On 17 December 2010 HMRC announced their intention to roll out a programme of Business Record Checks in the second half of 2011. At present they are consulting with professional organisations regarding the scope of their enquiries. This consultation will be completed and the results published by 31 March 2011.
If your business is selected HMRC staff will visit your premises and ask for access to all your business records. If they feel that there is a significant failure to keep proper records penalties may be charged and additional tax assessments raised.
HM Revenue & Customs are going to use existing legislation to check business records in up to 50,000 cases annually. Businesses targeted will have 250 employees or less and turnover below 50m Euros. (At present exchange rates just over £40m). Checks will begin in the second half of 2011 and HMRC will impose penalties for significant record keeping failures.
Once HMRC are aware that your record keeping is defective this will no doubt trigger visits from a number of their departments. You may get additional PAYE/NIC or VAT audit checks for instance.
Wwe’ve got a another free diagnostic tool on our website, just to check if your records are likely to be OK. It’s at www.hixsons.co.uk. It only takes a few minutes for a lot of peace of mind.
Clearly this is not an issue to ignore. Are your records in shape? Will they pass an inspection? Yet again we have a situation where smaller businesses are faced with additional pressures from the taxman. Unfortunately the threat of a visit is unlikely to go away. Be prepared!
Friday, 18 February 2011
Wednesday, 26 January 2011
… Different customers value things differently.
We all value things differently. We all have a different perception of the value of any product or service. So we all have a different maximum amount we are willing to pay for a particular product or service. It’s our personal judgement call – and it’s entirely subjective. “So what?” you might be thinking. Well, this seemingly tiny observation has a profound implication. You see, it means that whatever price you are currently charging, that price is WRONG!
Is that a big enough implication for you? Actually, I probably need to clarify that statement that your price is wrong. Let me be more precise. If you have a single price for your product, then that single price is WRONG… no matter what that single price actually is.
You see, having only a single price causes you to lose out in two different ways....
- For some customers that price is too high – so they don’t buy, and you lose them as a customer.
- And for other customers that price is too low – so you end up charging them less (and earning less profit) than they are willing to pay. Which means you lose again.
Economists call the amount by which you lose in this second scenario the “Consumer surplus”. So one of the keys to dramatically improving your profits is to claw back some of this consumer surplus by charging different customers different prices.
Let’s now look at the maths.
EXAMPLE
Imagine that you sell widgets that cost you £1 each and for which there are three potential customers: A, B and C.
- Customer A is willing to pay £4
- Customer B is willing to pay £3 and
- Customer C is willing to pay £2.
If you set a single price at £2, the all three customers will gladly pay you £2. So you’ll make total sales of £6 and profits of £3.
If you set a single price at £3, then Customer C won’t buy. But the other two will gladly pay you £3 each. So you’ll make total sales of £6 and total profits of £4.
If you set a single price at £4, then only Customer A will buy. So your total sales will be £4 and your total profits will be £3.
The MAGIC PRICE is the price at which you make the most profits. So in this example the MAGIC PRICE is £3 – since at that price you make £4 in profits – which is 33% higher than at any other price.
Now £3 is the MAGIC PRICE… because there is no other single price at which you can make higher profits. But we also know that: Customer A is willing to pay £4, Customer B is willing to pay £3 and Customer C is willing to pay £2.
So, if instead of charging those three customers all the SAME prices, we charge them the full price they are willing to pay, then our total profits will be £6. Customer A will pay £4, Customer B £3 and Customer C £2, so total sales are £9, with costs of £3. Which is half as much again as the £4 profits we made at the magic price.
Now it’s vital to recognise that there is nothing fishy or special about the numbers in our example. YES, I've kept the numbers as simple as possible. And YES, the real world is much more complicated.
But those complications do nothing to alter the fact that if you can find a way to charge different customers different prices – so that they each pay what they are willing to pay – then you will ALWAYS make more profits than you do by using any single price... even if that single price is your magic price.
In our example we made 50% more profits by switching from the magic price to charging each customer the full price they were willing to pay. In your business the impact could be more or less than 50%. But there WILL be an impact. Charging different customers different prices WILL increase your profits… and probably by a lot!
Economists call this “price discrimination” – but we prefer the Plain English description of charging different customers different prices, since that’s what it actually involves.
But how do you actually do it? Because it actually dies work, and it's not illegal, or immoral (maybe fattening)
Well, the key is being much more creative about pricing.
In future blogs) we’ll look at:
- exactly how you create different versions of your products and services,
- how you price those different versions,
- how you present (and explain) them to your customers, and vitally important,
- the order in which you present them to your customers.
Is that a big enough implication for you? Actually, I probably need to clarify that statement that your price is wrong. Let me be more precise. If you have a single price for your product, then that single price is WRONG… no matter what that single price actually is.
You see, having only a single price causes you to lose out in two different ways....
- For some customers that price is too high – so they don’t buy, and you lose them as a customer.
- And for other customers that price is too low – so you end up charging them less (and earning less profit) than they are willing to pay. Which means you lose again.
Economists call the amount by which you lose in this second scenario the “Consumer surplus”. So one of the keys to dramatically improving your profits is to claw back some of this consumer surplus by charging different customers different prices.
Let’s now look at the maths.
EXAMPLE
Imagine that you sell widgets that cost you £1 each and for which there are three potential customers: A, B and C.
- Customer A is willing to pay £4
- Customer B is willing to pay £3 and
- Customer C is willing to pay £2.
If you set a single price at £2, the all three customers will gladly pay you £2. So you’ll make total sales of £6 and profits of £3.
If you set a single price at £3, then Customer C won’t buy. But the other two will gladly pay you £3 each. So you’ll make total sales of £6 and total profits of £4.
If you set a single price at £4, then only Customer A will buy. So your total sales will be £4 and your total profits will be £3.
The MAGIC PRICE is the price at which you make the most profits. So in this example the MAGIC PRICE is £3 – since at that price you make £4 in profits – which is 33% higher than at any other price.
Now £3 is the MAGIC PRICE… because there is no other single price at which you can make higher profits. But we also know that: Customer A is willing to pay £4, Customer B is willing to pay £3 and Customer C is willing to pay £2.
So, if instead of charging those three customers all the SAME prices, we charge them the full price they are willing to pay, then our total profits will be £6. Customer A will pay £4, Customer B £3 and Customer C £2, so total sales are £9, with costs of £3. Which is half as much again as the £4 profits we made at the magic price.
Now it’s vital to recognise that there is nothing fishy or special about the numbers in our example. YES, I've kept the numbers as simple as possible. And YES, the real world is much more complicated.
But those complications do nothing to alter the fact that if you can find a way to charge different customers different prices – so that they each pay what they are willing to pay – then you will ALWAYS make more profits than you do by using any single price... even if that single price is your magic price.
In our example we made 50% more profits by switching from the magic price to charging each customer the full price they were willing to pay. In your business the impact could be more or less than 50%. But there WILL be an impact. Charging different customers different prices WILL increase your profits… and probably by a lot!
Economists call this “price discrimination” – but we prefer the Plain English description of charging different customers different prices, since that’s what it actually involves.
But how do you actually do it? Because it actually dies work, and it's not illegal, or immoral (maybe fattening)
Well, the key is being much more creative about pricing.
In future blogs) we’ll look at:
- exactly how you create different versions of your products and services,
- how you price those different versions,
- how you present (and explain) them to your customers, and vitally important,
- the order in which you present them to your customers.
Monday, 3 January 2011
New Year, old you?
“There’s no time!”
Well, you’ve got all there is. Yes, all of it. So if you haven’t got time, whose fault is it?
So often I’m at a client, trying to resolve some issue, and this is the reason it can’t be done. “There’s no time”. All these other things to do. No time to even stop to think if these things need to b done..so no one knows they they should be doing these things or not. No time to decide. Too busy doing exactly what they did yesterday, and the day before, and moaning they’ve no time!
Here’s a simple trick I use all the time. I wrote a small book a couple of years ago – Conversations for a Thoughtful Life – to my kids. It includes this little homily.
“Cut the crud
We live in an age of information overload. Added to that, we over think and worry, and find it difficult to sort out what is important from what is not. There are more and more demands upon our time and our thoughts. This is no doubt only going to increase.
What to do? My method is to be as lazy as possible, which will perhaps appeal to you. There’s no point in being a busy fool. You need to be effective rather than efficient. Also the only person's problems you want to deal with are yours. You don’t want half the world jumping on you, with all their issues, which they are sure (!) will be better dealt with by you. After all, you're only responsible for you, not everybody else you might come into contact with during the day.
So here's my simple little visualisation to tidy all this up in your mind. I simply imagine three big pigeonholes -- only three. In the first one are things that I have to do, of which there are only a few and there is quite a lot of space left. In the middle one are things that I want to do. This has a few more things in it, but there's still a lot of space left. And in the last pigeonhole is crud. This is full to overflowing -- it's impossible to cram another piece of paper in it. You know - you’ve been trying to cram more in all these years!
When something else is presented to me that apparently I have to do -- I simply measure it against the three pigeonholes. Do I have to do it? Do I want to do it? Or is it crud? And if it is crud -- which most of it is -- I simply don't do it. I've got enough crud to deal with already. Note the elegance of that last bit -- I'm not postponing dealing with this -- I'm not ever going to do it. If it's crud I don't need to do it. Don't confuse that with things that you will do at some point. You won't. It's crud. Remember? So why would you want to do it ever?
Liberating isn't it? And also quite a good filter for all the things which other people wish upon you. Things which are really their responsibility -- not yours. You've got enough of your own crud - remember?”
It works every time. It clears your mind so you’ve got the time to make small changes that make a big difference. Because those small changes get you even more time, so then you can think, really think, about what you want and need for your business to succeed. And then implement it. It’s what we do. Help clients get the time, do the plan, make the changes.
Here’s another small story to finish with, to help you with your personal time, and what other people may value about you.
Charles Francis Adams was Ambassador to Great Britain during the time of Abraham Lincoln’s presidency. He was something of a workaholic and rarely took the time to do anything with his son as a child.
However he did take time to write in his diary every day. It so happened that his son kept a diary too. After his father died, the son found the diary. The son recalled a day when, as a young boy, he had gone fishing with his father. So important and special was that day for the son that he wrote in his diary; “went fishing went with my father, the most glorious day of my life.”
The son was to refer to it repeatedly in his diary, but when he turned to the same date in his father’s diary, he found; “Went fishing with my son, a day wasted.”
Children spell many things differently to adults, and children spell love like this … TIME.
Well, you’ve got all there is. Yes, all of it. So if you haven’t got time, whose fault is it?
So often I’m at a client, trying to resolve some issue, and this is the reason it can’t be done. “There’s no time”. All these other things to do. No time to even stop to think if these things need to b done..so no one knows they they should be doing these things or not. No time to decide. Too busy doing exactly what they did yesterday, and the day before, and moaning they’ve no time!
Here’s a simple trick I use all the time. I wrote a small book a couple of years ago – Conversations for a Thoughtful Life – to my kids. It includes this little homily.
“Cut the crud
We live in an age of information overload. Added to that, we over think and worry, and find it difficult to sort out what is important from what is not. There are more and more demands upon our time and our thoughts. This is no doubt only going to increase.
What to do? My method is to be as lazy as possible, which will perhaps appeal to you. There’s no point in being a busy fool. You need to be effective rather than efficient. Also the only person's problems you want to deal with are yours. You don’t want half the world jumping on you, with all their issues, which they are sure (!) will be better dealt with by you. After all, you're only responsible for you, not everybody else you might come into contact with during the day.
So here's my simple little visualisation to tidy all this up in your mind. I simply imagine three big pigeonholes -- only three. In the first one are things that I have to do, of which there are only a few and there is quite a lot of space left. In the middle one are things that I want to do. This has a few more things in it, but there's still a lot of space left. And in the last pigeonhole is crud. This is full to overflowing -- it's impossible to cram another piece of paper in it. You know - you’ve been trying to cram more in all these years!
When something else is presented to me that apparently I have to do -- I simply measure it against the three pigeonholes. Do I have to do it? Do I want to do it? Or is it crud? And if it is crud -- which most of it is -- I simply don't do it. I've got enough crud to deal with already. Note the elegance of that last bit -- I'm not postponing dealing with this -- I'm not ever going to do it. If it's crud I don't need to do it. Don't confuse that with things that you will do at some point. You won't. It's crud. Remember? So why would you want to do it ever?
Liberating isn't it? And also quite a good filter for all the things which other people wish upon you. Things which are really their responsibility -- not yours. You've got enough of your own crud - remember?”
It works every time. It clears your mind so you’ve got the time to make small changes that make a big difference. Because those small changes get you even more time, so then you can think, really think, about what you want and need for your business to succeed. And then implement it. It’s what we do. Help clients get the time, do the plan, make the changes.
Here’s another small story to finish with, to help you with your personal time, and what other people may value about you.
Charles Francis Adams was Ambassador to Great Britain during the time of Abraham Lincoln’s presidency. He was something of a workaholic and rarely took the time to do anything with his son as a child.
However he did take time to write in his diary every day. It so happened that his son kept a diary too. After his father died, the son found the diary. The son recalled a day when, as a young boy, he had gone fishing with his father. So important and special was that day for the son that he wrote in his diary; “went fishing went with my father, the most glorious day of my life.”
The son was to refer to it repeatedly in his diary, but when he turned to the same date in his father’s diary, he found; “Went fishing with my son, a day wasted.”
Children spell many things differently to adults, and children spell love like this … TIME.
Thursday, 18 November 2010
Effective Conversations
I am constantly surprised at the number of people (a lot of them being my fellow professionals) who do not ask enough questions to provide effective solutions to their clients.
I ask so many questions. I’m probably quite annoying – in fact my kids tell me I am very annoying. But without effective questioning you don’t get to the heart of the matter. Things just hang. Problems can be identified, but solutions are not proposed. And clients get frustrated with this approach. I don’t blame them – I would.
Without getting too technical I saw a set of accounts this week which had been subject to an audit. The audit opinion had been qualified by the company’s auditors. This, in itself, is unusual – this was qualified on four separate counts which is almost unheard of. After questioning the director for about three quarters of an hour, we discovered that he could provide information in advance of the audit that would satisfy all of those things. As the nature of the company’s business involved substantial bank borrowings, the last thing the company needs is a qualified audit report which will most certainly spook the bank. Oh, and the audit will be cheaper this year as less angst needs to be expended by the auditors on the actual wording of the audit report!!
I looked as another set of accounts for a new client a couple of weeks ago where the owner directors were purely remunerated by salary. Without them having to sell one other thing, or incur one extra cost, they are now getting an extra £5,700 a year each after-tax in their hands. Suddenly, their view of the business is different, as now they can afford to enjoy more of what they work for.
These are just two examples of me not doing anything particularly clever. I’ve just asked why are you doing that, or why can’t you do this? I’m amazed that in times of recession simple effective well tried advice is still not being given, because the professionals are too obsessed by the technicalities. It’s a simple case of not seeing the wood for the trees.
Here’s another one. Another audit, which means that the auditor has to send a management letter to the company outlining issues that the auditor has discovered. The auditor correctly identified that there was a major issue with subcontractors which if there had been a PAYE investigation might have led to a very substantial bill for the company. I’m talking £250,000 or so. They put this in the management letter. With the management letter they sent their bill, which was double what the company was expecting. They did not tell the company how to rectify this problem. I did!
What did they do wrong? Well, apart from not warning the company about the increased fee, they forgot that they were not just doing an audit. They got to the end of the audit, filled in all their questionnaires and checklists, and stopped. They did all their internal processes, which are important to them, but no one else, bluntly, gives damn about them.
These are all relatively recent – I can find lots more. It’s exasperating.
I have a simple rule for my professional colleagues that work with me. Anybody in the office can come to me with a problem. The door is always open. But – they must come with their proposed solution as well. It’s what I want, and I know full well it is what my clients expect - solutions Why have so few people failed to work this out?
And for your businesses, do your internal processes stop short of what your customers need and expect? Should you be looking at ways of asking better questions, before your competitors do?
I’ll happily look at them with you if you like, to get you to be as annoying as me!
I ask so many questions. I’m probably quite annoying – in fact my kids tell me I am very annoying. But without effective questioning you don’t get to the heart of the matter. Things just hang. Problems can be identified, but solutions are not proposed. And clients get frustrated with this approach. I don’t blame them – I would.
Without getting too technical I saw a set of accounts this week which had been subject to an audit. The audit opinion had been qualified by the company’s auditors. This, in itself, is unusual – this was qualified on four separate counts which is almost unheard of. After questioning the director for about three quarters of an hour, we discovered that he could provide information in advance of the audit that would satisfy all of those things. As the nature of the company’s business involved substantial bank borrowings, the last thing the company needs is a qualified audit report which will most certainly spook the bank. Oh, and the audit will be cheaper this year as less angst needs to be expended by the auditors on the actual wording of the audit report!!
I looked as another set of accounts for a new client a couple of weeks ago where the owner directors were purely remunerated by salary. Without them having to sell one other thing, or incur one extra cost, they are now getting an extra £5,700 a year each after-tax in their hands. Suddenly, their view of the business is different, as now they can afford to enjoy more of what they work for.
These are just two examples of me not doing anything particularly clever. I’ve just asked why are you doing that, or why can’t you do this? I’m amazed that in times of recession simple effective well tried advice is still not being given, because the professionals are too obsessed by the technicalities. It’s a simple case of not seeing the wood for the trees.
Here’s another one. Another audit, which means that the auditor has to send a management letter to the company outlining issues that the auditor has discovered. The auditor correctly identified that there was a major issue with subcontractors which if there had been a PAYE investigation might have led to a very substantial bill for the company. I’m talking £250,000 or so. They put this in the management letter. With the management letter they sent their bill, which was double what the company was expecting. They did not tell the company how to rectify this problem. I did!
What did they do wrong? Well, apart from not warning the company about the increased fee, they forgot that they were not just doing an audit. They got to the end of the audit, filled in all their questionnaires and checklists, and stopped. They did all their internal processes, which are important to them, but no one else, bluntly, gives damn about them.
These are all relatively recent – I can find lots more. It’s exasperating.
I have a simple rule for my professional colleagues that work with me. Anybody in the office can come to me with a problem. The door is always open. But – they must come with their proposed solution as well. It’s what I want, and I know full well it is what my clients expect - solutions Why have so few people failed to work this out?
And for your businesses, do your internal processes stop short of what your customers need and expect? Should you be looking at ways of asking better questions, before your competitors do?
I’ll happily look at them with you if you like, to get you to be as annoying as me!
Friday, 5 November 2010
QE2 - the new Titanic?
QE2 is the name for the latest round of quantitative easing announce by America’s Federal Reserve this week.
If you want a 15 minute lecture on what QE is, go here What is quantitative easing?, it’s actually quite enlightening.
The Fed can’t cut interest rates (already done that, so has the Bank of England), so it has to print money to stimulate the US economy.
This has an impact on assets prices – stocks and bonds. We’ve done it here as well. It means, with low interest rates, that investors are driven to more risky assets to try and beat inflation with their money. Weaker, more indebted, less efficient companies survive, when in reality they should have failed, or been bought up by more successful rivals. Good companies are thus penalised, and handicapping the better businesses hampers your economy. So if you’ve got a decent business, blame the central bankers if you can’t expand, get credit, or buy up a competitor.
It also weakens the currency, which makes it easier to export, or such is the theory. But every major currently is trying to do the same, and they are all chasing their currencies down. Sooner or later, a major economy is going to say enough is enough, and introduce trade barriers, which should ensure we all suffer.
China is already not happy – they hold trillions in foreign currency – mainly dollars, which have just devalued. And China needs to export to maintain its growth. Where do most of those exports go? You guessed – the most consumption hungry country on the planet – the USA.
Commodity and food prices are already rising, and this would accelerate the trend. Inflation in prices but not in wages will hurt far more than anything the Chancellor proposed recently.
But anything to avoid the issue for a bit longer, which is the Fed’s game plan.
The Fed, by the way, has been in existence for 97 years. And in that time the dollar has lost 95% of its value. Not long to go!
If you want a 15 minute lecture on what QE is, go here What is quantitative easing?, it’s actually quite enlightening.
The Fed can’t cut interest rates (already done that, so has the Bank of England), so it has to print money to stimulate the US economy.
This has an impact on assets prices – stocks and bonds. We’ve done it here as well. It means, with low interest rates, that investors are driven to more risky assets to try and beat inflation with their money. Weaker, more indebted, less efficient companies survive, when in reality they should have failed, or been bought up by more successful rivals. Good companies are thus penalised, and handicapping the better businesses hampers your economy. So if you’ve got a decent business, blame the central bankers if you can’t expand, get credit, or buy up a competitor.
It also weakens the currency, which makes it easier to export, or such is the theory. But every major currently is trying to do the same, and they are all chasing their currencies down. Sooner or later, a major economy is going to say enough is enough, and introduce trade barriers, which should ensure we all suffer.
China is already not happy – they hold trillions in foreign currency – mainly dollars, which have just devalued. And China needs to export to maintain its growth. Where do most of those exports go? You guessed – the most consumption hungry country on the planet – the USA.
Commodity and food prices are already rising, and this would accelerate the trend. Inflation in prices but not in wages will hurt far more than anything the Chancellor proposed recently.
But anything to avoid the issue for a bit longer, which is the Fed’s game plan.
The Fed, by the way, has been in existence for 97 years. And in that time the dollar has lost 95% of its value. Not long to go!
Saturday, 30 October 2010
Keep calm and carry on. Unlike the French..
Just a few miles of water, yet so different. Here, we calmly accept swingeing budget cuts in welfare and public services. Over the Channel, there are riots over the relatively small change to pension ages. Even from schoolchildren who frankly don’t know what they are rioting for.
Yet, we, in Britain, are facing much more hardship in trying to deal with the public sector deficit. And let’s just remember, lest we moan first and ask questions later, that what is proposed is to take us back to spending levels in 2006-7, when we were hardly on the breadline. So maybe we can do this.
In earlier times, we as a nation were less keen on quantitative easing – a practice which now has worldwide approval, judging from the numbers of governments that practice it. In 1142 Henry II, when finding that some of his officials had debased the coinage, castrated some and cut the hands off the others. Now, their descendants are applauded for helping us to continue to spend above our means. Henry understood that the coinage was the wealth of the country, and debasing it devalued everything that could be bought and sold using it. How did we forget?
How much can we easily do without if we had to I wonder? Why not try now, while you still have the choice, and see what you can do? Will the car last another year? Do you need two foreign holidays next year, remembering that Airline Passenger Duty has just gone up? Can we manage? Of course we can. Will some people suffer? Of course they will? Will it be fair – when a good chunk of the burden falls on an overblown benefits system – no, it won’t. But is there a better way? Doubtful, and can we really wait to find out?
I know the answer to that one. I’ve had to be the nasty man that has employees that they have lost their jobs because the company couldn’t carry on as it was. I’ve known that it doesn’t just affect them, but their families, their kids’ aspirations, their community. And I’ve probably cut too deep, and put too many people out of work. Better too deep, and reemploy later, because if I hadn’t, and cut too little, they would all have been put out of work later. And that I think is where we are now. So it will hurt – a bit for some, a lot for many. Better than a lot of suffering for many.
And on a more cheery note, we can always remember what the difference is between civilised mankind and the animals. The English Channel!
Yet, we, in Britain, are facing much more hardship in trying to deal with the public sector deficit. And let’s just remember, lest we moan first and ask questions later, that what is proposed is to take us back to spending levels in 2006-7, when we were hardly on the breadline. So maybe we can do this.
In earlier times, we as a nation were less keen on quantitative easing – a practice which now has worldwide approval, judging from the numbers of governments that practice it. In 1142 Henry II, when finding that some of his officials had debased the coinage, castrated some and cut the hands off the others. Now, their descendants are applauded for helping us to continue to spend above our means. Henry understood that the coinage was the wealth of the country, and debasing it devalued everything that could be bought and sold using it. How did we forget?
How much can we easily do without if we had to I wonder? Why not try now, while you still have the choice, and see what you can do? Will the car last another year? Do you need two foreign holidays next year, remembering that Airline Passenger Duty has just gone up? Can we manage? Of course we can. Will some people suffer? Of course they will? Will it be fair – when a good chunk of the burden falls on an overblown benefits system – no, it won’t. But is there a better way? Doubtful, and can we really wait to find out?
I know the answer to that one. I’ve had to be the nasty man that has employees that they have lost their jobs because the company couldn’t carry on as it was. I’ve known that it doesn’t just affect them, but their families, their kids’ aspirations, their community. And I’ve probably cut too deep, and put too many people out of work. Better too deep, and reemploy later, because if I hadn’t, and cut too little, they would all have been put out of work later. And that I think is where we are now. So it will hurt – a bit for some, a lot for many. Better than a lot of suffering for many.
And on a more cheery note, we can always remember what the difference is between civilised mankind and the animals. The English Channel!
Friday, 3 September 2010
You don’t have to be a genius to make money (but a genius can lose it for you)
I’ve always curious about the role of the credit rating agencies (you know “Ireland has been degraded to AA, this has been graded a junk bond “– that’s BB by the way). And now, thanks to Addison Wiggins and The Daily Reckoning, I know. And more importantly I know why it matters to us all.
There are 3 main agencies – Standard & Poors, Fitch, and Moodies. All reside in New York. All staffed by geniuses, who do complex projections on the worth of sovereign debt, the bonds and credit worthiness of companies listed on the New York Stock Exchange, London Stock Exchange etc. Their ratings give us a clue as to the financial strength of the companies we (and our pension schemes etc) invest in. So AAA is the best, BB is junk. We thus have information how to best put our hard earned, after tax income. They are supposed to provide a clear playing field for all investors.
But they haven’t. They have mispriced risk over the last decade, and it has cost us all dear. A Senate study showed last month that over 91% of the AAA rated mortgage backed securities issued 2006-2007 have been downgraded to junk. S&P rated Iceland A+ three months before its currency collapsed. Only really clever people can muck it up this badly – hence the second bit of the title. All three rating agencies are run by brilliant quantitative economists, with Mensa levels of IQ and zero common sense. No model they used took account of generational crisis – all models were too short term. As I’ve pointed out before - study history!
Still they pontificate, and are used by just about all major firms and countries in the world. Why - because those firms offer securities which they want to be sold – to you and me, directly or otherwise. So we need information to encourage us to buy them. Would we buy if we thought our money was at far more risk, or would be expect more reward in terms of interest if we feared we would lose our capital? Of course we would, but that would make the cost of capital for the issuing firms that much higher, so the issuer wants a good rating.
Here’s a good rule that accountants use (well I do anyway). You should, too. Follow the money. Who gets paid by whom for what?
How do ratings agencies get paid? The big three get paid by the firms issuing the securities. That’s not to say the agencies are in cahoots with these firms. They are not; it’s simply a flawed model. Too cosy.
Other agencies do a different job – some would say better. Egan Jones is paid by the buyers of the bonds it rates. Does that sound better to you?Should you trust the truly important investments in your life to this circle of self interest? Ratings agencies, investment banks et al don’t bother with small companies, commodities, smaller funds and other such things with limited potential to make them money. Not you – them. Should you.
So by all means look at the barometers shown by the agencies, because that will tell you what everyone else is thinking, but don’t trust your widows and orphans fund to anything you don’t understand, or where you have to rely too much on someone else’s opinions. Especially if you aren’t a genius and they are.
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