgan StanManaging Director and Global Head of Morgan Stanley Real Es- ley may gain high returns, but they will need to overcome the tate, stated in a press release, “We believe India presents an ex- daunting bureaucratic red tape. But once a path has been paved tremely compelling investment story and we expect to be a long- through Indiaʼs unorganized and overcrowded property market, term investor in the real estate sector. The residential market is a dramatic increase in real estate investments are expected. If attractive because of the rate of rapid urbanization, the availabil- all goes well with Morgan Stanleyʼs stake in Mantri, then the ity of housing nance, and the strong growth of the consumer company will have built the foundation for a period of strong insegment.” Zain Fancy, Executive Director and head of Morgan ternational inuence in Indiaʼs economy. But, if the red tape triStanleyʼs Asian real-estate unit, elaborates that Morgan Stanley umphs, then future foreign investment could be severely stied. plans to invest in other real estate companies as well as in “hard The global implications of Morgan Stanleyʼs recent deal are for assets,” such as buildings, throughout the entire subcontinent. now uncertain, but the deal itself will surely play an important For Morgan Stanley, its joint venture with Mantri marks only the role in Indiaʼs future affairs.

Above: Commercial and residential real estate projects completed in 2005 by Anukampa Builders Pvt. Ltd., one of the many real estate developers in India boasting success.

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

I W

GLOBAL OUTLOOK

Investment Opportunities in Eastern Europe

hy do investors have Eastern Europe on their radar today? There are many answers to this question, ranging from the prevailing low corporate taxes in the European Union (EU) to the availability of cheap labor and better locations than Asia or Latin America. Furthermore, decent transportation, tax incentives, and other subsidies are proving difcult for investors to resist, and smaller cultural barriers means investors have to adapt less to fewer foreign customs. With several Latin American governments becoming more left-wing as election results roll in and experts wary of possible bubbles in Asian countries, could it be that Eastern Europe is becoming the perfect place to invest? Only by examining the pros and cons of the newly emerging labor markets of Eastern Europe

By Jan Zilinsky

can we come to a more rational conclusion. The political and legal institutions in most Eastern European countries are weak. Battles against corruption and inefciencies have been fought, but nevertheless these social dilemmas remain problematic. Furthermore, in these developing former Soviet satellites, many people lack the necessary English language skills. Nonetheless, these countries are now beginning to successfully shed their past inefciencies. There is still much potential in this region. To fully exploit it, however, investors must be cognizant of the macroeconomic, political, and cultural states of these different countries. Although many foreigners group them together, it is necessary to have an understanding of each country as a unique entity before investing there.

SLOVAKIA

Slovakia has been coined the ʻEastern European Tigerʼ and ʻInvestment Heavenʼ for several good reasons. According to the World Bank, Slovakia had the “fastest transforming business environment in the world” in 2004. The governmentʼs reform of the tax system and the elimination of various labor regulations were particularly well-received. The labor market is now more exible than many of its counterparts in Western Europe, in both working hours and obstacles to hiring and ring employees. In Bratislava, the capital city, there is ample supply of skilled labor which is generally efcient and furthermore, competent in foreign languages (especially German or English). Additionally, the wage for various professions in Slovakian labor markets is usually less than the comparable wage in most EU countries. Moreover, companies in Slovakia have recently seen record levels of productivity and low turnover. One uncertainty in Slovakiaʼs future is the effect which will arise from potentially joining the common European monetary system. This can be expected to produce an investor-friendly outcome by linking Slovakia with Western Europe. However, the greater ease of monetary transactions may eventually be outweighed by potentially increased labor costs. It is almost impossible to mention Slovakia without addressing its at 19% tax rate (corporate, income, and value added taxes). The tax system has been praised as efcient, simple, and appealing. This at tax has proved to be a huge incentive for foreign companies to invest in Slovakia. Tax relief for investments larger than 200 million Slovak Koruna (roughly $6.5 million USD) in Slovakian regions where unemployment is higher than 10% has also played an important role in investorʼs decisions. Peugeot-Citroen and Kia Motors, in particular, are building factory complexes, which eventually might lead to Slovakia producing “more cars per capita than any other country in the world by 2008,” according to economic analysts in Slovakia. HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

CZECH REPUBLIC

The Czech Republic has always had particularly strong trade and cultural ties to Western Europe, and it conveniently borders Germany and Austria. Although the Czech governmental structure could hardly be described as stable or predictable during the last decade, the macroeconomic data on this region is impressive nonetheless. With ination averaging well under 3% during the last four years (only 0.1% in 2003), and real GDP growth of around 4% plus a surprisingly stable currency, the Czech Republic seems to demonstrate the features of a mature, developed economy. Furthermore, with a recognized potential for greater growth and a signicant comparative advantage in labor costs (an hour of labor costs on average only 4.1 Euros in the Czech Republic compared to 26 Euros in Germany), its economy seems to be preparing for a massive take off. However, the country still faces numerous challenges. It has a relatively high corporate tax rates (26%). Furthermore, despite being somewhat developed, it has many of the same problems as its fellow Eastern European nations—only moderately reliable institutions and heavy corruption. Nonetheless, despite the high corporate tax rate and large mandated employer contributions to social security (35%), the Czech Republic, with its great grasp on ination and cheap labor market, will remain one of the top choices for investors looking at Europe as a whole. 43

GLOBAL OUTLOOK

HUNGARY

The Hungarian economy is largely focused on agriculture, tourism, and exports of machinery and equipment. Investors have also found the real estate market in Budapest particularly appealing. Unemployment in Hungary is relatively low and has remained constant for the last ve years (between 5-6%). However, ination is a risk because of former high volatility, ranging from 9.3% in 2000 to 4.7% in 2005. On top of these worries, there is also a 25% tax rate on dividends, a 16% corporate tax, and an income tax of up to 38%. Additionally, Hungaryʼs government has been very unpredictable recently. Lately, the potentially socially volatile Hungarian Socialist Party has been gaining power and is beginning to challenge its opponents for seats. While the country is estimated to have the potential of achieving a relatively high real GDP growth of 4% per year for the next few years, investors still nd the economic environment in Hungary too uncertain for large investments.

GLOBAL OUTLOOK

POLAND

Poland offers by far the largest labor supply in Central Europe. Corporate taxes have been lowered to 19% (from 27%), but personal income tax can still be fairly high (19-40%). Real GDP growth was 3.2% in 2005, but is forecasted to increase to 4% by the end of 2006. High unemployment rates (19%) and a chronic budget decit are the biggest problems that the Polish economy faces. Privatization of strategic sectors, such as natural resources and transportation, has been slow, but many small and mediumsized companies are now privately-owned. Machinery and intermediate manufactured goods make up a large percentage of Polandʼs exports. The domestic currency (zloty) is fairly volatile, perhaps providing more room for speculation than investment. The mood regarding currency in Poland seems to be ʻEuro-skepticʼ at best, leading most experts to predict that Poland will not switch to the Euro in the foreseeable future.

The remarkable improvement that we have witnessed in the past 5-10 years is encouraging, but it is by no means a guarantee of the continuation of crucial reforms, stable tax rates, investorfriendly policies, or even good policies in general. High Returns in Exchange for a Headache? Machinery and intermediate manufactured goods make up a large percentage of Polandʼs exports. The domestic currency (zloty) is fairly volatile, perhaps providing more room for speculation than investment. The mood regarding currency in Poland seems to be ʻEuro-skepticʼ at best, leading most experts to predict that Poland will not switch to the Euro in the foreseeable future. Corruption certainly remains a large problem. However, the effort to eliminate corruption in local governments and law enforcement institutions is genuine, and landmark progress has been made. The basic solicitations of bribes are now illegal, and public servants who commit such acts are aggressively prosecuted. Reform cannot happen overnight, but investors appreciate the general environment of optimism and progress. Furthermore, Eastern Europe does not have a convincing record of political stability. The remarkable improvement that we have witnessed in the past ve to ten years is encouraging, but it is by no means a guarantee of the continuation of crucial 44

Country

Minimum Wage

Average gross monthly wage

Slovakia

193

500

Czech Republic

277

704

Poland

252

719

Hungary

243

652

Wages in USD. Source: Dresdner Bank

reforms, stable tax rates, investor-friendly policies, or even good policies in general. Despite what some economic theories tell us, in reality, there is no such person as a “risk-loving” investor who is willing to pour in millions of dollars only to take a step back and see what happens. As they stand right now, the countries of Central and Eastern Europe are not the safest bets. But they are, nevertheless, regions of above-average economic growth which should be kept on the radar because, despite the occasional headache, the potential for astronomical levels of prot remains tantalizing. SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

Shari’ah Finance

By Rika Christanto

Investment inside the Islamic World

rincipled investments in ‘green’ environmentally-friendly funds and divestments from financiers of genocide indicate the emergence of a moral investor. Individuals are no longer content with the hands-off approach in securitizing their wealth; rather, they increasingly want a say in how their money is being used. The rapidly-growing popularity of Islamic banking is yet another indicator of this moral trend. Its peculiarities which arise from the heeding of Islamic law, for example, the prohibition of charging interest rates, have also begun to force the customization of various financial products in order to meet the financing needs of Muslim businessmen. Whether or not Islamic financial entities can achieve global prominence and revolutionize the financial services sector remains to be seen.

In America, Islamic nance originated through grassroots demand among the Muslim community. Several community banks, like the privately owned Devon Bank, have responded to demand in their predominantly Muslim locality while non-prots like World Relief Finance caters to the Muslim Somali refugees in Minneapolis and Nashville. Emerging larger banks conforming to the Sharʼiah, which is Islamic law, include SHAPE Financial and Reba Free, which provides products and consultation for other nancial entities. They have successfully marketed their services abroad to countries as diverse as Canada, Singapore, and Lebanon. Rising from its roots in a small number of Muslim countries, the industryʼs phenomenal growth has amassed international appeal. This phenomenon known as ʻIslamic nanceʼ is now widely practiced in many other countries. More moderate Muslim countries

W HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

GLOBAL OUTLOOK

like Indonesia and various Persian Gulf States allow conventional banks to co-exist with Islamic banks. Other countries like Iran and Pakistan rely solely on Islamic nancial institutions. The West, too, is catching up. Growing protability and demand has attracted the attention of leading Western nancial institutions, with Citigroupʼs Citi Islamic Bank, HSBCʼs Amanah, and UBSʼs Noriba joining the fray. On both sides of the Atlantic, Islamic mortgaging and small business nancing have been targeted as particularly lucrative niches. In 2004, Britain launched its very rst Sharʼiah- compliant bank, the Islamic Bank of Britain, and unbeknownst to most, the Dow Jones stock market indices of Sharʼiah-compliant companies were established seven years ago. Singapore recently announced plans to become the main SoutheastAsian center for Islamic nancial services. While academics and nancial analysts have had difculty assessing the current size of the market, the global asset worth of the Islamic nance industry is estimated to be between $200 and $250 billion. It is currently a small share of the global banking industry, but one which is rapidly gaining ground. Leveraging the Shar’iah Islamic nance is based on the main idea that prot should not be made without effort or risk and contains the underlying practice of prohibiting the application of interest rates. The Quʼran and the Prophet himself, however, are not against prot and even look favorably upon enterprising individuals. The overarching principle of Islamic nance is that business should be guided by conscience; businessmen should do the right thing. Thus, the prohibition of charging interest or ʻribaʼ is a means of preventing the act of proteering without incurring risks. For instance, money deposited in a bank should not incur interest, by Islamic law, as this translates to making money without effort. Another example is one where a bank which is nancing a random businessʼ project puts the burden of risk wholly on the business itself by having the business provide collateral upfront in the event of failure. Thus, the bank has no right to charge interest. In addition to the prohibition of riba, Islam-approved investment funds cannot invest in traditional nancial entities and businesses, which produce alcohol, pork products, or provide entertainment services or other non-ʻhalalʼ (permissible) goods. The use of conventional nancial tools that involve nancial 46

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speculation, and nancial derivatives and debt products are prohibited. In sum, Islamic nance goes beyond typical investing by enforcing that investments must be carried through by ʻhalalʼ means. Ruling out interest rates may seem like a daunting obstacle in the path towards establishing a nancial reward scheme. However, Muslim bankers have devised innovative ways to circumvent this problem. The main difference in these transactions is that the lenders also share the burden of risk with the borrowers, and the return on investment is based on prot or loss, not a pre-determined interest rate. Sharʼiah-compliant banks offer four types of nancing: murabaha, mudaraba and its variant, mushuraka, and ijara. Murabaha is used for a one-off loan when a customer requires a particular asset as working capital. The bank purchases the desired asset, like a computer, and then sells it to the customer at a marked up price. This is similar to charging interests when the mark-up rate is equal to the prevailing interest rate. While the difference only seems to be a matter of semantics, the key distinguishing feature is that during the period when the printer is owned by the bank, the bank is liable for any breakage and other risks of ownership. God, it seems, is in the details. Nevertheless, murabaha is not accepted as a proper Islamic nancial instrument by many Muslim jurists due to its similarity to charging interest. Mudaraba follows more closely the letter of Islamic law and is used for larger projects requiring longer term nancing. The lender and borrower share prots, but losses are borne by the lender, as the borrower is deemed to have contributed their share in the form of labor or intellect. Hence, the bank effectively becomes a shareholder in the company instead of lending money at interest. Musharaka is very similar but both parties share prots and losses in proportion to the capital they have contributed. The problem with mudaraba is that banks fear they will make many bad choices, thus ending up with more losses than prots. Industrialists with high expected returns will borrow from conventional banks to maximize return in the event of success while those with low expected returns will favor prot and loss sharing with Islamic institutions to minimize their losses in likely event of failure. This adverse selection problem is compounded by lack of disclosure by rms due to the risk of tax exposure. In an Ijara transaction, the bank once again purchases a desired asset for the customer and then leases it to the customer over an agreed period. The client has the option of purchasing the asset in its entirety either during or at the end of the leasing period. This allows longer tenures and variable returns determined by reference to international benchmarks like the London Interbank Offered Rate (LIBOR). A specic application of these transaction structures is in the trading of the Islamic equivalents of a conventional bond, the sukuk. They are widely used in Bahrain, now in its eleventh sukuk issue, and have been adopted in Malaysia, Qatar, and SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

Pakistan. These bonds are securitized by underlying assets like state-owned buildings instead of rental payments, following the practice of ijarah. Most surprisingly, a large proportion of bondholders include members of the non-Muslim community, who regard this form of debt highly because it is secured by a government with a good credit rating. According to Knowledge@ Wharton, companies such as the Swiss food giant Nestle bought $184 million worth of seven-year Islamic bond in 2003. As with

Another limitation to expanding Islamic funding is it has traditionally been used for small businesses. Large-scale nancing would involve hedging risk through derivative alternatives. However, as these derivatives often require gambling and interest, such means are prohibited. Nevertheless, Islam-approved derivative tools like prot rate swaps, analogous to interest rate swaps, are being devised to circumvent this barrier. Standardization also remains a signicant obstacle in this edgling industry,

The overarching principle of Islamic finance is that business should be guided by conscience; businessmen should still do the right thing. any issue of government bonds, the issue of sukuk funds infra- requiring the creation of regulatory bodies like the Accounting structure projects in developing Muslim countries. In March of and Auditing Organization for Islamic Financial Institutions. this year, Citigroup and Dow Jones implemented the rst global sukuk index, the Dow Jones Citigroup Index, which will measure History Predicts the Future the performance of global bonds in accordance with Islamic regulations. The news site Bernama.com reported that “the Islamic Most importantly, however, the Islamic nancial services bond market was growing at a double digit rate globally” with run the risk of irrelevance when they simply mimic established Malaysia leading the pack at having “more nancial instruments, instead of being a than 50 percent market share in Sukukʼs source of innovation. The Muslim world global market.” has a long history of restrictive religious Islamic financial Besides lenders, Islamic investment rules that undermine capitalism, like services run the risk rms, including Saturna Capital, Azthose which determine inheritance, orgazad Asset Management, and Allied Asnizational structures, and property right of irrelevance when set Advisors, have emerged to offer mulaws. Thus, the Sharʼiah threatens to curtual, growth and income funds that meet tail the potential capitalistic development they simply mimic Sharʼiah regulations. They have an asset of Islamic nance. Nevertheless, Muslims established financial base of $112 million, which is only a small scholars believe that continuing innovafraction of total investment assets, but tion in Islamic banking will spur nancial instruments, instead they have shown strong growth since their development in the Muslim world. Hisinception in the late 1990s. tory showed us how the Roman Catholic of being a source of Church in Medieval Europe also prohibitinnovation. Complications in Islamic Banking ed interest. Nonetheless, banks were able to get around this rule and vast nancial Despite the promise of allowing more institutions were developed because inMuslims to participate in the international nancial system, there stead of interest, for example, depositors were given gifts by the are pertinent reasons as to why Islamic banking has not seen truly innovative bankers. impressive growth. One problem is the challenge which resides The main driving force appears to be competition, which spurs in requiring products that satisfy both state regulation in secu- innovation of nancial tools and cost-competitiveness around lar nations and Islamic religious doctrine, while also remaining the world. Such competition is already being seen in the Islamic competitive. For example, tension between Muslim and secular banking industry, with approximately 150 Islamic banks now state regulation is exemplied in the example where the U.S Na- concentrated in the Muslim countries and large Western subsidtional Bank Act prohibits banks from the purchase or possession iaries. Perhaps, we have reached the threshold where Islamic of real estate to secure debts exceeding ve years. This would nance is ready to spring forth. automatically prohibit many Islamic home nance services Malaysia has been deemed to be the forefront of Islamic nancial available through ijarah-style nancing. Furthermore, the cum- innovation but with the nation of Bahrain strategically located in bersome process of having each transaction vetted by a Sharʼiah the Persian Gulf, Bahrain is quickly catching up. Malaysia and supervisory board also poses a hindrance to rapid growth. Bahrain are racing to capture the international Islamic money Moreover, the expansion of Islamic banking would be costly market, propped up largely by income from oil. The prize is esin acquiring mass appeal and introducing new products in the pecially lucrative due to the repatriation of assets into the Gulf United States. The cost includes developing innovative nanc- economies by Saudi families after 9/11. With many liquidating ing products, designing nancial documents to accompany such their western assets, estimated to be worth around $700-900 bilproducts, consulting both religious and regulatory experts, and lion, the Islamic nancial industry has just been delivered the training staff in unprecedented procedures. necessary boom to propel a new revolution in banking. HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

GLOBAL OUTLOOK

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“I

hope you enjoyed your flight on this Embraer jet” are words that stewardesses and frequent flyers alike worldwide are becoming more and more familiar with. The Brazil-based aeronautics company, which is trying to revolutionize the flying experience, has seen tremendous growth in the last year. Embraerʼs 2005 revenue amounted to over $3.8 billion, of which about $446 million was prot. Imagine yourself on a shuttle ight from DC to Boston in what can only be described as a marked departure from the past, more conventional, short travel experiences. With three abreast seating that allows the passengers in the middle to also have a window view, the experience on the Embraer-145 was pleasant to say the least A striking feeling, considering that Embraer is increasingly becoming the substitute in an aeronautics industry dominated by American and European rms such as Boeing and Airbus Industrie. Currently traded on both the New York and São Paulo Stock Exchang-

es, Embraer is represented as ERJ on the NYSE and since its opening day has posted amazing results. Starting at about $20, the stock quickly doubled, settling at $40 in only a matter of time. Crossing Borders Recent sales to airline companies all over the world have established Embraer as an emerging player in this industry long closed off to any signicant new competition. Substantial deals with noteworthy airlines like JetBlue have helped Embraer claim a major stake in the business. JetBlue received the rst of the 101 E-190 jets from Embraer this past year

By Kedamai Fisseha and plans on using the plane to service cities all over the U.S.. The E-190 is a vital component of JetBlueʼs popular New York to Boston shuttle service. The plane has four abreast seating which the manufacturer says helps to avoid middle seat headaches and also offers standard leather seating. An innovative new feature of the plane is its modied “double-bubble” fuselage. This change in shape allows for an unprecedented oor-to-ceiling height of 6ʼ7ʼʼ in the aisle and restrooms that can reasonably accommodate six-foot passengers.

Embraer ... Brazilian plane manufacturer nds success in the American commerical plane market

Itinerary Embraer and its numerous airline clients hope to generate consumer interest with these improvements. Embraerʼs acute awareness of the consumer market has helped it grow since its privatization in 1994. Started by the Brazilian government in 1969, Embraer began with the production goal of two planes per month. It grew through the seventies, establishing contacts in Europe and widening its capabilities with the construction of various hangars around Brazil. In 1972, Embraer formally entered the commercial plane market and has not lost any altitude since. As described by airline consultant Richard Aboulaa, “Since 1960, only one country and only one company succeeded in entering the jet market. That country is Brazil, and that company is Embraer.” Embraer began exporting commercial jets by the late 1970ʼs when it gained safety

occurred in 1994 and management of the corporation was relegated to major stockholders. Today, it is obvious that privatization has resulted in very public success for Embraer. Closed Skies Today, Embraer is one of Brazilʼs three largest exporters. Embraer is not just soaring in the Brazilian economy though. In spite of huge capital constraints and playing catch-up with companies like Boeing, the company has managed to claim its position as the fourth largest aircraft manufacturer in the world, behind only Boeing, Airbus, and Canadian rival, Bombardier. Bombardier, which began in 1942 as a snowmobile company also has a distinctly different story. Bombardierʼs entrance into the aviation industry was ushered along by their purchase of agging government-owned Canadair in 1986. Four

industry today. Airlines face huge nancial concerns in this post-9/11 world that ultimately have a great impact on manufacturers like Embraer. First, it is important to note that the airline industry has made a net loss in its short 90+ year history. Accounting for all of the governmental subsidies that the industry has been infused with over time, the industry still has a net prot of less than zero. Many defend the ʻfailingʼ industry by arguing that numerous externalities, which are indirect positive effects, have come as a result of the industry, citing increased communication, and thus globalization. The fact remains, however, that airlines are in a constant search mode for the best way to break even. The implications for Embraer here are two-fold. Airlines are faced with the decision to buy newer planes which might attract more customers to their company; however, history has shown that diversi-

In spite of huge capital constraints... the company has managed to claim its position as the fourth largest aircraft manufacturer in the world. certication from European aviation associations. The early 1980ʼs marked further strides in Embraerʼs production of planes both for commercial and military use. The most notable feat was the production of the Brasilia, a high performance passenger jet with a pressurized cabin that was able to gain FAA certication easily. Five years later the company ran into nancial turbulence, and eventually the Brazilian government realized the need for privatization. The privatization of Embraer

years later, the company acquired Kansas City-based Learjet, further solidifying its place in the lucrative industry. Similar to Embraer, Bombardier is also a fairly new entrant. In terms of size, Boeing, with 150,000 employees, dwarfs all of its competitors. Airbus employs only about 50,000 people. As for Embraer and Bombardier, they employ about 16,000 and 27,000 aviation employees, respectively. Financial considerations are the biggest headaches plaguing the aeronautics

fying their eet of airplanes only makes balancing the books harder. This poses a barrier of entry for companies such as Embraer that want to develop newer models in order to gain newer clients. The second implication, however, is that the airliners truly do need a way to raise their prots. Companies such as Embraer have an advantage here because they can offer newer, more exciting planes as an incentive for airlines to make the change.

...On The Rise HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

GLOBAL OUTLOOK

GLOBAL OUTLOOK that gure was 2.3 million barrels per day, and by 2010, forecasts suggest that it will have grown to 2.8 million barrels per day. Other Asian economies, rebounding from the Asian nancial crises of the late nineties, are also experiencing increased demand for oil. In total, Asian countries excluding Japan and China accounted for approximately 14% of the increase in world oil consumption from 2003 to 2004, and China alone accounted for a massive 40% of that gure. Add to this the growing U.S. demand for oil, the U.S. accounted for about 20% of the increase in world oil consumption between 2003 and 2004, and it becomes clear that increased demand is the major factor contributing to this unprecedented continuous surge in oil prices. Supply Shocks: the Consequences of Political Instability Source: New Mexico Petroleum Data collection, not adjusted fro inﬂation

OIL PRICES

Why Have They Soared So High? n his State of the Union address in January 2006, President George W. Bush coined the now-infamous phrase “America is addicted to oil.” Indeed, the President is right: in 2004, America accounted for one-fourth of the total world demand for oil. In the same year, Americans consumed 20.52 million barrels of oil per day, more than three times the consumption of the second-highest consumer, China, which consumed only 6.63 million barrels a day. As America continues to feed its addiction, oil prices have soared to unprecedented levels. The spot price of crude oil on the New York Mercantile Exchange (NYMEX) was $25 per barrel in September 2003. By August 2005, spot prices had hit a peak of $70.85 per barrel, not adjusted for inﬂation, and today’s prices per barrel remain in the mid-60’s range. The massive price increase has resurrected questions about what factors determine the price of oil. The answers, however, are as unclear as ever, with various changes in demand, supply, and speculation all ﬁguring into the ambiguous conclusion. Demand for Oil: Economic Expansion in China and Asia There is little need for an explanation on the growth of Chinaʼs economy since its 1978 implementation of economic reforms which relaxed price-controls, encouraged private investment, and liberalized foreign trade. From 1978 to 2002, Chinaʼs economy achieved a remarkable average annual GDP growth rate of 50

9.4%. Despite some growth hiccups over the past three years, Chinaʼs economy is showing no signs of slowing down, and its GDP is predicted to grow by an average of six percent per annum over the next 20 years—more than double the 2.9% average annual growth rate in world GDP over the same period. With Chinese demand for cars budding and industrial production on the rise, this growth in GDP has resulted in increased demand for oil in China. With demand growing at an ever-increasing pace, oil

Graphic: YiDing Yu for Harvard College Investment Magazine

By Hagop Taminian

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

prices have surged. The U.S. Energy Information Administration (EIA) predicts that Chinese oil demand will reach 12.8 million barrels per day in 2025—almost double its current consumption. Questions regarding the sustainability of Chinaʼs GDP growth rate and the accompanying growth in oil demand are increasingly becoming a concern for policy-makers, who predict that the continued increase in Chinese demand for oil cannot be met, thus resulting in further upward pressure on prices. India has also contributed to increased demand for oil. In 1995, India consumed 1.6 million barrels of oil per day. By 2004, HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

In an interview in August 2005, Texas oil tycoon T. Boone Pickens explained that in order to understand the increase in oil prices, “we have got to go back to the basics…starting with supply.” Pickens explained that because demand is outgrowing supply due to the decrease in drilling and exploration ventures being undertaken, then price has to rise and “kill the demand.” However, there is more to the supply problem than Pickens suggests: not only are drilling and exploration activities not keeping up with demand, but current oil resources have been subject to a series of supply shocks. These supply shocks are largely a result of political instability. The central preponderance of this instability is in the Middle East, starting with Iraq. Shortly after the beginning of the 2003 U.S.-led war against Iraq, Iraqi oil production plummeted from around 2.3 million barrels per day in pre-war levels to only 900,000 barrels per day in post-war levels. This plunge in production is mainly due to attacks against Iraqi oil facilities and pipelines by Baʼath party loyalists, Sunni extremists, and other insurgents hoping to unsettle the allied presence in Iraq. UN oil experts report that some southern reserves in Iraq are so badly damaged that their recovery rates have become severely compromised for years to come. Elsewhere in the Middle East, Iranʼs nuclear ambitions have also caused uncertainty about oil supplies, as the possibility of a military face-off between Iran and the West looms larger. If the West does take military action against Iran, oil supplies will face severe setbacks, since Iran controls the eastern part of the Straits of Hormuz, which service the ow of the majority of oil from the Persian Gulf. Analysts predict that if the Straits of Hormuz were blocked, oil prices could rocket to over $100 per barrel. The supply problem is exacerbated by the fact that only two countries, Saudi Arabia and Kuwait, have exhibited spare capacities of oil which could cover a potential supply shock. Moreover, it is uncertain whether these countries would mobilize their spare production if military action is taken against Iran. Supply problems are not restricted to the Middle East. Militias in Nigeria, seeking control of oil facilities, have kidnapped foreign oil workers and attacked pipelines, further crippling oil supplies. In Venezuela, whereich has rebounded from a nationwide strike in 2002 and 2003 which resulted in a 10% percent decrease of its oil production, President Hugo Chavez still faces 51

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Oil Prices (USD per barrel): 1861-2006

THE LOST PENSION GENERATION

Source: Michael Ströck using data by the Energy Information Administration

political uncertainty, raising questions on whether Venezuela can sustain a steady production of oil amidst a hostile political climate. Finally, in the U.S., Hurricane Katrina curtailed oil supplies from the U.S. Gulf Coast, halting the operation of more than 10% percent of U.S. rening capacity and thus, causing President Bush to tap into national oil reserves. Combined together, these supply shocks are another major factor contributing to todayʼs high price of oil.

decreasing supply, the oil market bubble will inevitably burst. The Bigger Picture

The current situation is not the rst time that oil prices have skyrocketed. How does the current situation compare to historical precedents? In October 1973, Syria and Egypt launched an attack on Israel, starting what came to be known as the Yom Kippur War. Speculation: the Gamblers on Wall Street The U.S. and other Western powers responded by declaring support for Israel. In retaliation, Saudi AraJohn Moody, an American nancial anabia, Libya, and several other Arab OPEC Many believe that lyst, once described the “outside public” as member states declared an oil embargo on “the delight and prey of Wall Street gamthe U.S. and other Western nations, effecthe surging oil blers.” Consequently, it is not surprising tively halting all their oil shipments to those prices are simply a that many believe the surging oil prices are countries. The result in the U.S. was that the simply a result of increased oil speculation price of oil per barrel quadrupled from apresult of increased by Wall Street hedge funds and investment proximately $3 in 1972 to $12 in 1974. One oil speculation banks. One estimate by a former OPEC Secthing was clear as a result of the embargo: retary General suggested that speculation OPEC exercises great power in controlling by Wall Street accounted for $10 to $15 of the price of oil oil prices. hedge funds and per barrel. The rationale for how speculation Six years later, in 1979, the Iranian Revraises oil prices goes as follows: Wall Street olution precipitated what would become investment banks. rms, realizing that some supply problems the most dramatic increase in oil prices in are raising prices, keenly cash in on the price history. Slightly one year after Shah Reza hike by taking larger positions in oil futures contracts. They then Pahlavi was overthrown in favor of a populist Islamic Republic resort to generating supply fears and increased demand fore- in Iran, Iraq invaded Iran in September of 1980. As a result, the casts to justify further increasing prices on futures contracts. The combined oil production of Iraq and Iran fell from 7.5 million problem, some believe, is that such fears are unsubstantiated and barrels per day in 1979 to a meager one million barrels per day merely exploitation by hungry Wall Street rms. As evidence, in 1980, causing the price of oil to shoot up from $14 in 1978 to they cite the fact that oil consumption has not kept up with the $35 in 1981. When adjusted for ination, this 1981 price level of trading volume of oil, with the former increasing only 5.6% over oil is the highest in modern history. the past ve years and the latter increasing by 29% over the same The rest, as they say, is not history but journalism: entire volperiod. Such increased investment in futures contracts, lagging umes have been written to explain why oil prices behave the way behind consumption increases, suggests that Wall Street rms they do, with no conclusive answers. Is todayʼs surging oil price are milking the situation by inating the price of oil. If specu- a mere blip, or is it precipitating a new historic high in prices? lators are mistaken in their forecasts of increasing demand and The answer, unfortunately, is not glamorous: only time will tell. 52

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ver the past decade, the issue of the impend- estimated 117,000 employees. In March 2006, General Motors ing Social Security decit has plagued the condence (GM) made a similar announcement in hopes of improving its of United States economists. As baby-boomers ap- nancial woes. GMʼs plan By Robert Andrew Davis proach the age of retirement, inows to the Social is to freeze the accrueSecurity pool of funds will slow and outows from the pool of ments of its 42,000 American workers after January 1st, 2007, funds will increase rapidly. As a result, if changes are not made much to the dismay of the United Auto Workers Union. In each of these cases, the companies are eliminating their to the system, the Social Security trust funds will run out of pension benets in order to reduce their money by 2041, at which point Social Seown risks and the size of their operating curity will only be able to pay out as much budgets. However, these company savin benets as it takes in through workersʼ The dissolution ings are coming at the cost of the welfare tax payments. of employee of their employees. The dissolution of Congress faces a great deal of presemployee pensions could cause a potensure to confront the problems of the Social pensions could tially catastrophic reduction in workerʼs Security system. However, if Congress cause a potentially retirement savings plans, especially if thought it had its hands full trying to fund pensions previously served as a workerʼs the retirements of Americaʼs elders, their catastrophic main contribution to their retirement problems recently became much larger. reduction in plan. Congress, as well as many nancial The cause: the current upward trend of rms, has realized the problems that the businesses eliminating their employee penworker’s retirement elimination of employee pensions could sion systems. Since the end of 2005, sevsavings plans. cause for retirees in the United States. eral blue chip Wall Street companies have While nancial rms have begun to offer announced the elimination of their emnew programs to provide for comfortable ployee pension plans. Verizon announced in December 2005 that it will stop paying pensions to 50,000 retirements, Congress recently devised a bill which the President managers after June 30, 2006 in order to save $3 billion over ten signed in August 2006 to strengthen the obligations of compayears. International Business Machines (IBM) followed suit in nies providing pensions. While these programs and Congressʼ January 2006 with its plans to discontinue the addition of value bill might be going in the right direction, will they be enough to to workersʼ pensions as of January 1st, 2008. This will affect an keep the retired workers of the United States nancially stable?

HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

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The Recent Trend The elimination of employee pension plans is due in large part to recent macroeconomic factors. As the Bull market drags on and economic expansion continues for a fourth year running, it is becoming more and more difcult for companies to post consistent prot gains. What makes prot growth more difcult is the rising burden being put on companies due to their pension obligations. Recently, more and more workers of the Baby Boom generation have approached the age of retirement, which will soon translate to higher benet costs. The idea behind getting rid of pension benets is that removing these costs from the companyʼs balance sheets allows for greater accounting gains, which in turn leads to increased income. However, the urge to increase prots is not the only reason behind the elimination of pensions. The stock market has also played a large role in the reduction of the number of American employees receiving pension benets. In most cases, companies have a trust fund from which pension benets are drawn. To increase the value of these trust funds, companies invest this money in the stock market. As many market analysts predict the end of the bull market on the horizon, market returns for the pension trust funds will eventually decrease and become less predictable. Whereas only a few years ago companies saw surpluses in their pension trust funds, current economic factors are putting heavy strains on companies and their pension funds. As a rapidly growing company, Verizon Communications Inc. was searching for an easy way to decrease pension obligations in order to increase quarterly prots. In an attempt to streamline its budget, Verizon decided in December to eliminate future pension benets for its 50,000 managers. By not offering pension benets to managers hired after January 1st, 2006 and by not allowing current managersʼ pensions to accrue after June 30th, 2006, Verizon hopes to save three billion dollars over ten years. To save additional costs, managers employed by Verizon for fewer than 13.5 years will no longer receive subsidized retiree medical benets from their employer. Verizonʼs pension cuts come amid growing pressure from investors to decrease the companyʼs $38 billion debt load. Furthermore, there is pressure accruing from the forecasted costs of approximately $20 billion which will be needed to improve Verizonʼs ber optics system. Even by cutting future pension costs, Verizon is not completely freeing itself from all aspects of pension costs. Under the current plan, Verizon managers who have worked for the company for a certain number of years up to the June 30th cut-off date will still be 54

INVESTING TODAY

given pension benets for their previous years of work. The same type of changes will be made to the pension benets of IBM employees. The 117,000 recipients of pensions at IBM will stop accumulating benets at the end of 2007. With the focus of retirement benets shifting from pensions to 401(k) programs, IBM expects to save $450 to $500 million in 2006 and $2.5 to $3 billion for the period between 2006 and 2010. According to Randy MacDonald, the senior vice president of human relations at IBM, the “changes are consistent with [IBMʼs] direction and will give us more predictable retirement plan costs, along with benets that remain ahead of—but more in line with—our competitors.” This refers to the fact that many of IBMʼs competitors in the technology industry only offer 401(k) plans to their employees. While IBMʼs pension plan is currently fully funded with assets of $48 billion, the elimination of pension obligations ensures IBM better viability regarding its future obligations to retirees. While Verizon and IBM are cutting their pension plans in order to better compete with competitors, General Motors is freezing its pension plans in order to remain nancially sound. In March 2006, the company announced that as of January 1st, 2007, the 42,000 American GM salaried workers will no longer accrue benets for their pension plans. The announced cut comes as GM struggles to lower costs and return to protability in its North American operations. By switching away from pension plans, GM expects to save $1.6 billion in pension liabilities for 2006 and an anticipated $420 million in savings the following year from pension expenses. While these cuts only affect white-collar General Motors workers, many see this announcement as an indication that GM will soon seek pension settlements with the United Auto Workers (UAW), the union representing the employees of GMʼs manufacturing arm. With the current problems between GM and UAW, any future disagreements regarding pensions will not appear positive to GM investors. Like GM, many airlines are also reducing pensions in order to cut costs and successfully emerge from bankruptcy. In March 2006, Delta Airlines announced that it would likely eliminate its pilotsʼ pension plans and shift these pension obligations to the Pension Benet Guarantee Corporation (PBGC), a federal agency. Delta had hoped to receive $305 million per year in concessions from the Air Line Pilots Association, but eventually was only promised $140 million per year. To replace the lost benets, Delta is trying to offer the Pilots Association a $330 million note. Previously, Delta announced that it would freeze its non-union pension plan as of December 31st, 2006 but there might still be SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

hope that the pension plans covering non-pilot union members will be saved. With their decision, Delta joined US Airways and United Airlines in terminating pension plans as a result of Chapter 11 bankruptcy. US Airways handed the decits of its pension plan to the PBGC in February 2005, and this move erased over $200 million in employee pension benets. Following suit, United Airlines defaulted on its $9.8 billion pension plan on May 11th, 2005 and handed the costs over to the PBGC. This move will eventually cost workers $3.2 billion in benets.

6%. Still, IBM admits that many of their workers will be worse off than before the pension cuts. According to their estimates, 19% of IBM employees will be hurt due to the benet changes, with an average reduction of 12% in retirement benets. GM is also going in the direction of replacing pension benets with 401(k) benets, but GM will install a new type of 401(k) plan for their employees called the Roth 401(k) savings account. In ordinary 401(k) plans, employees contribute pre-tax earnings towards their savings plans. Then, once they retire and withdraw

Many airlines are also cutting pensions in order to cut costs and emerge from bankruptcy successfully. Replacing the Lost Pensions It is true that these companies would improve their prots greatly if they eliminated all types of retirement benets, but this drastic option is not realistic. Maybe the upside for these thou-

from their accounts, they must pay taxes on those withdrawals. In the case of Roth 401(k) plans, the earnings are taxed before being contributed to the plan, so that when retired employees withdraw from their Roth 401(k), they do not have to pay any taxes on the withdrawals. These plans are really advantageous

PENSIONS FREEZE OVER February 2005 US Airways defaults on pension plan

March 2006 Delta eliminates pilot pension plans

May 2005 United Airlines defaults on pension plan

June 2006 Verizon eliminates managersʼ pension plans

sands of employees is that these pension cuts are not coming without concessions. Companies realize that eliminating pensions without replacing them with alternate systems would have detrimental effects on their employees. Companies have decided to eliminate their pension benets in order to switch to other systems in order to reduce risk and costs. The option that most companies have chosen is to replace pension benets with 401(k) plans. Verizon chose to replace its pension plans for managers by increasing the companyʼs contribution to the managersʼ 401(k) plans. Before the switch, Verizon contributed 5% of an employeeʼs wages to their 401(k) if the worker contributed 6% of their own earnings. In the updated system, Verizon will contribute $1.50 for every dollar contributed by the worker. However, this agreement is only applicable up to a maximum of 6% of the employeeʼs wages. IBM also chose to replace pension plans with increased contributions to their employeesʼ 401(k) plans. Previously, IBM only contributed fty cents for each employee dollar contributed to the plan. Now, IBM has agreed to match each dollar contributed by their employees, up to 6% of the employeesʼ salaries. In addition, employees will now be given contributions from IBM for up to 10% of their salaries, whereas the previous maximum was HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

December 2006 Delta will freeze non-union pension plans

January 2008 IBM pensions will stop accruing value

January 2007 GM will freeze white-collar pension plans

to young workers because it is likely that young workers are in a lower tax bracket now than they will be when they retire. While corporations have been trying to replace their pension plans with 401(k) plans, Congress is attempting to x the problems of pension plans. The central goals of Congressʼ pension bill are to force companies to better fund their plans and to reduce the strains on the over-extended PBGC. In addition, the pension bill addresses the problem of companies with debt ratings below investment grade. Since these companies often have under-funded pension plans, the bill requires them to include extra contributions to their pension plans. Since GM and Ford currently have debt ratings that are below investment grade, this provision could have serious consequences. If the bill is harsh on car companies, it is lenient on airlines. One of the provisions in the pension bill gives Delta and Northwest Airlines ten years to fully fund their pension plans while Continental Airlines and American Airlines each receive three extra years. Congress deemed this necessary since many of the airlines just recently emerged from bankruptcy. The catalyst for the pension bill was that the PBGC is currently running a $23 billion decit, and unless there is a way to keep more companies from defaulting on their pension obligations, 55

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the PBGC decit will continue to grow. Since companies with sub-investment grade debt ratings are often the companies that enter bankruptcy and default on their pension plans, Congress thought it would be benecial to increase pension requirements for these companies. However, this stipulation became a major clashing point within the Senate, which is why the bill stalled. A less controversial step towards reducing the PBGCʼs decit is to increase the premium that companies pay for each employee. Currently, companies must pay $19 per year to the PBGC for each employee covered, but there have been proposals to raise this premium to as much as $46.75. Still, there are worries throughout Congress that the higher premium and the debt rating provisions could cause greater problems for the PBGC because they would just increase the pressure on struggling companies, causing them to go bankrupt quicker. Worker Worries

According to their estimates, 19% of IBM employees will be hurt due to the beneﬁt changes, with an average reduction of 12% in retirement beneﬁts.

With companies emphasizing earnings and Congress emphasizing the PBGCʼs decit, these groups have lost focus of the central issue, the welfare of the average American worker. Between 1985 and 2004, the percentage of Fortune 500 companies with pension plans dropped from 89% to 51%. Even IBM, which claims to have one of the most generous 401(k) systems, admits that switching from pensions to 401(k)s reduces the average workerʼs retirement benets by 12%. The rapid elimination of pension plans could have a detrimental effect upon an entire generation. Future workers will not be hurt because they never enjoyed pension plans, but many current workers are dependent on these plans for retirement. The question then becomes what the best option is for aging workers who are experiencing pension cuts. Clearly, a 12% decrease in retirement benets is not preferable, so switching to 401(k) plans is not the best option. The Roth 401(k) plans are preferable when compared to regular 401(k) plans, but most of the benets of these plans are geared towards younger workers who will benet from avoiding the higher tax brackets that await them upon retirement. Congressʼ pension bill might produce positive results for pension recipients, but the bill may have been passed too late for some workers. Even if it is not too late, the bill could cause some potential problems. It will take a long time for the PBGCʼs decit to be reduced from 56

$23 billion and since forty-four million Americans have pension plans insured by the PBGC, this could pose a serious problem. Furthermore, although the bill tries to force companies to better fund their pension plans, it does not mean that companies can do so and remain nancially healthy. Since these plans are all suspect, workers are being forced to rely upon themselves, rather than their companies, for retirement savings. Sadly, this means that workers are facing two equally dire choices. One is to put away more of their current earnings into savings accounts for the future. The extra money going into a retirement account will help off-set the loss in pension benets, but it also means that the employees will consume less in the present and thus experience a lower standard of living. The other option is for workers to forego retirement for a few extra years so that they can keep working and earn enough money to last the rest of their lives. Recently though, some new options have been created by nancial management rms. In these options, the customer invests his money in a plan that acts a lot like a pension plan. MetLife Inc. created the Personal Pension Builder. For this plan, if a person invests $3,000 per year starting at age 40, they will receive $10,200 per year starting at age 65. Genworth Financial Inc. has a version called ClearCourse, and New York Life Insurance Co. will soon come out with a version called Personal Pension. These plans are safer than 401(k) plans because they are not dependent upon the stock market as 401(k)s are. The main risk involved is that if the insurance company fails and disappears, the money invested in the pension builders will disappear as well. There are many options to replace these traditional pension plans which are disappearing, but it is clear that every option has its own weaknesses. While working longer is the most assured plan for success, it is also the least attractive. Conversely, while switching to a 401(k) plan is the least burdensome option, it is also the riskiest option. As companies try to escape the risk of economic downturns by eliminating employee pension plans, it has become clear that there is only one thing that will x pension problems: the resurgence of strong economic expansion in the United States.

SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

The Savings Rate

MYTH By Mimi Yu

hese days, it seems like nobody is storing up for a rainy day. For the past decade, Americans preferring to spend rather than save is a familiar story. The U.S. personal sav-

ings rate has been steadily declining and fell into negative territory in 2005, marking the ﬁrst time the ratio has gone negative for an entire year since the Great Depression. Recently, the savings rate sank to an unprecedented low of negative 0.5%. It is no wonder that when former Federal Reserve Chairman outlays, 97% of which consists of personal consumption expenAlan Greenspan gave a testimony to Congress earlier last year ditures (including consumer durables), interest payments on conhe said, “The sizable gains in consumer spending of recent years sumer debt, and net personal transfer payments from disposable have been accompanied by a drop in the personal saving rate to personal income. However, there is one caveat within the NIPA an average of only 1 percent over 2004--a very low gure rela- calculation: the construction of NIPA treats the ow data associtive to the nearly 7 percent rate averaged over the previous three ated with current production as consistent and therefore gives an decades.” While economists and policy-makers are alarmed by incomplete picture of household savings behavior by overestiAmericaʼs savings imbalance, are their pemating consumption and underestimating rennially gloomy outlooks valid? In order savings. Since capital gains are not exThe Aghion model to come to a more accurate conclusion, one plained in the NIPA calculation and persuggests that even though must explore the measurements and denisonal saving is only a small portion of the tions of savings rates, the possible reasons national savings, the personal savings rate savings should affect why savings rates are low in this country, is only indicative of household consumpgrowth, it does not matter and its resulting consequences and implition possibilities whereas the national as much in relatively rich cations for the overall economy. savings rate can more effectively evaluTo better analyze the low savings rate, ate investment towards capital accumulacountries. one needs to rst understand how a persontion. This rate, unlike the paltry negative al savings rate is calculated and the differ0.5% mentioned earlier, is nowhere close ences between personal and national savings. Personal savings, to zero. in its simplest form, constitute personal income less consumpWhat then are the causes of the low personal savings rate? tion. National savings is dened as the total national income left There currently exist ve frequently cited hypotheses to account over after all expenditures on national goods and services are for the sharp decline of the U.S. savings rate. First, it can be deducted. The most frequently cited measure of the personal sav- ascribed to the consumption boom and subsequent “wealth efing rate is based on the National Income and Product Accounts fect.” As the real value of assets rises and home prices surge, the (NIPA). Personal savings is found by subtracting total personal booming housing market increases the wealth for the individual HARVARD COLLEGE INVESTMENT MAGAZINE • SUMMER 2006

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Shrinking Savings

Source: U.S. Bureau of Economic Analysis

household, stimulates consumption, and thereby, decreases the savings rate. A second explanation results from the encouraged free spending and the relaxation of liquidity constraints within America. The readily accessible credit market and the lure of a myriad of credit cards are irresistible especially for the younger generation. As Harvardʼs Economics Professor David Laibson points out, “the pull of instant gratication” can induce a rational, utility-maximizing consumer to forgo savings and increase current consumption when facing these inter-temporal choices. Third, the low savings rate is a consequence of poor stock market returns. With an average of just 0.4% over the past ve years, which is much lower than ination or the market fund, households would prefer to consume rather than save. The fourth contributing factor is rising labor productivity. Higher labor productivity amounts to higher expected income so when the present value of future income rises, the need for saving for the future falls. The nal reason for the poor savings rate is slow cash ow. After adjusting for ination, disposable income growth has been eroded by the inationary consumer price index, which causes the cash ow to circulate more slowly and therefore, makes it more difcult for households to save. The low personal savings rate has elicited concerns within the nation mainly due to the “twin decit” hypothesis: the low retirement funding, and the impairment of long-run economical prospects. The twin decit hypothesis states that if changes in private savings and investment are about equal, the budget and trade decit will be “twins”- approximately the same size and moving in the same direction. Hence, this suggests that a low personal savings rate correlates with a high budget decit, which in turn produces a trade decit. The hypothesis, however, implies that private savings minus investment must be zero for the budget decit to match the trade decit, which is an invalid analysis in an open economy with international trade. A second cause for worry is that savings are essential to economic development and that the current low personal savings rate will fail to support high levels of capital investment, which are essential to power long-run economic growth. However, if business and government savings are added to personal savings, the aggregate gross saving as a percentage of GNP is high enough to alleviate concerns regarding negative household 58

savings. Furthermore, the U.S. is relying excessively on foreign capital to nance its debt, which can lead to potential nancial crises. The excessive dependence on foreign capital is unsustainable and needs to be curtailed. Eventually, the high-saving Asian countries, such as China and Japan, could choose to fund their own investment opportunities over foreign projects, which would then decrease the available funds for U.S. investment. Another major concern that has been expressed is that savings are now too low to sustain adequate nancial security for retirees, especially of the baby-boomer generation. As Jack Gillis of the Consumer Federation of America comments, “our sense is that people donʼt have enough put away for a rainy day.” The rationale behind the statement assumes that the savings rate directly indicates how susceptible households are to sudden shocks in the economy or to unexpected rises in interest rates. Therefore, the low savings rate threatens economic prospects for the elderly if the interest rate continues to climb. However, just analyzing the declining savings rates does not present the whole economic picture. In order to determine the effectiveness of the household balance sheets, other measures of wealth accumulation are essential. Savings rates alone are not sufcient enough to determine whether each household is prepared for retirement or not. To address the concern of retirement preparedness, the U.S. will need to look at more than NIPA savings measures to determine how to follow up on various important policy questions. Professor Philippe Aghion, Harvardʼs Robert C. Waggoner Professor of Economics, recently published a paper entitled “When Does Domestic Saving Matter For Economic Growth?” He analyzed how domestic savings affects economic growth in a world of capital mobility. His model suggests that even though savings should affect growth, it does not matter as much in relatively rich countries. “Saving provides the local entrepreneurs with collateral which may give them enough of a stake in their innovation projects, but relatively rich countries are not as affected due to their small distance to the technological frontier. The prediction and our model are borne out by the panel of 118 countries for which we have data on savings over the 1960-2000 period,” says Professor Aghion. In light of the current low savings rate, several governmental interventions such as a consumption tax and higher interest rates have been proposed. However, both are problematic. Consumption tax is regressive and introduces dead weight loss while high interest rates may even be negatively correlated to savings rates according to empirical evidence. It is certain that some form of national savings is important to the overall economy. Nevertheless, the current U.S. savings rate crisis seems to be more of a myth rather than a scare. SUMMER 2006 • HARVARD COLLEGE INVESTMENT MAGAZINE

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