Businomics Blog

Starbucks Strategy: Trial and Error at the Beginning

Starbucks began with a willingness to experiment, according to Taylor Clark's new book, Starbucked: A Double Tall Tale of Caffeine, Commerce, and Culture.  The book begins with a story from when the company had only eleven stores.  The Vancouver BC store was at capacity, and another location in the city was hard to find.  Howard Schultz saw a failing restaurant across the intersection from the Starbucks location and rented it--not to replace the existing store, but in addition to it.  So the bit about Starbucks opening a store across the street from another store dates back to the beginnings.

They weren't sure it would work, but they tried it and monitored the results.  Actually, the monitoring did not require a sophisticated statistical analysis: both the old and the new store did a great business.

We learn from this story the value of the experiment.  It sounded stupid to me.  No amount of head office analysis would have justified the new location.  Some things you have to learn by doing.

What will you get if you try this approach?  A lot of failures.  Later in Clark's book there are plenty of stories of early plans that needed adjustments.  I'm certainly not endorsing bet-the-company risks every day.  But the businesses that succeed best are continually testing the waters with new ideas, new products, and new markets.  Even if the new market is just across the street.

(Want to read that story?  Go to Amazon's Starbucked page, click the "Search Inside" page, and search for "Experiment."  Look for the entry in Front Matter (where the introduction is).  It's one of several items; what you're looking for is the book's Introduction.  That will give you the first few pages.  The first real chapter of the book is available on the publisher's web site.)

Economic Forecast for 2008 and 2009: Better than I Expected

In updating my economic forecast for the new year, I surprised myself.  I walked into the spreadsheet moderately gloomy (I thought) and plugged in conservative numbers.  Out came a fairly pleasant forecast:

There's weakness in the current (fourth) quarter, and then things look better.  I did put some dreadful numbers in for housing construction, but that sector is now only 4.5 percent of total GDP.  I clobbered housing starts, but that doesn't have a huge impact on GDP.  I brought down the growth rate of consumer spending for a couple of quarters, and kept inventory growth down to near zero in the first half of 2008.

What's keeping the forecast up?  Export growth will remain strong, and import growth will weaken.  Nonresidential construction, though it will decelerate, still grows at a nice pace.  Late in 2008 I see business spending on equipment and software recuperating.  Defense spending grows at the recent pace, then the growth rate slows.  I have less confidence in this area.

Why the disconnect between my economic outlook and the news reports?  I think it's a weighting issue.  For instance, when the housing starts numbers come out and they are rotten, that fact is seized on by the press.  Same thing for falling home prices.  If you weight the facts by the barrels of ink spent on them, then gloom prevails.  In my forecast, though, I actually plug in how many dollars are represented by the new residential construction sector.  Turns out the impact of that sector is relatively small.

Why am I not in with the extreme doom-and-gloomers?  I think they are so committed to their hell-in-a-handbasket theories that they weight the evidence by how much it confirms their dour forecast.  Maybe I could be accused of weighting the numbers by my usual optimism, but I honestly started my latest forecasting exercise expecting a lower forecast.  I went subsector by subsector putting in my best estimate of the forecast, then calculated the total.  "Wow!" I said, something must be wrong.  I even double checked the spreadsheet to make sure the formulas were working correctly.

Then, just for fun, I created a recession forecast. The easy way is to just pencil in a couple of bad quarters of GDP.  I interesting way is to start depressing the specific components in a reasonable way that results in a recession.  First pass: I only got one negative quarter of GDP.  So I went through a second time, and this time got a very mild recession.  You have to be really harsh with your assumptions to get a hard-core recession.

My economic forecast: sub-par GDP growth for two quarters, then a return to reasonably bright growth.

Businomics: Resources for Teachers

Professors who use Businomics in their classes have a new resource: a set of Power Point slides created by Professor Tom Potiowsky of Portland State University (who is now returning to serve as Oregon's state economist.) The deck can be downloaded from the Resources for Teachers page.

Thank you Tom.

Index Mutual Funds: An Interview with Paul Merriman

Paul Merriman is a guru of investing with index funds.  I interviewed him for the Businomics Audio Magazine.  You can listen to his insights here.

Also available on the interviews page: Marsha Egan on email productivity, Mish on the economic outlook for 2008, Mark Sanborn on leadership, Dan Harris on China, and Mark Thoma on the Great Moderation.

Firefox Gets the Trial and Error Economy

The folks at Mozilla who put out the Firefox browser (which is great) understand the Trial and Error economy.  They recently wrote up a description of an experiment they did in marketing their download web site. (Hat tip to Steve Levitt at Freakonomics.)

Here's the test: if you go to a search engine to download the Firefox browser, you get the official website as the number one result from most of the popular search engines.  So should they pay Google or Yahoo for a pay-per-click ad on those search results when they are already number one?  It turns out that they get a little more traffic when they do.

One lesson from this, though, is that the majority of the traffic that comes from pay-per-click advertising would have come anyway; a majority but not all of the traffic.  So your cost per customer is not really what you are paying per click; it's your total costs of the clicks divided by the customers who would not have come to you without the pay per click.

In one experiment, it appears that about seven out of every ten people who clicked the paid advertisement would have clicked the regular search result (called "organic search") if the paid ad had not been present.  So all of your click payments only brought you those three out of ten who otherwise would not have come to you.

It takes a lot of work to get a good experiment, and you often have to keep running more experiments to get the results fine tuned.  But you can learn far more, and boost your profit tremendously, by regularly experimenting in your business.

Home Prices Falling in Most Cities

Home prices are falling in the major cities, according to the Case-Shiller data.

A couple of things to keep in mind: the hinterlands--meaning the area outside the 20 largest metropolitan areas--are doing better than the big cities right now, so the national average isn't quite so bad.

As always, the average masks the most interest stories.  Three of the 20 largest cities have home price increases over the last 12 months (Charlotte, Seattle and Portland), though all cities are showing month-to-month declines in the latest two months.

On the downside, it's a lot worse than average in some places.  Cities with double-digit 12-month declines are Detroit, Las Vegas, Miami, Phoenix, San Diego and Tampa.

Chicken-and-egg question: are falling prices causing defaults and foreclosures, or are defaults and foreclosures causing falling prices?  At this point, they feed on each other.

Most likely to turn around of these big price losers: cities with very strong population growth (Las Vegas and Phoenix) followed by cities with strong population growth (Miami and Tamp) followed by slow population growth (San Diego) and no population growth (Detroit).

Oil Price Outlook: Megaprojects Offer Hope

A few hardy volunteers at the Oil Drum are tabulating press releases from dozens of companies to identify expected output from megaprojects.  It's a large task, but they are doing it.  Their chart is intriguing:

Hat tip to Jim Hamilton at EconBrowser, who provides some context:

Because production from older fields naturally declines as the oil is removed, we need to find something like 3-1/2 million barrels per day in new production each year just to keep global production from falling. And although the projects identified above as having a 2008 start-up are supposed to begin production next year, production at the peak levels reported above is often not anticipated until 2010 or later.

The Oil Drum people seem to be a) peak oil believers, and b) dedicated to open, honest, transparent discussions.

OK, it looks like we'll be having net gains in production in the coming years.  By how much does oil demand grow from year to year?  Recent data come from the U.S. Energy Information Administration:

Change in world oil demand:
2004: 2.72 million barrels per day
2005: 1.32
2006: 1.07

Note that the price of oil (West Texas Intermediate) averaged only $41 dollars a barrel back in 2004; conservation was not really kicking in.  Global economic growth also factors in; it has been edging up, thanks to emerging countries.  Nonetheless, I think there's a good chance we'll see a greater increase in oil production next year than consumption.  If that's the case, then prices will start to edge down.  Then commodities investors may--or may not--panic and send prices down sharply.

The folks who are sure they know what will happen to oil prices next year are not to be trusted on the subject--including me.

Fed's New Mortgage Rules: Not Much Impact, Just a Few Unintended Consequences

The Fed is proposing new rules regarding mortgages.  The new broad rules that apply to all mortgages (see the Fed's announcement for details) are reasonable, but probably covered by current fraud statutes.  I'm not a lawyer, but they seem to be rules implementing common law standards.

The other rules that apply to subprime mortgages are a different story. To a large extent, they require practices that used to be skipped, but which mortgage investors have already figured out should be used.  For instance, the new rules would require underwriting loans based on a person's ability to repay the loan out of income--sounds like a good idea.  Similarly, verifying incomes of borrowers seems like a good idea.  The Fed's new rules are mostly unnecessary, because the mortgage industry has already figured out that it should be doing this.

So why not have federal rules in place?  Because there will be some adverse impacts of these new rules.  Not huge, end-of-civilization impacts, but negative impacts none the less.

For instance, suppose a borrower wants a loan that is a stretch out of current income.  Should it be illegal for the borrow to stretch, and for the lender to take the risk that it's too big a stretch?  Do we really want a federal marshal with a gun on his hip policing these transactions?  With rules you get gray areas.  Suppose a borrower wants a mortgage, and the lender thinks the guy is good for it.  They'll have to also run numbers to see if they conform to federal guidelines.  If they don't, well, maybe the lender will risk an exception; maybe not.

Example: a newly-minted MD is heading into a residency program.  Her mortgage will be a real stretch based on her income.  But she's used to being a poor student, and she'll soon be making very big bucks as a surgeon.  Should it be illegal for her to get a mortgage?  The Fed will probably say that their regs will allow exceptions.  But that sounds like it would be illegal to set up a business targeting such customers, even if they would be profitable, in the aggregate.

Example: a young stripper works for tips.  She receives no salary, no W-2, no 1099.  All of her income comes in cash.  But she's making a good income and wants to buy a house.  Because she has a limited credit history, she's subprime.  There's no way to verify her income without sending someone into the strip club where she works to record her tips.  Now it shall be illegal, a federal offense, to lend her money for a house.

Unintended Consequences: What happens with other lending "protections" aimed to help consumers?  A recent study by economists at the Fed of New York looked at two states that banned expensive "payday loan" operations.  Those states had increases in bounced checks and Chapter 7 bankruptcy, relative to other states, after they banned the payday lenders.  Maybe they weren't helping consumers after all.  (Hat tip to Steve Buckstein.)

Distribution of Mortgages by Type: Surprising Results

Mark Perry over at Carpe Diem has an interesting post showing the distribution of mortgages:

Note that about one out of three homes has NO MORTGAGE AT ALL.  Mark has a companion chart showing which categories have foreclosures.  (Hint: the folks with no mortgages have no foreclosures.)

Now I have to share a brief summary from the Wall Street Journal story, "Mortgage-Relief Plan Divides Neighbors" (subscription required).  Karenn and Steve Oropeza bought a house in Corona, California in 2004 for $557,000, with a $500,000 mortgage.  They refinanced three times, most recently in 2006 for $835,000.  In other words, their cash out from refinancings was about $335,000 over two or three years.  They used the proceeds for some home improvements, like a backyard waterfall, and to pay off credit card debt. 

Earlier this year, while their credit was good, they bought a house outside of Houston for $283,000.  (They got 3600 square feet, which says something about where the good housing values are.)  Early this year they also bought a new Lexus and a Chevy Suburban.  They took a Caribbean vacation.  Then they moved out of their California house, leaving it to the lenders.  Just walked away.  Mrs. Oropeza is quoted as saying, "We're sad because there goes our credit, and because people think we are a bunch of flakes who walked away from the house and tried to make money."  Yes, I'm sure she's right: that's what people think.

Shouldn't there be some sort of government subsidy for these poor people?  They are living in a 3600 square foot house, driving a new Lexus and Suburban, but their credit stinks.  They won't be able to borrow any money for a long, long time.  I'm sad for them.  No telling how long until they can take another Caribbean vacation.  I doubt they'll be able to save for one, so they'll have to wait until their credit rating improves.

Why Economists Are Betting a Recession Won't Happen

I stole that headline from the Wall Street Journal (subscription required).  I'll repeat their reasons, but first give some perspective and then a sixth reason added on top of theirs.

Perspective on recession:  Recession is not the norm; growth is the norm.  So the burden of proof is on those who forecast a recession.  I liken recessions to car accidents.  If you study any particular one, you can see that it was avoidable.  But in the aggregate, we know that we'll get some.

Now let's roll through the Journal's five reasons why not:

1. The Fed is on the case.
2. Strong global growth is propping up the U.S. economy.
3. The economy is still creating jobs, supporting incomes.
4. The housing downturn's pain will continue, but has already done much of its damage to growth.
5. Government spending remains strong.

In my interview with Mark Thoma regarding business cycles, he says that when he's considering the possibility of a recession, he looks for a story.  That story will vary from time to time.   Right now the most likely story that puts us into recession is a credit crunch:  the subprime mortgage problem leads to a cutback in credit availability outside of real estate.  As I mentioned in a recent post, there's no evidence that this is happening.  It's something to worry about, for sure, but as of today, it's not happening.

However, the risk of recession is high enough that businesses and families should do some contingency planning.  Use the google search bar on this blog to find my earlier posts about planning for recession.