Archive for November, 2009

Network investing thought experiment

Monday, November 23rd, 2009

Say 3 companies simultaneously identify a big network-effect opportunity, and none has a particular tactical advantage. If rational and omniscient, each should invest up to its expected present value, or one third of the industry’s estimated PV. The net present value for the entire industry will then be zero, because all the money was spent up front in the battle for the winner-take-all #1 position.

Now move back to the real world, with uncertain, subjective estimates of market size and odds of success. Humans are known to be at their least rational in estimating NPV in low-odds, high-payoff situations (that’s why Lotto tickets sell). So presumably there is a bias for all three entrants to overestimate both the market size and their own odds of victory.

Thus all three are more likely to overinvest than to underinvest, so the industry NPV is negative.

Critically, the above experiment presumed no tactical advantage, and unlimited capital. This shows the incredible importance of tiny tactical advantages in early-stage network effect markets. In addition to being first mover, choosing the deepest-pocketed, fastest-moving VC is tactically useful in signaling to other hopefuls, as early as possible, that the game is over.

One reason wages are stagnant

Tuesday, November 17th, 2009

Why have US real salaries been stagnant for over a decade?  As mentioned in the previous post, part of it is undoubtedly competition from a globalized labor force.  But offshoring is not easy.  This begs the question:  aside from cost, is there some other appeal in outsourcing, despite the quality and management challenges that come with it?

In answer, consider this partial list of things you can eliminate by offshoring:

  • Medical insurance
  • Worker’s comp insurance
  • Worker litigation risk
  • Weekly, monthly, quarterly and annual tax filings
  • Pension management

This is an interesting list, because it corresponds closely to the areas where US business costs and complexity have exploded in the past 20 years.  It suggests that stagnant wages and offshore competition may both result from rising costs that neither employer nor employee can control.

As partial support for this position, note that health care costs per worker have risen more in the past decade than wages rose during the Clinton years. Stated differently, if health care costs were capped, worker income might have increased significantly.  And this is just one of the unbounded, uncontrolled costs mentioned above.

It’s not just the money, but also the manager’s time and attention.  Complexity has a cost.  Eliminating the five things above, in favor of simply wiring funds, is tremendously simpler.

The US might enjoy surprising gains by applying drastic simplification and cost control to the above list.

Trouble in Chimerica

Tuesday, November 17th, 2009

As you read this, recall that I generally buy the general laissez-faire, free-trade commerce argument.  Generally, but not religiously.  And, as always, the most interesting posts explore not the rules, but the exceptions.

Economists and investors have argued for a decade that moving US manufacturing capacity to China is not a problem — actually a good thing — because all the profit remains here.  The argument is reasonable, and runs something like this.

iPods are designed in the US, but made in China.  Some of the price of an iPod goes to China, but none of that is profit, because Chinese manufacturers are intensely competitive producers with consequently low return on capital.  Apple keeps nearly all the gross profit in wholesaling an iPod, while the unfortunate Guangdong manufacturer passes almost all its revenue through to its employees and capital expenditures.  Apple’s profit then funds more R&D and design work by highly paid employees in the US.

This all makes sense.  I buy it.  And it works well in other high-wage, non-mercantile countries, such as Denmark.

But the argument makes simplifying assumptions, rarely mentioned by proponents:  neutral trade balance, and stable corporate earnings as a percentage of revenue.  These assumptions have been generally false in the U.S. for over a decade.

Because they are false, the loop is broken.  The consumer spends $100 to buy an iPod from the Apple website;  about $30 of that ends up in China, essentially all with either employees or capital equipment lenders — no profit;  the remaining $70 remains in the US as gross profit to Apple.  But all of the growth in that profit over time goes not to consumers, but rather to AAPL management and shareholders, because wages have stalled for 15 years.  Meanwhile, because of the trade deficit, the $30 that went offshore doesn’t come back as revenue, but rather as loans, and thus cannot be sustained indefinitely.

Compounded over time, this situation should produce exactly what we see:  collapsing wealth and stagnant income in the middle class.

But note the problem is not directly with the free trade, nor with the export of manufacturing.  Those are benign, IF (and only if) the trade balance is neutral and at least some of the growth in corporate earnings flows through to US workers.

Both of these problems result partly from distortions in the dollar/yuan exchange rate.  We know the dollar is artificially high, based on purchasing power parities.  This, in turn, is caused partly by our reserve currency status, and partly from intervention by mercantilist central banks (China, Japan, Korea, Taiwan).  It directly exacerbates both the lopsided trade balance and the lack of US worker competitiveness.

So, while I don’t love the idea of a dollar collapse, it may be a tactical necessity until we can solve longer-term problems with competitiveness: poor K-12 education, wasted resources (prisons, military, health care), serial overindebtedness, and more.

The longer-term problem with worker competitiveness is extremely serious.  No American of any political stripe seems to be asking an obvious question: what if US wages are stagnant because US workers have grown less competitive for some other reason, and not just the cheapness of offshore labor?  Not saying it’s true, just that it’s a question worth asking.  The next post has some thoughts on US labor competitiveness.

Yet another bubble

Monday, November 9th, 2009

A geographically distant reader asked me today:

Maybe you can explain why, despite high unemployment and cratering real estate, the stock market has skyrocketed this year.  Our church’s weekly contributions are suddenly off 25%, so I’m concerned something broader is going on.  Thoughts?

His message comes at an interesting time, as local businesses tell me the same.  The owner of the local dry cleaner, who has predicted economic trends for the past 25 years by watching foot traffic out his window, tells me things have fallen off another cliff since September.

Corporate earnings from summer 2007 to spring 2008 suffered a 92% decline — the most abrupt in U.S. corporate history — yet share prices act as if all is well.  Why?

There are really just two possible explanations.  Either the market is pricing in a nominal recovery (meaning either a real recovery or massive inflation), or we are in another asset bubble.

I suspect the latter, because the market’s P/E ratio — a basic yardstick priciness — is at an all-time high, by far, while there is no evidence of price inflation, and little evidence of recovery.

The following indicators are at, or near, the worst on record, and still worsening:

  • Consumer spending.
  • Personal bankruptcy.
  • U-6 unemployment.
  • Mortgage delinquency and default.
  • Consumer credit growth.

    Those are off the top of my head.  The list is endless.

    We may see some form of “recovery” in the next few months, such as stabilization at the new, lower levels.  This does not justify the dizzying heights of current share prices.

    A hypothesis widely circulated among other finance and economics blogs, which makes sense to me, is that capital simply has nowhere else to go but the capital markets.  Consumer cannot borrow more — they are struggling to pay off the debt they have.  Business investment is way down, worldwide, because there is overcapacity in almost every capital asset.

    Instead, capital flows to where there appears to be a high short-term return:  equities and commodities.  In sufficient quantity, and coupled with the momentum-driven strategies that dominate high-frequency trading, this causes equity prices and underlying value to decouple.  This decoupling is known commonly as a “bubble.”  Perhaps you’ve heard of it.

    For the past 10 years, the common factor of all asset bubbles has been excessively loose credit, both artificially low interest rates and artificially easy lending practices.

    This appears to be happening again with finance sector rescue programs from the Fed and Treasury — i-banks and lenders simply convert to bank holding companies, whence they can borrow at zero, on easy terms, and put the money anywhere they want.  There are few rational places to put it, so there is incentive to put it in irrational places.  So the S&P goes to 140 times trailing earnings.