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The Tyranny of Low Cost Strategies and the Gospel of Walmart

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High Frequency Trading is in the news again. HFT is highly computerized stock trading, which secures faster execution for bigger computers located physically closer to the stock exchange. It now amounts to over half the daily flow on the stock exchanges.  Critics argue it amounts to legalized front-running, is unethical, and should be illegal.

The issue was raised starkly in a July 24 2009 CNBC interview  wherein a critic of HFT (Joe Saluzzi) accuses a proponent (Irene Aldridge) of defending unethical behavior. Aldridge’s reply:

“How dare you accuse us being unethical! We are the ones cutting margins, you are the ones being unethical.”

Ms. Aldridge’s response captures perfectly the moral flip-flop that business has achieved in the past few decades. Never mind whether HFT amounts to front-running, involves collusive behavior by the exchanges, or is unfair to retail investors, says Ms. Aldridge – the moral high ground, the Ethical Trump Card, is Low Cost. In the name of lower prices, even fractions of pennies, all is justified.

The Gospel of Walmart

Let’s leave Wall Street for Main Street. We all know the Walmart story – low prices all the time. But as a Fast Company article wrote, back in 2007:

The giant retailer’s low prices often come with a high cost. Wal-Mart’s relentless pressure can crush the companies it does business with and force them to send jobs overseas. Are we shopping our way straight to the unemployment line?

If revenue were GDP, Walmart would be the world’s 25th largest economy. That is pretty big market power.

Walmart’s benefits are clear: lower prices, all the time, for millions of consumers. But along with those costs come trade-offs. The reduction of brand power. The exporting of jobs. The reduction of pay and benefits for workers in the name of lower costs to consumers.

More insidiously, what we get in the Walmart deal is lowest-common-denominator consuming. We get buyers who aren’t presented with quality alternatives, can’t recognize them if they are presented, and are trained to view low price as the primary Pavlovian trigger for purchasing.

That’s how we get tramplings at 5AM holiday store openings; that’s how the US produces twice the garbage per capita of Sweden; and I suspect (though can’t prove it) it helps us move toward becoming a nation of hoarders.

Is it all worth it?

The Tyranny of Low-Cost Strategies: Linking Wall Street and Main Street

What links high frequency trading to Walmart?  There is a common ancestor in the family tree of business thinking.

In the 1970s, thinking about business strategy took an abrupt turn – from CUS to COM.  That is, from being about the company’s relationship to its customers, to being about the company’s relationship to its competitors. (If you’re interested, the leading thinkers were Bruce Henderson, Michael Porter, and the Boston Consulting Group).

By 1980, the conversion was complete: anytime anyone said “strategy,” you knew it meant “competitive strategy.”

One of the most powerful points Porter made in his classic Competitive Strategy was that there were two successful generic strategies, and the first of them was Low Cost Producer. He who got the lowest cost got the greatest volume, which led to higher market share and higher profits, which led to lower costs, and so on. It was a road toward legal monopoly, insofar as laws permitted.

Porter’s rules were learned very well: by Jack Welch at GE, by Walmart, by the mortgage business, by Wall Street traders, and by every exec ed program in every business school in the world. It became – and I do not use the word lightly – gospel truth that the highest business good was to lower costs.

The root purpose of lower costs was to gain sustainable competitive advantage for the company. But the collateral benefit, the offshoot which could be spun for great PR, was that the consumer benefited as well. Allegedly.

This insight took only a little bit of tweaking (let’s revise Adam Smith and Milton Friedman, season with a dose of Ayn Rand and a dash of Alan Greenspan, and voila!) to come up with an ideology that said not only is low cost a successful business strategy, it is also the Key to Capitalism, which in a capitalist society is also the source of ethics. Allegedly.

This is how we get to Ms. Aldridge’s high dudgeon at being accused of unethical behavior (“Moi?!”) In this all-too-common alternative view of the world,  profit underlies ethics, business success is the root of morality, and low cost is the Ur-explanation that requires no further referent point for ethical discussion.

“We are the ones cutting margins – you are the ones being unethical.” In that statement, the transformation is complete: low cost is the new moral high ground.

Be careful what you wish for.

 

Deer in the Headlights Decison-Making

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I’m reading A Demon of Our Own Design, by Richard Bookstaber. He did not cause the major market meltdowns of the last two decades, but—as he puts it—“let’s just say I was in the neighborhood.”

More on that book another time. There is one fascinating passage about human behavior. Bookstaber noticed major league top Wall Street traders caught like a deer in the headlights on the wrong side of a bet about the outcome of a potential MCI/BT merger.

As the bet soured from a $100 million loss to worse, the team gathered to re-assess the situation. A half-dozen variables had moved against them since the last discussion a few weeks earlier. Yet, amazingly, the outcome of the meeting was to ratify the existing position. Bookstaber puts it:

Stavis and I joked after the meeting how miraculous it was that with all the dislocations in the market, with all the surprise events and changes in the fortunes of the trade, it turned out that the position we had on at the time of our meeting still just happened to be exactly the right amount.

He expands:

It was a phenomenon that I found again and again and that seems to be an innate part of trader behavior: inertia against changing a losing position, and more specifically, inertia when faced with losses coming from unexpected corners. In experimental biology there is a term for this: experimental neurosis. An animal in the laboratory, beset by a strange environment and events that are outside of its past experience, will sometimes simply curl up in a ball and ignore all of the stimuli. Its reaction to the alien environment is to freeze in its tracks…this is not limited to the behavior of animals in the lab; it is a phenomenon that arises from the core of how we approach the world.

Damn right.

Now—contrast that with one of the great business stories of our time—Andy Grove and Intel’s exit from memory technology, as told by Richard Tedlow:

NB: How did Intel make that transition?

RT: They knew they had to get out of memories. Freud talks about a cognitive state he calls “knowing but not knowing,” which he defines as a state of rational apprehension that does not result in effective action. Intel was being clobbered by Japanese manufacturers. They knew something was happening, but they didn’t know how important it was. They were feverishly debating various ideas of how to respond.

Andy proposed a thought experiment to his then boss, Intel CEO Gordon Moore. “What would happen,” he asked, “if the board kicked us out and brought in new management?” Moore immediately replied, “They’d get us out of memories.” Andy looked at him and said, “Why don’t we walk through the door, come back, and do it ourselves?”

By creating a fantasized new management, he was able to escape from the legacy of Intel as the memory company. At least in part because of that moment, the United States today is the world’s leading manufacturer of microprocessors.

Grove probably would have gotten out of the MCI trade too. He had figured out how to beat the deer in the headlight phenomenon, the boiling frog problem, the sunk costs problem.

More broadly: he figured out how to change.

And it’s actually not complicated to understand. Here it is in conventional folk wisdom terms:

You can start your day over anytime you want
It’s never too late to have a happy childhood
This is the first day of the rest of your life.

The truly great decision-makers aren’t those schooled in hyper-quant theory.

They are those secure enough with themselves to remember what they learned in kindergarten.

Update: "Deer in the Headlights Decision Making" is a featured post at the Huffington Post.  Trust Matters readers may want to check out the discussion there as well.