Clever Geek Handbook
3 February 2026

The New Financial Capitalists

Recommendation

This revealing book covers a highly charged and controversial period of American investment history. George P. Baker and George David Smith study the emergence of the investment house Kohlberg, Kravis, Roberts (KKR) and follow it during the decade KKR ruled the world of leveraged buyouts. The authors begin with the early days when the partners worked together at Bear Stearns. They track the men as they build their own firm and create their own success. In clear, straightforward language, the book presents KKR’s intentions and the economics of leveraged buyouts (LBOs). It discusses KKR’s role in structuring and managing the deals. BooksInShort recommends this book as a must read for anyone interested in LBOs or the history of KKR. Executives at all levels will find the KKR saga interesting and useful.

Take-Aways

  • A leveraged buyout (LBO) is like buying a house; the purchaser expects a good return on the investment.
  • The partners in Kohlberg, Kravis, Roberts (KKR) modernized the European concept of merchant banking to establish the LBO industry.
  • Requiring managers to become equity investors in the leveraged company is critical to the venture’s success.
  • LBOs fail in the face of unforeseen circumstances or incorrect valuation.
  • The twentieth century’s four merger and acquisition waves involved financial capital, management capital, conglomerates, and LBOs.
  • KKR did large sophisticated LBOs. One year, when the company did just a single deal, it still constituted twenty percent of the year’s total LBO investment.
  • Junk bonds provided access to the unsecured capital that fueled the dramatic growth of LBOs in the late 1980s.
  • Despite its propensity for large deals, KKR remained a relatively small investment house where the three partners controlled the business.
  • KKR viewed its purpose as long-term value creation.
  • When KKR opened its doors in 1976, the average American businessman managed his business to limit the total amount of debt even if it lowered the value of the company.

Summary

KKR and LBOs

In the realm of corporate mergers and acquisitions, the actions of Kohlberg, Kravis Roberts (KKR) were very innovative. The firm’s introduction, development, and use of leveraged buyouts (LBOs) altered the way corporate ownership changed hands, particularly as regards under-performing or poorly managed companies. In the realm of mergers and acquisitions, KKR took some very disturbing steps. The power to resolve a distressed company’s performance problems shifted from corporate management to KKR. While experts disagree about whether or not the use of LBOs is good for society, they agree that KKR is the most well known and notorious LBO player.

The Four Waves of Merger and Acquisition Activity

Four waves of merger and acquisition are landmarks in the United State’s economic history. The use of LBOs is the fourth wave, which started in the late 1970s. The three earlier waves of merger and acquisition activities were financial capitalism, managerial capitalism, and conglomerate formation. Financial capitalism refers to the period from the late 1890s to the 1910s, when the large capital requirements of infrastructure industries led companies to make public equity offerings. The signature consolidation of this era was the formation, in 1901, of U.S. Steel from eight separate steel companies. A syndicate led by investment banker J.P. Morgan financed the consolidation. Morgan’s new company was 61 percent leveraged and he placed his partners on the board of directors.

“When the deal is done the work begins.”

During the peak of the financial capitalism period, from 1897-1904, "some 4,277 American companies consolidated into 257 companies." Most of these consolidations were similar to the U.S. Steel consolidation, in that the consolidated companies were in the same business. The Sherman Antitrust Act, which passed in 1890, may have encouraged this wave of consolidation because it prohibited cooperation between companies, but not combination. The underlying reason for consolidation, however, was efficiency, not monopolization. In addition to horizontal consolidation, the first wave was also marked by the push for vertical mergers. Vertical mergers were "the combination of entities engaged in sourcing, production and distribution." Companies pursuing vertical mergers - for example, public utilities - generally wanted to expand from regional to national operations.

“In leveraged buyouts, the probability of distress was greater, if only because it would happen sooner in the course of a company’s decline.”

The second wave, managerial capitalism was driven by the separation of corporate ownership from management control. Managers under this wave did not have ownership stakes or family ties to the businesses they managed. Rather, they had strategic talents, and technical and organizational expertise. The growth of General Motors under the leadership of Alfred Sloan was an example of successful managerial capitalism. Over time however, the strength of managerial capitalism became its weakness. The personal interests of the managers became increasingly removed from the interests of the shareholders. The ability of managers to control boards and to get long-term employment contracts, permitted managers to build personal empires that did not directly enhance shareholder value. This wave peaked during the rapid expansion of the U.S. economy following World War II.

“As general partner and corporate directorate, KKR performed its most important economic function: long-term value creation.”

The third wave of mergers and acquisitions, conglomerates, grew out of the power of corporate managers, a change in antitrust policy against anti-competitive mergers, and a surplus of investment cash. During this third wave, corporations of all types purchased businesses that did not necessarily relate to their core business. For example, in 1969, during the height of the consolidation wave, 6,107 transactions were announced. Most companies, however, failed to manage the vast conglomerates created through consolidation. In one case, ITT acquired 350 companies between 1959 and 1970, and yet failed to develop a cohesive management strategy. The company took a substantial loss when it sold most of its acquired entities during the 1970s.

“Good organizations have strong memories.”

The fourth merger and acquisition wave was marked by the financial strategies of hostile takeovers and leveraged buyouts. Several factors contributed to the emergence of the fourth wave. These factors included changes in the markets and in technology that made former assets obsolete and made personnel redundant. The conglomerate boom "saddled corporations with unwieldy, inefficient or under-managed operations." Deregulation of the airlines, telecommunications, and the trucking industry revealed their excess capacity. The United States had a general feeling that its largest companies "were suffering from low productivity and a widely perceived loss of managerial confidence."

“Flexibility in financing and adaptability to unforeseen events are crucial determinants of success.”

KKR’s success during this wave was a result of its ability to use LBOs to extract value from under-performing assets. Although KKR did not execute the largest number of LBOs during the 1980s, it was responsible for some of the biggest and most visible successes and failures. For example, at this time, KKR financed the leveraged buyouts of Houdaille, Beatrice, RJR Nabisco, and Borden. The RJR Nabisco LBO was particularly visible because it required $31 billion dollars of financing.

KKR and the Role of Debt

People in the U.S. have a paradoxical perspective about debt. While people feel a strong historical aversion to being in debt, high leverage (that is, a high level of indebtedness) is a key tool for amassing wealth. Beginning in the early 1960s, the societal aversion to carrying debt began to change. Leveraged buyouts in the form of bootstrap acquisitions started to multiply. "All bootstraps were financed by using a company’s own assets or cash flow to secure high levels of debt financing." KKR’s Jerome Kohlberg is credited with modernizing the bootstrap process by "adding the role for management as owners."

“Expansive empires and local tribal cultures alike have tried to curb entrepreneurial behavior with political restraints and social taboos, lest it upset the status quo.”

Additionally, KKR also took on the role of merchant banker in financing acquisitions by becoming a principle investor. At the start of KKR in 1976, the company still used the term merchant banking to refer to its own financing of projects that required a lot of debt. Over time, however, as the projects became larger, "LBO" replaced the term merchant banking. KKR’s pro forma plan for a LBO was ten to twenty percent equity and eighty to ninety percent debt. A typical plan would have a company "repaying the acquisition debt within five to seven years."

“The essential populism of American culture is uncomfortable with financial schemes, which have so often been associated with venal fraud and scandal, or worse, unfruitful labor.”

In 1978, KKR acquired Houdaille, in the firm’s first breakthrough use of a LBO to acquire a mid-sized public company. They succeeded even though the company’s investment banker, Goldman Sachs, believed such a buyout strategy was impossible. The Houdaille buyout set the stage for the rapid growth of the LBO tool in the 1980s. Financial analysis of the deal established the basic operating premise of LBOs: "Value creation does not necessarily come from growth" of the acquired business.

“Still, debt remained in Revolutionary America what it had been throughout the history of Western civilization: a moral problem. For many, to take on debt may be necessary, but it was not a good thing to be in debt.”

Following its success with Houdaille, KKR scaled up its ability to do larger deals by evolving its relationships with debt and equity investors. The growth of pension fund investment was particularly important, as was the use of junk bonds from Drexel Burnham Lambert and Michael Milken. The availability of large amounts of unsecured junk bond debt permitted rapid decision-making since Milken could issue assurances letters. Although these letters were non-binding, the marketplace viewed them as certainties. That enabled KKR to use them to acquire several companies including: Motel 6, Storer Communications, Owens-Illinois, Beatrice, and RJR Nabisco.

Owner Managed Corporations and Value

As KKR’s success in doing deals increased, so did criticism of LBOs and - by association - of KKR. The public perceived that LBO firms such as KKR were robber barons. The public believed that KKR purchased companies, cut spending and staff to the bone, and made great short-term profits. Media accounts of KKR’s transaction fees reinforced this perception. These criticisms stung KKR because they believed they provided a way to increase value in their acquired companies. KKR compared their actions to the typical U.S. citizen’s purchase of a house saying, "We see a house and we like it, so we pay the owner a premium price. Like every other American we borrow money to do it. The average American puts down maybe ten to twenty percent to buy a house - a highly leveraged transaction. We do the same thing." KKR doesn’t let its house rot. Like any homeowner, it improves the building’s condition, fixing what needs to be fixed and ripping out old plumbing and windows. And like most people, it plans to sell the house for a profit sometime after buying it.

“The nature of the relationship between owners and managers in a highly leveraged firm rested on a basic principle: make managers owners by making them invest a significant share of their personal wealth in the enterprises they manage.”

To ensure that a transaction creates value in the future, KKR follows a policy of aligning owner and management interests. Managers from the company in the buyout, for instance, are required "to invest a significant share of their personal wealth in the enterprises they manage." Managers, therefore, are converted to owners because that makes them personally liable for the results of their decisions. At the same time, investors in the buyout would only see a return if they remained committed to a long-term relationship with the acquired company. LBOs typically run for five to seven years before debt is paid down, and a high return on the investment is possible. A team from KKR also played an important part in the success plan. KKR was required to give (either internally or externally) expert support services to the newly formed KKR-controlled management board. KKR Board members had to provide ongoing support at a level beyond the scope of board members at non-leveraged companies. For a buyout to be successful, therefore, all the players - from management to investors to KKR directors - had to be aligned to a common plan implemented during a five to seven year timeframe.

“There is no question that RJR Nabisco was a unique transaction for KKR and in the end it failed its equity partners.”

KKR’s purchase of Duracell in 1988 is an example of unlocking the unrealized value in a healthy company. KKR bought Duracell from Kraft Foods, where it was too small for the corporate parent to provide the attention it needed to grow. The post acquisition plan for Duracell was "simply to find the best way to increase its business." By 1996, after a successful and aggressive plan to increase international business, and after research and development in conjunction with INTEL produced a smart laptop battery, Duracell was sold to Gillette Corporation for a 39 percent annualized return on its investment of $350 million. The total return was $4.22 billion.

“In the scramble to build wealth, high leverage was not a good thing.”

Not all KKR buyouts were successful. Some investments ran into financial distress due to unforeseen factors or too large a purchase price. KKR ran into financial distress due to unknown factors when it purchased Jim Walter Homes. Jim Walter Homes owned another company called Celotex, which was sold as part of the acquisition by KKR. A year after the sale of Celotex, Jim Walter was named in a class action asbestos suit against Celotex. KKR could not have know this was coming. The asbestos litigation placed pressure on KKR and Walter, which forced the company into bankruptcy. Eventually, Walter settled with the asbestos litigants for $375 million, and KKR and its investors received a poor return on their investment.

“Since it relied heavily on external sources for finding and minding companies, and since it had to bring investors back to the table time and time again, KKR also encouraged the kinds of personal behavior that would promote trust in the markets for information and capital.”

An example of an investment with too large a purchase price was RJR Nabisco. In a bidding frenzy, KKR paid $109 dollars per share or $31 billion dollars for RJR Nabisco. In formulating the bid, KKR overestimated the value of the tobacco business. Legal battles over tobacco-related health concerns and sales competition from Phillip Morris dragged down the company’s value. KKR could not make its projection. Several years later, as part of the buyout of Borden, KKR exchanged RJR Nabisco stock and divested itself of RJR Nabisco stock.

KKR and Internal Management

KKR managed LBO value creation through an internal group structure called a "LBO association." This term indicated KKR partnership groups who developed specialized industry knowledge. Internal and external observers found it ironic that this organizational structure was the same conglomerate structure that LBOs dismissed as undervaluing assets. While partly true, academic observers tended to classify the KKR LBO association as more closely resembling a Japanese keiretsu. The keiretsus held equity stakes in multiple entities and monitored their performance. However, KKR was not a holding company, so the analogy does not fit perfectly. Critically, the basis of the LBO investment was limited partnerships, which generally had a life of twelve years. After that, the partnerships were dissolved and the equity returned to the investors. KKR, therefore, had no organization structure in common with the companies it bought and sold.

About the Authors

George P. Baker, a Harvard Business School business administration professor, holds his Ph.D. in business economics and a Harvard MBA. He is an associate editor of the Journal of Financial Economics, and a director of Clear Communications, Inc. His many articles cover management incentives, leveraged buyouts, and organizational economics. George Davis Smith, clinical professor of Economics and International Business at New York University Stern School of Business, earned his Ph.D. in history from Harvard in 1976. A consultant to major corporations, he has written numerous articles and four books, including Anatomy of a Business Strategy and From Monopoly to Competition.

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The New Financial Capitalists

Book The New Financial Capitalists

Kohlberg, Kravis, Roberts and the Creation of Corporate Value

Cambridge UP,
 


3 February 2026

ReWiring the Corporate Brain

Recommendation

If you’re looking for a philosophical, out-of-the-mainstream approach to restructuring your company, author Danah Zohar offers it. She presents an exhaustive, if at times repetitive, case for replacing inflexible, old-line companies with more agile, quantum organizations. Problematically, Zohar devotes too many words to theory and not enough to practical steps for restructuring, and her book is light on examples of companies that have successfully used quantum theory to reorganize. Still, her underlying case is strong. Anyone stuck in a staid bureaucracy would prefer a company where assumptions are actively questioned. To her credit, Zohar offers a starting point for the difficult task of streamlining stodgy organizations. BooksInShort recommends her ideas to any manager seeking an unusual and thoughtful look at corporate restructuring.

Take-Aways

  • Companies pay lip service to restructuring and reengineering, but true change requires us to rewire our brains.
  • Real change requires a fundamental shift at each of the three levels of the self: mental, emotional and spiritual.
  • The sciences of the 20th century show the relationships between systems.
  • A company’s vision isn’t a five-year plan but a sense of identity and motivation.
  • A company must always acknowledge its spiritual core.
  • The human brain provides a model for creative thinking in corporations.
  • Quantum systems are chaotic and thrive on uncertainty and ambiguity.
  • Newtonian organizations are bureaucratic, focusing on top-down control, tight structure and imposed solutions.
  • While debate is the preferred method of communication in Newtonian organizations, dialogue is radically different and more productive.
  • Servant leadership is the goal of quantum thinking and quantum leadership.

Summary

The Reality of Change

Corporate executives and high-paid consultants love to tout processes of change, such as restructuring and reengineering. But most corporate change is superficial, a rearranging no more significant than shuffling furniture in a room. True transformation requires executives to rewire their brains - to rip out the old wires and completely change the way they think.

“Deep, transformational change requires that we literally rewire our brains, that we grow new neural connections. That means we must feel the old wires being wrenched loose.”

Because corporations organize humans, they operate on the same levels as humans. People have three levels: mental, emotional and spiritual (which doesn’t necessarily refer to religion). Most attempts at change aim at only one level. To transform an organization successfully, an effort to change must focus on all levels. This reflects the holistic nature of the world acknowledged by 20th-century science. People don’t consist of compartments titled "Mind," "Heart" and "Spirit," nor should a company be divided into "Product Development," "Marketing" and "Finance." A corporation must nurture all three types of thinking - mental, emotional and spiritual.

Adding Meaning to the Hierarchy

Maslow’s hierarchy of needs divides human requirements into basic needs and growth needs. Basic needs are survival, the most essential, followed by safety. Growth needs go from belonging to esteem and self-actualization. This hierarchy is illustrated by a triangle with survival at the bottom and self-actualization at the bottom. While this hierarchy is useful, it’s too hierarchical itself. It assumes that self-actualization - which can be interpreted as spiritual fulfillment - is an afterthought, but not an essential part of life. This isn’t true. The need for meaning is a primary human requirement, one that has led people to sacrifice comfort, relationships and food for a greater purpose.

“All the sciences of the twentieth century, both physical and biological, are holistic. They show that the world does not consist of separate, isolated parts but rather of intricately interrelated systems.”

Consider replacing Maslow’s hierarchy with the more accurate "Layers of Self," a chart showing four concentric circles with spiritual factors in the center circle. This central circle is labeled the quantum self, which is defined as an organization’s basic vision and values. A company’s vision isn’t just a five-year plan; it’s a deep-seated sense of identity, motivation, aspiration and the organization’s role in the wider world. The second circle represents transpersonal issues such as principles. The third circle encompasses important relationships, such as family, and the final circle includes practical, business and social factors. Spiritual factors lie at the center because meaningful change in an organization requires concomitant change on the spiritual level of reflection, meaning and value. Like an individual, an organization must remain in contact with its spiritual level. The spiritual realm provides the only way for a company to rethink assumptions, change leadership patterns and transform itself.

Types of Thinking

The human brain is an amazing organ that is always adapting and rewiring itself. The brain provides a model for the type of creative thinking that an organization must embrace if it hopes to change successfully. But creative thinking is just one of three kinds of thought the brain engages in. These are:

  1. Serial thinking is logical and unambiguous. It’s the type of thought required for mathematical problems and it recognizes only black and white, not shades of gray. Corporate structures typically are based on serial thought, as reflected in rules requiring people to punch time clocks, take breaks at certain times and follow dress codes.
  2. Associative or parallel thinking is emotional and experience-based. For instance, associating hunger with food or the color red with danger is parallel thinking. Associative thinking also includes trial-and-error learning, the type of thought used for skills such as riding a bicycle or driving a car. The disadvantage of this type of thinking is that it is slow and inaccurate. Also, bad habits are difficult to unlearn.
  3. Creative thinking, also known as quantum thinking, comes from the spiritual level of the self. This kind of thought challenges assumptions and breaks old habits. Quantum thinking also is holistic. It combines the information from serial thinking and associative thinking and then processes the information into a coherent story.

Old Paradigm Vs. New Paradigm

When studying organizations, it’s useful to do so in the context of old and new paradigms of science. Old paradigm science is fragmented and atomistic. New paradigm science is holistic and integrated. The old paradigm focuses on separate parts, while the new paradigm looks at the relationships among parts.

“The organization, potentiality and thinking processes of the human brain are our most powerful models for creative thinking in organizations.”

Most corporations are Newtonian organizations. They are tradition-bound and bureaucratic, relying on centralized control, hierarchy and predictability. Newtonian organizations are unwilling and unable to change. Such companies tend to stifle individual creativity. The new model for corporations shows that companies must become less Newtonian and more closely follow the scientific disciplines of the 20th century, such as relativity, quantum mechanics, chaos and complexity theory. Twentieth century science also is holistic, acknowledging the connections between systems. These concepts move away from simplicity and certainty; instead, they embrace pluralism, diversity, ambiguity and contradiction. Newtonian science, while a useful building block, represents the old paradigm. Quantum mechanics and relativity represent the new paradigm. In short, the Newtonian model is essentially simple, law-abiding and certain, while the quantum model is complex, chaotic and uncontrollable.

“The need for meaning is primary. There are countless documented instances of people sacrificing comfort, companionship, food, even life itself in pursuit of meaning, higher morality or higher ideals.”

The Newtonian approach defines modern commerce. The pin factory described by economist Adam Smith provides a prime example. Through division of labor, each worker concentrated on a specific task, such as making the heads of pins. This approach is more efficient than having each worker make whole pins. This sort of specialization has taken hold in Western medicine, education and management. But according to quantum physics, the world is not made of separate, solid things. At the most basic level of reality, physical systems are patterns of dynamic energy.

“In any human being or in any human organization, real change requires a fundamental shift at each of the three levels of the self.”

Iron laws rule old paradigm science. But new paradigm systems rely on uncertainty and ambiguity. The reason for this difference can be found in the Western mind. Westerners tend to look for concrete explanations to mysterious events. Newtonian determinism became popular because it helped explain the world to people who felt they were being buffeted by unpredictable natural catastrophes. That mindset has carried through to Western management styles, while Asian managers tend to be more comfortable with uncertain circumstances.

“Quantum and chaotic systems thrive on uncertainty and ambiguity.”

Newtonian science is by definition reductive - it reduces systems to their smallest parts. For example, Adam Smith’s division of labor reduces production to its individual components. But quantum science is emergent - the properties of systems emerge just at the edge of chaos. Under this theory, systems are self-organizing. They can’t be controlled by any outside forces. In the old paradigm, the parts define the whole. In the new paradigm, the whole is greater than the sum of the parts. In management terms, the old paradigm represents top-down management, while the new paradigm embraces bottom-up management. The old paradigm is reactive, while the new paradigm encourages imagination and experimentation. Newtonian organizations tend toward the bureaucratic and focus on top-down control, tight structure and an obsession with efficiency. The quantum leader, on the other hand, draws inspiration and insight from the group he’s leading.

“Many a Newtonian organization has created a bureaucratic Frankenstein’s monster with its emphasis on top-down control, tight structure and imposed plans or solutions, and its obsession with efficiency.”

Old-paradigm, mechanistic science focuses on knowing the answers to life’s mysteries. Heisenberg’s Uncertainty Principle casts some insight on this approach. This principle says that the answers of any inquiry are influenced by the questions asked. It also says that studying a system interferes with it and, therefore, changes the results. This concept can be applied to an interview with a potential employee. Under the old paradigm approach, the interviewer would ask the candidate only for facts, such as employment history and educational background. The interviewer would come away with a number of facts but little impression of the job candidate’s personality. Under the new paradigm, the interviewer might take the candidate to lunch and chat about hobbies. The interviewer would learn more about the potential employee as a person but few facts.

Managing Under the New Paradigm

The new and old paradigms produce much different results when applied to management styles. Newtonian management yields competition, while quantum management brings cooperation. Newtonian management defines one best method; quantum management allows for many effective viewpoints. In a Newtonian organization, employees are passive units of production. In a quantum organization, employees are partners.

“Dialogue is essentially an attitude. It is a radically different attitude toward oneself, toward others, toward knowledge and problems and relationships.”

You can see these differences if you compare Western managers with Eastern managers. The two cultures have divergent views of the self. In Asia, the culture creates stability through discipline of the self. In the West, stability is achieved by excluding the self and emotions, and by organizing the predictable parts of relationships.

Debate Versus Dialogue

The differences between the old paradigm and the new paradigm are apparent in communication. An organization can host two types of discussion: debate or dialogue. Debate is about knowing, while dialogue is about finding out. Debate seeks answers; dialogue asks questions. Debate has winners and losers, while dialogue results in sharing. Debate is about power, while dialogue emphasizes respect and reverence. Debate seeks to prove a point or defend a position, while dialogue hinges on listening and exploring new possibilities. Dialogue is an attitude, one that puts quantum thinking into practice. Dialogue doesn’t necessarily seek consensus, but by organizing into dialogue groups, companies can improve communication and understanding among employees.

The Servant Leader

The end result of all this new-paradigm thought and communication is to create a servant leader. This is the essence of quantum thinking and quantum leadership. Andrew Stone, joint managing director of the British company Marks & Spencer, provides an example of the servant leader. Well-read but lacking formal education, Stone left school at 15 and lived on the streets in England. He later joined the Israeli army to fight in the Six Days War. When he joined Marks & Spencer, the retailer hired him not because he was qualified but because it feared becoming bureaucratic. Stone rose through the ranks, adopting quantum management. He hosts weekly "bitch sessions" in which critical directors can gripe about whatever is bothering them.

“Servant leadership is the essence of quantum thinking and quantum leadership.”

When Stone wanted his thirteen directors to develop a new global procurement policy, he presented a vague outline to a dozen colleagues. He told his colleagues, frustrated by his lack of detail, that he excelled at generating ideas, while they were good at implementing them. The meeting turned into a freewheeling dialogue where many ideas were given. His ambiguous approach released the creativity of his colleagues. What’s more, by seeking their input, Stone created a process by which everyone felt a part of the solution, rather than merely having the new procedure foisted on them.

About the Author

Danah Zohar  , a management consultant and lecturer, is the author of The Quantum Self and The Quantum Society. She has a bachelor’s degree in physics and philosophy from the Massachusetts Institute of Technology and did postgraduate work at Harvard. She lives in Oxford, England, where she teaches in the Leading Edge course at Oxford Brookes University and in the Oxford Strategic Leadership Program at Oxford University’s Templeton College.

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ReWiring the Corporate Brain

Book ReWiring the Corporate Brain

Using the New Science to Rethink How We Structure and Lead

Berrett-Koehler,
 


3 February 2026

Investing in the New Europe

Recommendation

Eric Uhlfelder’s book could be titled "Europe 101: An Introduction for Americans." European readers will not gain much by reading this work, which is filled with the very basic basics of Europe’s politics, economies and companies. But for Americans looking to diversify their newly constructed stock portfolios, it is a valuable resource, profiling the EU and the economic strengths and weaknesses of EU and non-EU countries. The book also profiles key companies, such as Nokia, SAP, Adecco and others, and discusses which individual stocks and mutual funds you should acquire. BooksInShort recommends this interesting primer to Yankee readers, who might be surprised to learn how fast Ireland is growing, how much Austria’s fling with the far right cost the country and how a French utility firm is positioned to take over the world.

Take-Aways

  • The European Union is comparable in size and GNP to the United States.
  • The EU is still a great investment opportunity, despite the lagging euro.
  • Many European countries aren’t part of the EU, including the United Kingdom, Switzerland, Norway and Denmark.
  • The uniform rules of the EU have forced countries to become more competitive.
  • A close look at Europe reveals the existence of five distinct investment regions.
  • These regions are The Core, The Tigers, The Independents, The Latent Reformers and The Emerging Markets.
  • Ireland and Portugal are among the fastest growing countries in the EU.
  • The German multinational SAP is the world’s third-largest software company.
  • Each country has fiscal strengths and weaknesses.
  • You can look at European investment by sector regions, such as banking.

Summary

The Promise of Europe

Investors should buy European stocks for two reasons. First, continental companies are superb investments and, second, improving corporate fundamentals are driving up European earnings. Europe encompasses 19 major markets, each with its own resources. Despite the continuous decline of the euro, the big news is the government and corporate restructuring that’s been going on for nearly a decade.

“Europe has started to shed its government influenced, border-conscious, structurally rigid style of doing business and is increasingly committed to competing in the global marketplace.”

The "new Europe" is attracting the United States’ largest banks and investment houses and the big money is betting that Europe is poised for success. European companies are becoming increasingly Americanized. Systemic change makes European investment attractive not only as a way to diversify your portfolio, but as a way to lock in strong returns. The common currency has fueled progressive change including improved macroeconomic conditions, market deregulation and the increased efficiencies of more open competition. "The bottom line is that you can find Microsofts, Baby Bells and ExxonMobils in bourses across Europe."

Some Pretty Heady Numbers

Western European equity markets, which have been on a tear, rose collectively in 1999 by nearly 28% in local terms, led by Finland (up 193.7%), Sweden (up 87.4%) and France (up 50%). Stocks within the Eurozone performed even better, rising 37.5%. This favorable comparison with the U.S. market goes further. Eurozone returns between 1996 and 1998 matched the performance of U.S. stocks. Half a dozen bourses beat the Dow. These numbers may surprise some, but for the first time, many European countries are focused on profitability.

“Europe has made a stunning turnaround from the not-so-distant past, when it was common to see governments push businesses to effect social policy (jobs created, taxes paid and pensions funded) and for large corporations to be more focused on serving this agenda rather than return on investments.”

European economic and monetary union is one of the most significant global changes since the end of World War II. The European Monetary Union (EMU) created dramatic improvements by forcing countries to:

  • Reduce national debt to no more than 60% of gross domestic product (GDP).
  • Allow government deficits of no more than three percent of GDP.
  • Keep domestic inflation and interest rates within 1.5 percentage points of the average of the three best-performing economies within the Eurozone.
  • Create stable foreign exchange rates.
“Supported by a wide range of European Union directives seeking to open up markets and competition, economic and monetary union has helped unleash a more effective form of capitalism rippling across the entire continent.”

Common currency has forced governments to get their houses in order and - in combination with European Union (EU) directives seeking to open up both markets and competition - has created a more effective form of capitalism. The EU has generated a number of positive developments: the privatization and deregulation of major industries, key mergers and acquisitions, a focus on shareholder value, a new cost harmonization between nations, pension reform and an increase in productivity.

European Investment Geography

The Eurozone, which is comprised of 11 countries, is the most recognizable investment region in Europe. These initial participants in EMU are Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. Greece was added in 2001. The Eurozone is a broken landmass ranging from Finland in the northeast, Ireland in the northwest, Portugal in the southwest, and Greece in the southeast. The Eurozone population is roughly the same as the United States and has a GDP that’s nearly 80% of the U.S. GDP.

“Europe is realizing its traditional economic formulas can’t be sustained, because the global marketplace in which it’s competing plays by a far less restrictive set of rules.”

A more refined look at Europe beyond Eurozone borders reveals the existence of five distinct investment regions. Inspect these regions to gain a better understanding of European finance. These regions are called The Core, The Tigers, The Independents, Latent Reformers and Emerging Markets.

The Core

Germany, France and Italy comprise nearly two-thirds of the Eurozone’s wealth. Switzerland and the United Kingdom, which are not currently part of the EMU, had the least to gain during the phase-in of common currency. Except for Italy, currencies in these core countries have been Europe’s most stable and their public finances are the region’s soundest. Their strong private sectors are home to some of the world’s best-run companies. As the monetary union adds to economic integration, companies based in the large core countries should enjoy increased market share across Europe, especially through mergers and acquisitions. The Euro should also allow those same countries to reach beyond the Eurozone to less developed countries, such as Portugal, Greece and Hungary, with less risk.

The Tigers

Europe’s tiger economies, Ireland, Spain, Portugal and the Netherlands, lie on the continent’s periphery. Common currency has allowed these countries to grow at twice the rate of Europe’s core economies. A sense of legitimacy and the prospect of monetary convergence with the core countries have encouraged these smaller, less developed economies to clean up their fiscal acts. Furthermore, their governments’ willingness to tackle structural reform - including more flexible labor laws, wage restraint and the privatization of prized national assets - has "triggered rapid expansion of foreign direct investment within their borders."

The Independents

The Nordic region is one of the most prosperous economic zones in the world. In a mark of the region’s independence, only Finland decided to join the EMU. Remaining suspicious of Brussels and EU policy, the other Nordic countries decided to maintain their own fiscal and monetary sovereignty. Nordic currencies, such as the Swedish krona and the Norwegian krone, held up fairly well in 1999, depreciating only slightly against the dollar. Strong market ties between the Scandinavian and Eurozone economies ultimately will dictate equity performance. The region offers investors a non-euro alternative to participating in European growth. However, pending public referendums on joining EMU could change the region’s policy toward Eurozone membership over the next several years.

Latent Reformers

Belgium and Austria have been under-performing the rest of the Eurozone because of their slower pace of structural reform. Their core businesses have not kept up with their neighbors’ rapid growth, and they will find it difficult initially to benefit from common currency. Substantial unemployment, high tax rates and government spending have stifled competitiveness in Belgium and many of its blue chips have become acquisition targets. The Austrian market is far more commodities-oriented, however, it lacks the telecoms and technologies that have driven growth in other European markets. The nepotistic Austrian political system has hurt the development of a pro-business culture. Jorg Haider, an ultra right-winger who has been compared to Hitler, didn’t help Austria either. His political ascension translated into EU sanctions against Austria. Greater liberalization should come to both economies as restrictive domestic policies give way to EU reform.

Emerging Markets

Three of Europe’s four core emerging markets - Poland, Hungary and the Czech Republic - lie just east of Germany and Austria, and are defined by their low levels of income per capita. However, these countries are enjoying an influx of investment from foreign corporations in search of cheap labor and low production costs. They also share the additional advantage of proximity to Western Europe’s central markets.

“Systemic change is making European investments not only an effective way to diversify a portfolio but a smart bet for locking in strong returns.”

Greece is also a part of Europe’s emerging markets. All four of these economies offer potential investors rapid growth. The risk is that these countries are still learning the realities of capitalism. Their economic infrastructures are still evolving and corruption remains a significant concern. Exchange-rate stability is also a major concern. This instability is due to higher inflation and interest rates, proximity to Russia and the need for additional structural reform.

The Sectoral Approach

Sector-based investing is a reflection of European integration and globalization, key factors that are driving stocks. Domestic performance is no longer a measure of a particular stock’s appeal. So while economic policy and product specialization still have national faces, policy shaping Europe’s investment environment is increasingly defined by its industry sectors. Findings in each sector indicate:

“Sector-based investing is a reflection of European integration and globalization, key factors that are driving stocks. In fact, one would be hard-pressed to find a stock whose appeal is primarily based on domestic performance.”

Banking - Industry deregulation and more liberal markets have made firms more efficient, bank stocks have soared by nearly 31% and banks are deriving an increasing flow of their profits from asset management. Insurance - European insurers are among the largest in the world and the life industry is widely recognized as the sector’s fastest growing profitable segment. Retail - There is a major trend toward consolidation, there have been extensive acquisitions and Wal-Mart’s entry is triggering significant restructuring and consolidation. Telecommunications services - Deregulation and the breakup of state-run monopolies have transformed telecommunication services into one of Europe’s top-performing sectors where growth is being driven by the demand for data and Internet access. Utilities - Privatization and market liberalization are turning utility stocks into good investments, utilities are beginning to benefit from moves into the new economy. Tremendous demand for improved water distribution will drive industry growth worldwide.

Model Stocks, Model Companies

The Continent’s most prominent growth stories represent a wide array of investment opportunities in the New Europe. Focused operations are a common feature among all these stocks - No highly diversified conglomerates here. Every company has achieved significant market share in its respective industry.

“Although economic policy and product specialization still have national faces, Europe’s investment environment is increasingly being defined in terms of sectors.”

Nokia has the technology and marketing acumen to exploit the industry’s increasingly open standards and geometric expansion. Nokia is one of Europe’s top growth stocks and has become one of the globe’s largest manufacturers of mobile phones, but its high proportion of institutional ownership and sky-high valuation exposes shares to substantial volatility.

“The easiest way to profit from Europe is through funds invested across the Continent. Because they are able to shift assets freely from one end of Europe to the other, gaining exposure to the full offering of various industries, these funds have notched the best long-term returns.”

The German multinational SAP is the world’s largest manufacturer of enterprise resource planning software (ERP), with a 39% market share. Spawned and spurned by IBM, SAP is now the third-largest software company in the world and the company’s CEO is known as the charismatic European equivalent of Larry Ellison or Bill Gates.

“The one theme that characterizes investing in the new Europe is change. It is occurring at a cosmic pace, and at any given time, events can turn askew even the most basic investment assumptions.”

Suez Lyonnaise des Eaux is a France-based multinational utility that competes for services not only in Europe, but also throughout the world. The company is poised to exploit the world’s expanding utility needs. Its stock is defined as "defensive-growth" and the company is expanding into telecom by moving into mobile and cable services. It offers a likelihood of sustained, long-term growth.

About the Author

Eric Uhlfelder  has been covering international markets as a writer and analyst for more than 10 years. His work is featured in Business Week, Euromoney’s Global Investor, Individual Investor, Mutual Funds and Fidelity Focus magazines.

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Investing in the New Europe

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