I was delighted to hear that Oliver Williamson was awarded the Nobel Prize in Economics (shared with Elinor Ostrom). Oliver Williamson is recognized for his contribution to the field of Transaction Cost Economics, building on the path-breaking work of scholars like Ronald Coase.

Transaction Cost Economics is a central theory in the field of Strategy. It addresses questions about why firms exist in the first place (i.e., to minimize transaction costs), how firms define their boundaries, and how they ought to govern operations.

In Transaction Cost Economics, the starting point is the individual transaction (the synapse between the buyer and the seller). The question then becomes: Why are some transactions performed within firms rather than in the market, as the neoclassical view prescribes.

The answer, not surprisingly, is because markets break down.

As a consequence of human cognitive limitations, coupled with the costs associated with transacting, the basic assumptions associated with efficient markets (e.g., anonymous actors, atomistic actors, rational actors, perfect information, homogeneous goods, the absence of liquidity constraints) fail to hold. For these reasons it is often more advantageous to structure transactions within firms. And this is why firms are not just ubiquitous in our society, but also worthy of study in their own right. This contrasts with the typical view of firms in neoclassical economic theory as, at worst, a market aberration that ought not exist, and at best, a black box production function.

Williamson’s contributions to the field of Transaction Cost Economics complement, and extend, those of Coase. First, Williamson started with an explicitly behavioral assumption of human behavior (bounded rationality). Second, he recognized that transacting parties sometimes behave opportunistically and take advantage of their counterparties. Finally, he identified features of transactions (e.g., specificity, uncertainty, frequency) that cause markets to fail; and hence, are likely to lead certain transactions to be organized within firms (hierarchies) rather than markets.

I was pleased to see Oliver Williamson recognized not just because of my inherent intellectual bias — my research has drawn on, and contributed to, the field of Transaction Cost Economics and I have worked with students of Williamson (see my research page for details) — but also because of what his selection implies for the broader field of economics. It implies that the field is moving in the direction of greater inclusion of economic perspectives that are based more on behavioral theories (see Krugman on the Future of Economics).

It was also fun to watch establishment economists make sense of the selection (see the Economists View post for some perspective). For example, Steven Leavitt writes:

When I was a graduate student at MIT back in the early 1990’s, there was a Nobel Prize betting pool every year. Three years in a row, Oliver Williamson was my choice. At the time, his research was viewed as a hip, iconoclastic contribution to economics — something that was talked about by economists, but that students were not actually trying to emulate (and probably would have been actively discouraged from had they tried to do so). What’s interesting is that in the ensuing 15 years, it seems to me that economists have talked less and less about Williamson’s research, at least in the circles in which I run.

MY COMMENT: I think Leavitt underestimates the impact of Williamson’s work because he is neither a Strategy scholar, nor is he in a Strategy or Management department. Go to any Strategy or Management department and you will find oodles of researchers (and doctoral students) working on Transaction Cost problems. It is a dominant paradigm.

Paul Krugman (in his post An Institutional Economics Prize) writes:

The way to think about this prize is that it’s an award for institutional economics, or maybe more specifically New Institutional Economics.

Neoclassical economics basically assumes that the units of economic decision-making are a given, and focuses on how they interact in markets. It’s not much good at explaining the creation of these units — at explaining, in particular, why some activities are carried out by large corporations, while others aren’t. That’s obviously an interesting question, and in many cases an important one.

…Oliver Williamson’s work underlies a tremendous amount of modern economic thinking; I know it because of the attempts to model multinational corporations, almost all of which rely to some degree on his ideas.

MY COMMENT: Krugman gets it partially right, but he does a lot of handwaving with respect to Williamson’s specific contributions. But with all due respect, he certainly makes no claim to be a Strategy scholar. He is right in the sense that the award speaks volumes about New Institutional Economics, broadly defined. However, in the case of Williamson, the specific contribution is to the field of Transaction Cost Economics. Moreover, the contributions of Williamson’s work extend far beyond the field of international business (or international strategy), but I agree that Transaction Cost Economics has been influential in those fields as well.

Nevertheless, my congratulations to Oliver Williamson, and to his students (many of whom I know well), who have long carried the torch for this important, yet underappreciated, branch of economics.

The folks at the Effective Executive magazine asked to interview me last month for an upcoming issue of the magazine. I was asked to share my thoughts about the global economy, the financial crisis, and the growth of developing countries.

Below are excerpts from that interview.

[Y]our current research centers on the management and economics of international expansion. However, with the US financial crisis hitting the world economy hard, even the developed countries seem to be contemplating on going very slow on globalization. And in fact, there is a wide rhetoric about developed world (including most of the G-15 countries) embracing protectionist attitudes. Do you think such a move would indeed undo all the progress that has been made in the last decade?

The benefits of globalization are many. Not only does globalization allow countries to specialize in the productive activities in which they have an advantage, but it also provides an important conduit for the exchange of ideas across countries. As my research points out, the exchange of ideas across countries is critical to innovation and growth.

Therefore, I think it would not only be a mistake for countries to enact protectionist policies, but in the extreme, such policies could threaten the currently fragile economic recovery. Economies have become so intertwined that restricting the cross-border flow of goods and services (and capital) could lead to severe disruptions for developed and developing countries alike. For students of history, a refresher on the impact of the Smoot-Hawley Tariff Act (and protectionist policies adopted by other world economies) during the Great Depression might serve as a guide for the potential deleterious consequences of protectionism.

That said however, I think we are a far stretch from undoing all the progress brought about by globalization over the past decade. I would like to believe that most interested parties (politicians, lawyers, managers, etc.) recognize how important globalization is to economic growth and prosperity. But certainly, the emerging level of protectionist rhetoric bears some monitoring.

What are the best practices that you have, over your distinguished research and teaching career, noticed regarding market entry strategies and international expansion strategies? Any interesting observations that you have noticed either from American companies, European Companies or Asian companies?

One of the things that I have noticed both in my research, and in my interactions with managers, is that managers often exaggerate the benefits and underestimate the difficulty of foreign expansion. Managers are quite good at identifying the demand-side benefits (the ability to tap into additional demand in the foreign market) and supply-side benefits (decreasing input and labor costs) associated with expansion, but systematically underestimate the additional costs imposed by operating businesses across differing institutional environments. Cultural, political, and economic environments vary greatly across countries. These differences manifest as real costs to firms, as research demonstrates that foreign entrants take a longer to set up operations in foreign countries, are forced to pay higher wages than local domestic competitors, run afoul of the law more frequently, and are generally less likely to succeed than similar domestic businesses.

All of this makes it critical for companies to have a sound understanding of how the cultural, political, and economic differences that they face across countries are likely to affect their business. Firms should first see if their business (and business model) is appropriate to the environment, understanding that it might be better, in some cases, not to enter a country. However, once they’ve decided which countries are appropriate targets for entry, they should choose an entry mode appropriate to the environment.

In my experience, I have found that those firms that perform best in this respect pay special attention to the cultural, political, and economic risk factors present in the host country.

Did you find any interesting insights from Chinese companies’ market entry strategies and their international expansion strategies as opposed to let’s say either South Korean or Japanese companies? Do you think Chinese companies are taking the same route as South Korean or Japanese companies followed several years ago or are they chalking out their unique strategies?

This is an interesting question. When I think about China, Japan, and South Korea, certainly some similarities can be drawn. All three followed an export-led growth path to prosperity. However, once a certain level of prosperity had been achieved through trade, the three countries diverged with respect to international investment. South Korean firms have generally followed a more organic growth strategy – eschewing acquisitions of foreign targets in favor of building businesses from scratch. Japanese firms followed a similar strategy up to a point. While many of Japan’s industrial firms preferred organic growth, Japanese firms acquired a vast portfolio of real estate holdings in the late 1980’s and early 1990’s. Insofar as China is concerned, although we are in the early stages of China’s international expansion, it seems so far that Chinese firms are following a more growth-through-acquisition type of strategy, acquiring foreign firms in both basic materials and high-tech industries.

My sense is that this has a lot to do with the capabilities of the firms from these countries. That is, by the time Japanese and South Korean firms began to expand, they did so from a position of technological strength. For this reason, they were able to organically extend existing advantages to other countries. China, by contrast, is expanding from a relatively weak technological position not only vis-à-vis Japan and South Korea, but also vis-à-vis the rest of the developed world. In this sense then, Chinese firms are embarking on a strategy of acquisition in order to acquire the technological capabilities their firms currently lack.

There was more to the interview. The soft copy is currently in newsstands (mostly in India). I am assuming they will post the interview on-line in a few months time. I will update when a link to the on-line version becomes available.

Last week I discussed winners and losers in M&A deals (see Acquisitions: A Great Shareholder Ripoff?). I lamented what I see as a transaction that too often rewards interested parties, top executives, and shareholders of the target firm at the expense of acquiring firm shareholders. I mentioned, in particular, how top executives on the sell-side stand to benefit from a takeover of their firm – e.g., via handsome golden parachutes and the immediate vesting of generous option packages.

I was therefore interested to stumble across a recent academic study (mentioned on CNBC.com) that details one interesting way top executives from target firms may be appropriating private rents at the expense not only of acquiring firm shareholders, but also at the expense of their own shareholders (see Should CEO Buyout Options be a Securities Violation?).

According to Eliezer Fich, the author of the study, and of the CNBC story:

The revelation that Marvel Entertainment CEO Isaac Perlmutter received option grants for more than a million shares while the merger of his company to Walt Disney was underway is a recent example of how CEOs of target firms have used this practice for personal gain. Indeed, in my research paper titled: “Stock Option Grants to Target CEOs during Private Merger Negotiations,” which is co-authored with Jie Cai and Anh Tran, we document that the Marvel situation is just another example of a target CEO benefiting from the private knowledge of the impending acquisition [of] his firm.

…during our data collection stage we uncovered many instances in which target CEOs received substantial unscheduled options when their firms were privately been sold.

These awards would end up netting these target CEOs millions.

…well-timed option awards (such as those received by Perlmutter) are not actionable as insider trading violations.

Despite the fact that granting unscheduled options to target CEOs might not violate insider trading laws, according to our research, such practice might be costly to target shareholders. This occurs because after receiving the options target CEOs can only cash in the options if deals go through. This might prompt these executives to accept lower takeover bids.

The Marvel case along with our findings illustrate potential loopholes in existing securities laws aimed at deterring insider trading and weaknesses in the way executive compensation is reported by public firms. Moreover, we suspect that if regulators go over data related to merges in the recent past, the issue of unscheduled stock options to target CEOs during merger negotiations might reach a status similar to the recent option backdating scandal.

Fascinating stuff! So it’s not just the shareholders of acquiring firms that stand to lose. In some cases, target firm shareholders do as well. If you want to check out the full article, please visit the SSRN site for Professor Fich’s study (click Stock Option Grants to Target CEOs).

Disclosure: Eliezer Fich and I overlapped as Ph.D. students at Stern. He was two years my senior and served as the TA (and tutor) of my Micro Econ I Theory course. That I stumbled across the article on CNBC.com and found it interesting enough to write about is mere coincidence, …although it makes me no less proud of his accomplishments. Good on ya Eliezer!

I have written much about the perils and pitfalls of acquisitions (see Why M&A Deals Go Bad, Acquisitions: A Great Shareholder Ripoff?, or DaimlerChrysler Post Mortem). So in the interest of fairness I thought I would share a story of a deal that seems to have provided value to the acquirer.

In an article that appeared in today’s New York Times, Ashlee Vance details how HP was able to derive value from its acquisition of EDS (see HP’s Bet Seems a Winner). Consistent with what I’ve mentioned in previous posts, it is in the integration phase where deals are either won or lost, …and HP seems to have been able to generate both cost saving and revenue enhancement synergies through this deal.

Ashlee writes:

After Hewlett-Packard bought the computer services company last August for $13.9 billion, it immediately began hacking the work force. Led by a master cost-cutter, Mark V. Hurd, H.P. laid off 25,000 E.D.S. workers, and cut the salaries of some by more than 20 percent. Mr. Hurd even stripped the E.D.S. brass of their plush offices and corralled them into 6-by-6-foot cubicles.

The bloodletting pains Mort Meyerson, who served alongside Mr. Perot at E.D.S. and Perot Systems for many years. “It’s sad to see this happen because of the decades of work the men and women of E.D.S. put into the company,” he said. “But that’s what happens in business.”

H.P. executives concede that the company’s aggressive pruning comes with costs…But they say that tough actions were needed to bring E.D.S. in line with competitors like I.B.M., Infosys and Wipro Technologies.

But HP has been able to derive value from EDS not simply through cost cutting. They have also benefited from revenue enhancements (cross-selling HP hardware to current, and future, EDS clients).

Historically, E.D.S. promoted computing gear from H.P. rivals like Sun Microsystems, Xerox and Cisco Systems. But Mr. Eazor says that more of H.P.’s own hardware is slated to go into deals that are currently up for bid.

Even though the equity markets did not applaud the deal at first, it looks like market participants might have gotten this one wrong.

When H.P. announced its intent to buy E.D.S. in May 2008, H.P.’s share price sank…By common business yardsticks, the Hurd touch on E.D.S. appears to have worked better than investors and analysts had expected.

Last quarter, H.P.’s operating profit margin on services hit 13.8 percent, the highest in a decade.

HP even seems ready to declare the integration a success.

On Wednesday, H.P. will take another big step toward full integration of E.D.S., extinguishing the 47-year-old company’s name. The new name, H.P. Enterprise Services, reflects the union of the services operations at the two companies.

Ashlee even goes so far as to suggest that HP’s success moving into a complementary goods market (the services business) may have motivated Dell’s acquisition of Perot Systems.

…the acquisition has paid off big for H.P. — so well, in fact, that an important rival has decided to strike a similar deal. Dell announced Monday that it was paying $3.9 billion for Perot Systems, the Texas computer services company started by H. Ross Perot after he left E.D.S.

And there you have it. Not all deals destroy value…

It’s no secret that most acquisitions fail (see Why M&A Deals Go Bad). Academic research has long demonstrated that acquisitions generally fail to create value. But if most acquisitions fail, the question then becomes: Who wins and who loses?

Kudos to David Weidner of the Wall Street Journal for asking the question (ht David). In his insightful piece, Wall Street’s Biggest Con, David sheds some light on the acquisition game:

M&A is a mostly empty exercise built on promises of profits and efficiencies that rarely come to fruition. Companies almost always overpay for their targets, hurting their shareholders and enriching few except the CEOs who do deals and the investment bankers who goad them into the next must-have merger.

Multiple studies have shown no evidence that shareholders of acquisitive companies do better than their stingier counterparts. Some companies are able to wring costs from acquisitions, but usually don’t.

With so many deals failing to meet expectations, it would seem that corporate boards and CEOs would be skeptical of the practice. They aren’t though, not when presented with smooth-talking investment bankers whispering in their ears and financial incentives awaiting them.

Investment banks love the M&A business. Except for underwriting initial public offerings, advising on mergers is the most profitable business on Wall Street…Wall Street bankers are constantly scheming up potential deals for their clients. They schmooze. They cold call. They spread rumors in the media that a company is for sale, or on the prowl, or cheap, or needs to do a deal. Strategies change like fashion: one year diversification is important. The next, a company should focus on its core business and sell non-essential divisions.

Executives of acquired companies are [even] famous for getting big payouts.

These financial incentives and the pressure from advisers make it hard for even the most confident and skilled CEO to ignore the M&A race…The sad backdrop to all of this is that companies and CEOs feel compelled to merge in lieu of anything exciting happening in their own company.

Not all deals are bad, but making a deal for the sake of the deal says something about the executive suite. Seduced with the temptation to get bigger, richer and a lot of attention, why would Joe CEO ever want to get smarter?

So let’s take stock.

Winners:

1. Top-level executives on both the buy-side (who can justify higher salaries as a result of presiding over larger empires) and sell-side (who take out a one-time windfall in options and golden parachutes)
2. Interested parties (e.g., bankers and lawyers) whose collect fees associated with deal consummation
3. Target firm shareholders
4. Merger arbitrage funds

Losers:

1. Shareholders of the acquiring firm whose wealth gets transferred to the various winners mentioned above

But these are not new problems.

We’ve known about the perverse financial incentives underpinning the M&A market for decades. The truly sad part is that armed with this information, shareholders of acquiring companies and their boards have done little to keep managerial behavior of the acquisitive kind in check.

Kudos to The Economist for recognizing that overcapacity continues to plague the automobile industry and just won’t go away (see Trouble Down the Road). Although cash-for-clunkers and other government subsidy programs meant to prop up the ailing automakers have helped the industry avert imminent disaster, the reality is that by enacting such programs governments have simply kicked today’s problems down the road until tomorrow. Not one of the major automakers has been allowed to fail in any meaningful sense, whereby massive productive capacity has eliminated from the industry.

According to The Economist:

LAST December the boss of Fiat, Sergio Marchionne, predicted that the economic crisis would finally force the world’s car industry to confront profit-destroying overcapacity and change its broken business model…But his predictions look increasingly like wishful thinking.

Across the world governments have lavished their ailing car firms with subsidies. Although General Motors (supported with over $50 billion of taxpayers’ money) has shed some brands and factories in America, so far not a single carmaker of any size has disappeared. One of the weakest was Chrysler, but thanks to a $7 billion federal bail-out and a deal with none other than Fiat, it motors on. So too does GM’s perennially lossmaking former European arm, Opel/Vauxhall, propelled with a €4.5 billion ($6.5 billion) dowry from the German government last week into the arms of Magna, a Canadian auto-parts company, and Russia’s Sberbank.

…the remarkable thing is that not a single car factory in Europe has closed in the past 12 months. According to industry estimates, overcapacity in Europe next year will be around 7m units, or 30%. In America, a market of similar size, overcapacity will fall from about 6m vehicles this year to 3.5m next year, but a great deal of the overcapacity elsewhere will be aimed at America when sales begin to recover…

All this means that the industry’s return to health is by no means assured…predictions that the car business will have to close factories to reduce overcapacity on the one hand, and consolidate into a smaller number of big firms to cut costs on the other, may not come true next year. But one way or another, they will come true eventually.

I agree with the sentiment expressed by The Economist. Even with rapid growth in developing markets, the auto industry is (and will continue to be) dogged by overcapacity. Capacity has got to be purged.

I have expressed concerns about overcapacity on several occasions. For example, in August I wrote (see A Patriotic Cerberus?):

The automobile industry has been plagued by mass overcapacity and has been in decline for decades.

In June I wrote (see Appearance on Cavuto):

…we discussed some of the ills confronting the global auto industry – i.e., the severe overcapacity problem (in the order of 20-30 million units per year). We also talked about the prospects of Chrysler ending up right back in bankruptcy within 5 years. That is a distinct possibility.

In April (see Now Introducing Fiat/Chrysler):

The global auto industry continues to be plagued by massive overcapacity. Keeping a weak competitor like Chrysler around will certainly not resolve systemic overcapacity in any meaningful way.

Overcapacity is a real problem, and expecting sales to bounce back quickly enough to eliminate that overcapacity is wishful thinking. A full recovery of the auto industry’s fortunes will not happen until the overcapacity problem gets resolved, and that likely translates into fewer plants and fewer firms.

There are many compelling reasons that companies look to developing countries for growth. Less-developed countries hold the promise of large, fast-growing consumer markets (e.g., the BRICs); an abundance of cheap labor; and access to otherwise unavailable natural resources. Managers are often lured by this unbridled potential.

But there is a reason these countries are considered “developing” – largely because of the under-developed state of their institutional environments (see also Summer Reading: The Birth of Plenty).

Although developing markets hold jaw-dropping potential, it often remains just that. Realizing potential from developing markets is incredibly challenging. Companies often find that the institutional (cultural, political, and economic) environments in the developing markets they enter are not only underdeveloped in an absolute sense, but also in a relative sense. That is, the cultural, political, and economic environments in developing markets are so vastly different from anything that they encounter in their own domestic market (or even in other developed markets) that the costs involved in navigating them exceed even their most conservative estimates.

For this reason, companies from developed countries (and developing countries) often struggle when they enter developing countries. Their investments often fail to achieve desired returns; and worse, they can get mired in red ink.

Take IKEA, for instance. It entered Russia in 2000. Its operations are still struggling, largely due to the nature of Russia’s institutional environment, in which corruption and graft are commonplace. According to the New York Times (see IKEA Tries to Build a Case Against Russian Corruption):

Weeks before the opening of its flagship store outside Moscow in 2000, Ikea was approached by employees of a local utility company. If the Swedish retailer wanted to have electricity for its grand opening, it had to pay a bribe.

Instead, Ikea rented diesel generators large enough to power a shopping mall. The generators roared to life in a loud rebuke to the corrupt executives who thought they had the retailer cornered, and soon the utility turned on the power.

As Ikea opened stores across Russia, and became one of the most outspoken Western corporate critics of Russian corruption, renting generators to thwart extortion from power companies became standard practice. Ikea executives took great pride in their creative solution — renting generators “instead of putting ourselves into a squeeze,” as Christer Thordson, an Ikea board member and global director of legal affairs, put it in an interview.

But Russian graft may have proved more stubborn than Ikea.

The board of Ikea’s operating company, which is based in the Netherlands, has concluded that the Russian executive hired to manage the generators was taking kickbacks from the rental company to substantially inflate the price of the service. Ikea said that such a fraud could cost it about $196 million over two years.

MY COMMENT: IKEA was clever to find an alternative to its energy problem. Unfortunately, it discovered that graft is endemic to Russia’s culture.

Ikea canceled the contract and sought redress in Russian civil court. But in rulings over the last two weeks, Ikea has lost another 5 million euros in damages that the judges awarded the generator rental company for breach of contract.

“We have encountered something here that is outside the scope of what we normally encounter,” Mr. Thordson said, describing the global retailer’s situation in Russia. “I have never experienced anything like this.”

The ballooning costs built into these two deals were so large they eliminated all profit from Ikea’s business managing a dozen shopping centers in Russia in 2008, Mr. Thordson said.

Ikea lawyers, in a letter to the board of Ikea’s operating company, said the opposing lawyers seemed to know the outcome of these cases in advance, suggesting collusion with the judges…“I can only suspect there have been some irregularities behind the scenes,” Mr. Thordson said.

MY COMMENT: Not only did IKEA discover that corruption and graft are endemic to the culture, but that redress through the court system is dubious for foreigners. Even when the judicial system is not corrupted and there are laws on the books to protect the interests of foreign investors, laws on the books do not equate to laws enforced. There is still a large home-team bias.

IKEA learned these lessons the hard way. Unfortunately, problems such as these are all too common for foreign companies operating in developed countries.

Entry into developing countries is not for the faint at heart…

I meant to write something last week about the market for corporate control and the recent spate of high-profile deals. I never quite got around to it. Thankfully, Michael de la Merced did (see Signs of an Upswing in Merger Activity).

What I especially appreciate about Michael’s piece (see also Private Equity: Out of the Ashes) is that it faithfully reports the recent uptick in corporate transactional activity, while being careful not to exaggerate the trend or extrapolate from the coincidental timing of a small number of high-profile deals. Michael is careful to point out that we are a long way from a “healthy” market for corporate control, and I could not agree more!

As Mr. de la Merced points out:

Merger mania may not be quite in full swing. But the pace of deal-making is showing signs of rousing back to life after nearly a year.

Kraft Foods’ hostile bid for Cadbury on Monday was only the latest potential blockbuster deal in recent days. In the last week, several multibillion-dollar deals have been announced, including those involving prominent companies like Walt Disney and eBay.

Yet many of the bankers and lawyers who piece these mergers together, well versed in reading economic tea leaves for signs of an industry’s health, caution that deal-making is likely to rise only in fits and starts for now.

“The clouds have broken a little bit, and there’s a little bit of sunshine,” said Douglas L. Braunstein, the head of investment banking for JPMorgan Chase. “But it’s too early to say the storm’s over.”

Deal activity remains far below the giddy heights of only a few years ago. About $1.32 trillion worth of deals have been announced this year through Monday, according to data from Thomson Reuters. That figure is down 37 percent from the same point last year and 56 percent from 2007. (It also includes deals that have yet to close.)

In fact, until last week, August shaped up to be the slowest month for deals since 1994, according to Thomson Reuters. Now, it is just the slowest month since last November.

Another trend that Michael has picked up on, and one that I have discussed in previous posts, is the acquisition of troubled/distressed/bankrupt targets:

…the troubled deals of yesterday have led to opportunities for companies and private equity firms, which are snatching up targets out of Chapter 11. The number of bankruptcy-related mergers and acquisitions has risen to 241 this year through August, a 65 percent increase over the same time in 2008, according to Thomson Reuters data.

…What lies in store is mostly expected to be more of what has transpired this year: opportunistic purchases by corporations with healthy credit ratings, stock values and cash.

That is where I expect the lion’s share deal-making activity to take place over the next few years years (see Private Equity: Out of the Ashes). There will be a hearty market for distressed assets, in which companies with strong balance sheets acquire those with weak balance sheets. This will likely usher in a wave of industry consolidation.

Several months ago I wondered aloud whether the current rally had legs based on Q1 corporate earnings (see Are Better-than-Expected Earnings Illusory? or Corporate Earnings Redux). I concluded in June:

The key then to the future of corporate profitability lies in whether you believe corporate earnings have bottomed out and will now begin to increase from a lower base, or whether you believe that there is still substantial downside risk that increasing unemployment and decreased consumer spending will continue to put a crimp in profitability. Given the nearly 40% rally in equity markets over the past several months, market participants clearly believe the former. I fear that the latter might be more representative.

Markets have continued to rally since June, and were up more than 50% from the March lows. But Q2 earnings looked no different than Q1. The story, again, was better-than-expected earnings based off greatly reduced earnings expectations, and greater-than-expected cost cutting. There was not much revenue growth; instead, revenues broadly declined.

Given the lackluster nature of corporate profitability, many have now begun to question the underlying rationality of the rally, including the following thought-provoking piece from this week’s edition of The Economist (see Has the Tide Turned for Corporate Profits?). According to The Economist:

The recent rally in shares has been driven…by hopes of economic recovery. But if those recovery hopes do not translate into a rebound in profits, it is hard to see how the rally can last.

The American second-quarter results season was undoubtedly better than expected. But it is worth remembering that such positive surprises are quite common, with companies massaging down expectations in the run-up to their figures. David Rosenberg of Gluskin Sheff, a Canadian asset-management firm, says profits were actually down 27.8% year-on-year…

MY ADDENDUM: Again, it’s not simply that companies/analysts ratcheted down expectations leading to better-than-expected earnings, but that companies beat expectations due, in large part, to greater-than-expected cost cuts.

With profits still falling, the rally has thus been driven by a re-rating of the market. Assuming operating earnings hit $50 a share in the third quarter, the S&P 500 index is trading on a price-earnings ratio of 20, the kind of multiple normally associated with boom conditions. Clearly, investors are expecting a robust profits recovery in the years ahead.

But companies are digging themselves out of a deep pit…

It is this deep pit that should be most disconcerting. And again, it all comes down to the assumptions that you are willing to make about how quickly firms are likely to emerge from that pit. Some expect demand to increase rapidly leading corporate profitability to snap back (at least that’s how the market seems to be pricing it). But given the precarious state of consumer balance sheets, top-line growth drivers are less than obvious to me, …even if we are experiencing something of an economic recovery. Moreover, cost cutting is not a sustainable path to profitability. For these reasons I remain less sanguine than most about the speedy return of corporate profitability.

On my way out of town for a much needed break. Here are a few things that caught my attention:

1. American Graduates Finding Jobs in China
2. Hints of a Rebound in Global Trade
3. Interest Fizzles in Cash for Clunkers
4. Volkswagen and Porsche Close In on Deal to Combine
5. The Pay at the Top (Compensation for 200 Chief Executives)
6. Life without Landlines
7. An Early Stab at Quantitative Easing
8. US Homeowners Cut Asking Prices
9. GM and Chrysler in Different Paths to Recovery
10. Asia’s Astonishing Rebound?
11. A Debate over Cause and Effect (kind of geeky, but how can I not include an article that mentions instrumental variables)

Happy Weekend!