Saturday, November 16, 2013

The Social Media "Bubble"

               In a post on valuing social media companies, Aswath Damodaran, properly warns not to be misled by the fallacy of aggregation (http://aswathdamodaran.blogspot.com/2013/10/when-pieces-dont-add-up-micro-dreams.html).  More specifically, with regard to these companies relying on advertising as a source of revenue he notes that the total advertising revenues of the companies cannot exceed total online advertising.  His calculations suggest that the valuations of social media companies are inconsistent with this constraint – implied total advertising revenues of even a relatively small sample of companies exceeds total projected on-line advertising expenditure.

               With respect to a host of the newer social media companies such as Snapchat, Pinterest, WhatsApp and no doubt numerous of companies of which I am unaware, I think he significantly understates the extent of the overvaluation.  There is a second aggregation issue that Damodaran does not account for – namely that advertising will ultimately be correlated with consumption.  There is little point in advertising products to people who will not or cannot buy them.

               It turns out that the dramatic growth new social media is driven by people ages 12 to 22 or even younger.   This is not surprising.  Research in biology suggests that there are evolutionary reasons why the “sexing” of the brain in adolescence produces an intense focus on social interaction and sort.  Social media are now the method of choice for that interaction instead of passing notes in class or gathering in the corridors.  The social media services that are currently seen as cool have a dramatic spikes in usage, but there a good reasons why in all but a few unique cases that popularity will never be monetized.  They include, most prominently, the following.

1.  Young social media users account for a small fraction of total consumption.  Eventually, advertisers will realize you can’t sell washer-dryers or home remodeling services to teenagers.

2.  Point one might not be a problem if the audience were loyal users who became committed to a service for years or decades, but just the reverse is true.  Young people are adverse to what the previous generation found cool.  Novelty is a virtue in and of itself.

3.  Possible solutions to point two are switching costs and barriers to entry, but neither works for most social media companies.  The cost of producing new applications is within the resources of small startups.  The current hot media companies are examples.  The switching costs, if they are even costs, are small as well.  To young people trying new things is novel and fun so there may be switching “benefits”.

4.  The foregoing points also rule out charging for service.  What could be more uncool than paying for something that the latest and greatest start-up is offering for free.

The bottom line is that for social media companies that rely on the young the problem is not that they have yet to monetize their operations, it is that they never will.  The path to profits is not through “cool” but through necessity.  At one time, Amazon and Google were cool innovations used mostly by the young.  Now they are both necessities used by everyone.  That is why the companies are so valuable.  But few sexy new social media companies are likely to make that transition to necessity so investors should “be afraid, be very afraid.”

Tuesday, October 29, 2013

Is Apple Going the way of Louis Vuitton?

     The last several months have revealed two interesting things about Apple.  One - an apparent slowdown in innovation - has been widely discussed.  The new Macbooks, iPads and iPhones are only incremental changes on proven past designs.  Nothing fundamentally new has been introduced since the death of Steve Jobs.

     Does this mean apply is in decline and its stock is headed for a drop?  Not necessarily.  Consider Louis Vuitton.  The parent company, LMVH, has a market value of $70 billion despite a spotty record of technical innovation.  Coca-Cola has a market value of $175 billion based primarily on one product that the company proudly declares has not changed in nearly a century.  Can this be the new niche for Apple - a technical follower, but a brand leader?  The second piece of news from the last several months suggests that Apple may think so.  The company's two most high profile hires have come from Louis Vuitton and Burberry.  Neither were software wonks or hardware designers.

    If this is the new Apple, my take is it will not work.  What makes a brand cool and desirable in technology is different than in fashion or soft drinks.  Cool in technology is defined by innovation.  That is why Google is such a threat to Apple.  The company just seems edgier - more willing to try things and let the public judge.  My conclusion is that this willingness to try dramatic new things is what is ultimately rewarded in the technology space. Being yesterday is being uncool and no one wants to buy uncool technology products.

Friday, September 27, 2013

More on Tesla

               Several weeks ago Professor Aswath Damodaran of NYU posted a detailed valuation of Tesla that I discussed with him and examined carefully.  In a previous post, I noted that Aswath made a host of highly optimistic assumptions regarding the future earnings performance of Tesla.  Despite the optimism, however, his value indicator fell short of $70 per share.  At the time, Tesla was trading at $160.  Friday it closed above $190.  This leads to a very interesting question – who was buying Tesla at $190?  There are two basic possibilities.

               One is that there are those who see an extraordinarily bright future for Tesla.  And I do mean extraordinarily.  To justify a price of $190, it is necessary to assume astronomical growth rates in revenues over the next 10 years at continued high margins – in the highly competitive automobile industry.  It is hard to believe there are enough such optimists out there to maintain a price of $190.

               The second possibility is that investors are willing buy the stock, even at prices that exceed what they see as fundamental value, because they believe that they will be able to sell it higher prices still in the relatively near future.  This is the basis for what is commonly called “momentum trading.”  Although such trading appears to exist, economists still do not understand what causes it to arise and then collapse.  Some models suggest that what happens is that when prices stall, momentum traders attempt to take their profits.  But in trying to take profits, momentum traders end up attempting to sell into a market where there are no buyers because fundamental traders have already concluded the stock is overpriced.  The only buyers were momentum traders and now the momentum traders are trying to sell.  The result is a dramatic drop in prices to a level at which fundamental traders are willing to start buying the stock.

               Of the two possibilities, the second seems to me to be a more accurate characterization of the trading in Tesla stock though there is no way to know for sure.  If my conclusion is correct, at some point there will be a sudden, and likely quite dramatic, drop in the stock price reminiscent of the collapse in the price of Apple.

Monday, September 9, 2013

What is Tesla worth?

           I know investors hate plowing through complex spreadsheets, but sometimes it is worth the money.  This is especially true with regard to Aswath Damodaran’s valuation of Tesla.  Aswath was a student of mine at UCLA and we have been colleagues for many years.  His work is always careful and insightful.  Perhaps even more importantly it is transparent.  When Aswath posted a $68 valuation of Tesla on his website last week, he also posted a detailed spreadsheet that showed all the calculations and assumptions.

            I spent part of this weekend going through Aswath’s spreadsheet.  What struck me is how bullish his assumptions were.  Had I not known the outcome, that he would conclude the stock was overvalued, I might have accused him of hyping the stock by making such optimistic assumptions – sustained rapid growth for 10 years in a highly competitive business while maintaining margins!  Not easy things to do.  Furthermore, despite the risks inherent in a Tesla investment he discounts future cash flows at less than 10%.  Again an assumption that greatly favors a high valuation.

            Despite these optimistic assumptions,  Aswath’s valuation still comes to about $68 compared to a market price of over $160.  I urge anyone thinking of trading Tesla stock to plunge into the details of Aswath’s work.  You will find, for example, that dilution associated with outstanding options plays an important role.  If that undertaking seems to daunting, it is probably not a good idea to be investing in Tesla’s stock.

Monday, July 22, 2013

Apple, Google and Amazon: A Valuation Mystery

            In an earlier post, I noted that the value of a company’s equity equals its current book value plus the present value of all future expected excess earnings – earnings in excess of the cost of capital times a company’s book value.  Companies with great prospects are valued far in excess of their book value due to expectations of large future excess earnings.  Consequently, a good metric for measuring the market’s estimate of a company’s expected future success is the ratio of the market value to book value.

            What is surprising is that when this ratio is calculated for Apple, Google and Amazon the result appears to say that the three companies have markedly different prospects.  Using the most recent balance sheets for March 31, 2013 and stock price data for the same day, the market to book ratio is 3.0 for Apple, 3.4 for Google, and 14.1 for Amazon.  Are the future prospects that much brighter for Amazon than for Apple or Google?

            The answer is no and the clue to the mystery is in the past, not in future expectations.  In the last five years, Apple and Google (particularly Apple) have had immense earnings.  Rather than investing those earnings in their core businesses, or paying them out to shareholders, Apple and Google have built up large cash holdings which are included in book value but which are unrelated to the operations of the firm.  Because cash only earns its cost of capital, the excess earnings on these large cash holdings are zero, dragging down the market to book ratio.  Amazon does not have this drag because, somewhat ironically, its past earnings have been meager or even negative, so there is relatively little excess cash.

            A solution to the problem is to exclude cash holdings and recompute the market to book ratio for an adjusted balance sheet.  In effect, the ratio is computed using the book value of the company’s core business.  The calculation is a bit tricky because it requires a precise definition of a company’s “excess cash.”  Remember some cash is required to run a business.


            When I make the cash adjustments the ratios come out to be approximately 17 for Apple, 13 for Google, and 18 for Amazon.  It turns out that the market thinks the future for the three companies is quite comparable, initial appearances to the contrary.

Monday, May 27, 2013

(Very) Long-run Economic Problems

            The figure below plots real per capita economic growth over the last 500,000 years.  The dramatic fact is that virtually all of the increase in living standards that humanity has experienced occurred in the last 500 years!  To be sure, there were economic fluctuations prior to that.  Living standards ebbed and flowed with wars, droughts, floods, plagues and so forth, but there was no trend.  One century looked much like the next.  It was not until the scientific revolution that humans begin to understand and exploit natural laws so as to better the conditions in which they lived.  And the impact has been dramatic.  A middle class family today lives far better than royalty of 500 hundred years ago when you consider things such as dentistry, medicine, sanitation, indoor plumbing, dwelling climate control, transportation, and electric lighting and appliances.  Real per capita growth of 1.7 percent per year may not sound like much but compounded over three centuries it leads to an improvement in the standard of living of more than 150 times!

       This fantastic growth, however, does not come without risk.  It allows for dramatic increases in population with associated demands for clean water, fresh air, sufficient sources of energy, and adequate natural resources.  It also means that for the first time human activity is having a measurable impact on the global environment.  What makes these risks new is that they are the result of slow, but steady, compounding.  In response to economic growth and rising population, the global environment does not change noticeably from day-to-day, or even year-to-year, but it keeps changing.  Over the course of a century that change can be dramatic.  This impact of compounding is well known.  What is less commonly appreciated is that it is far from clear that we have developed the social and political institutions necessary to cope with it.  Until the last few centuries all of humanity’s problems were the result of short-term crises that attracted our attention and focused our minds.  It is uncertain how well we will be able to deal with problems that seem almost boring in the short run, but could well threaten our species in the long run.  We have never faced such problems in our evolutionary history.

Sunday, May 26, 2013

Political Economic Leadership

            One of the most important aspects of political leadership is accurately framing an issue so that the populace can understand what is at stake and choose accordingly.  Unfortunately, this aspect of leadership often comes into conflict with getting elected.  In no area is that more clear than medical care and retirement savings.  Providing for lifetime medical care and adequate retirement income are issues that have to be addressed early in life and monitored continually.  By the time old age arrives it is typically too late to adjust.  For that reason, people need a clear understanding of what the government can be expected to provide and what it will cost.  Because estimating these costs and benefits is complicated, particularly at a national level, it is not something that individuals can do for themselves.  They rightly turn to their political leaders to present the trade-off.


            It is here that leadership, both Republican and Democratic, has failed at all levels of government.  With changing demographics, increasing life expectancy, and improving medical technology, we have some very difficult decisions to make regarding the allocation of resources.  For example, how much should the working young be expected to pay for the retired elderly?  The unfortunate fact is that with a few exceptions these issues have not be accurately depicted by those running for elected offices.  Governmental organizations from small cities to the federal government have made a host of promises regarding retirement and medical care that cannot possibly be fulfilled.  As a result, we will need even stronger more forthright leaders in the future.  Now we face the prospect of first telling people that the promises on which they based lifelong plans cannot be honored as a precursor to deciding what type of commitments can reasonably be fulfilled.

Monday, May 20, 2013

The Cost of Nuclear Weapons

            Here is an interesting fact hidden in David MacKay’s wonderful book “SustainableEnergy without the Hot Air.”  I quote:

The financial expenditure by the USA on manufacturing and deploying nuclear weapons from 1945 to 1996 was $5.5 trillion (in 1996 dollars).  Nuclear-weapons spending over this period exceeded the combined total federal spending for education; agriculture; training, employment, and social services; natural resources and the environment; general science, space and technology; community and regional development (including disaster relief); law enforcement; and energy production and regulation.


Saturday, May 18, 2013

Job "Creation"

            Hardly a day goes by without somebody trying to take credit for “job creation.”  Politicians from local mayors to the President are the most prominent claimants to the title of job creator but many business leaders also trumpet their achievements in this area.  The implication is that but-for the efforts of these people jobs would not have been created and employment would be permanently lower.  That makes no sense whatsoever.  People want to work to enjoy the fruits of their labor and others want to employ them for the goods and services they produce.  It is the role of the job market to bring together the buyers and sellers of labor services.  It is the labor market that creates jobs by matching buyers and sellers of labor services.

            But there is one BIG mystery.  Why does the labor market take so long to clear?  In other words, why do we have extended periods of unemployment?  As the attached graph shows, unemployment does tend to return to a normal frictional level of “full employment,” but it does so slowly.  The mystery of this slow adjustment has been an issue about which virtually every practicing macroeconomist has written at one time or another and I have nothing to add here.





         But there are two related points worth stressing.  First, the market does eventually clear and second, it is not the number of jobs that determines our well-being but the productivity associated with those jobs.  After all, we could virtually assure full employment by foregoing all technology in agriculture.  Under those conditions, the numbers of “jobs” in agriculture would be immense, as they were in 1790, but we were hardly better off.  The long-run path to prosperity is not through job creation, but productivity enhancement.  From a policy perspective, that means focusing on policies, including tax policy, which maximize the incentives for productivity growth.  Unfortunately, this does not seem to attract the same attention as the misguided focus on job creation.

Tuesday, April 23, 2013

Apple, Samsung and Google

            Most discussions of the swoon in Apple stock focus on competition from Samsung, but that overlooks the fact that Apple is as much of a software company as it is a hardware company.  What makes Apple devices so attractive and easy to use is the seamless integration of hardware and software, not either one alone.  Of the two components, it is the software that is more difficult to copy and, therefore, provides the barriers to entry that allow value creation for shareholders.  For that reason, the real threat to Apple and its stock price is not Samsung, but Google.  Profit margins on pure hardware look to be headed toward PC levels, while margins on creative software remain largely intact.

            What makes the Google threat particularly dangerous for Apple is that Google appears to be innovating at a much higher rate.  Hardly a month goes by in which there is not an announcement from Google of one type of new product or another.  Meanwhile, Apple remains hidden behind its curtain of secrecy.

            If Google can overcome the difficulties of providing software across a variety of manufacturers, as they appear to be doing with Android, and if that software is as good as Apple’s, the reason for paying a premium for Apple products may disappear.  That poses the greatest risk for Apple investors.

Sunday, April 21, 2013

GDP, Earnings and Stock Prices

            Earnings are the fundamental source of the value of common stock.  Although short-term market movements are unpredictable, in the long-run the market capitalization of companies cannot grow faster than their earnings.  On an economy wide basis, furthermore, earnings cannot grow faster than GDP unless the fraction of earnings to GDP continues to rise, which makes no sense economically or politically.

            The foregoing implies that to understand the recent behavior of the stock market, it is useful to take a look at the behavior of the earnings to GDP ratio.  Based on data from the Federal Reserve, the chart below plots the ratio of total corporate profits to GDP.

          As the basic theory predicts, the ratio is trendless.  Because earnings are more volatile, the ratio rises during good times and falls during bad times, but it always tends to revert to its mean value.  The most notable feature of the chart is the recent behavior of the ratio.  It reached its maximum in 2007, dove close to all-time lows in 2009, and then recovered to near record levels by the end of 2012, mimicking closely the behavior of the market.

            The chart appears to serve as a warning.  The ratio has risen to near record levels.  If it reverts as usual will stock prices fall?  The answer is they should not because the mean reverting behavior of the ratio is well documented and, therefore, should be reflected in market prices.  But there is a caveat with the foregoing should.  Research by John Campbell and Robert Shiller indicates that the market fails to fully account for the tendency of the ratio to revert.  If that is the case again, the chart does suggest that the rapid run-up in stock prices is likely coming to an end.

Friday, April 19, 2013

Apple and Buybacks

            One recommendation that Warren Buffett gave Steve Jobs is that if he thought Apple’s stock price was “cheap” there was no better use of Apple’s cash than buying back its own stock.  Mr. Buffett not only gives this advice, he follows it.  Stating that he believes Berkshire is worth at least 1.2 times its book value, he stands ready to buy Berkshire stock below that level.

            Research in financial economics suggests another reason why Apple should be paying attention to Mr. Buffett’s advice today.  Stock prices serve as signals, not only for investors, but consumers as well.  A collapsing stock price and a meager P/E ratio says that the market has little faith in the company’s future.  As a consumer, do you want to buy a product from a company whose future is bleak?  How comfortable do you feel buying a Dell computer today?  Such a collapse in consumer confidence is no minor problem.  As consumer confidence declines, prices fall and margins compress leading to a vicious cycle.

            To make matters worse, if Apple management does not begin a buyback it serves as another signal – namely that they do not think the price is “cheap.”  That rightly exacerbates both investor and consumer concerns, particularly in light of how cheap the stock appears to be.  Previously, I noted that the ratio of the value of business operations to earnings for Apple was only about half that of Microsoft.  Perhaps even more surprisingly it is significantly less than the same ratio for Dell!  The market clearly is saying that Apple’s future is bleak.  If Apple management does not see this as a value enhancing  buying opportunity, that speaks volumes as well.

            Management may choose to be secretive about Apple’s future products for strategic reasons, but there is no reason to be secretive about their confidence in the future of the company.  If they are confident, then it is hard to believe they will fail to conclude that the stock is cheap at less than $400 per share.  If they reach that conclusion, they should say so publicly and act accordingly.

Wednesday, April 17, 2013

Apple versus Microsoft

            I keep hearing that the PC is dead.  The future is tablets, phones, glasses, watches and the like.  Microsoft is toast.  Apple is the future.  Well not so fast – at least as far as the stock market is concerned.  It turns out that the market is a significantly more bullish on Microsoft than Apple (though it is bearish on both).  If that surprises you, let’s do the numbers.  What we really need to compare are the values of the competing business operations.  The table presents the calculation of those values.
 

(in billions) Apple Microsoft
Current Market Capitalization 378 241
 + Total debt 0 12
 - Cash and investments 140 70
 = Value of operations 238 183



2012 Earnings 41.7 17
Value of operations/2012 Earnings 5.71 10.76

Starting from the market capitalization, the value of operations is calculated by adding back any debt used to finance the company and subtracting out holdings of cash and investments that are not part of operations. 
            The calculation reveals that the operating values of the two companies are not that different  - $238 billion for Apple versus $183 billion for Microsoft.  But the earnings are vastly different.  Apple’s 2012 earnings of $41.7 billion were almost 2.5 times greater than Microsoft’s earnings of $17 billion.  Consequently, for the two values to be approximately equal the market must be placing a much greater operations multiple on Microsoft than Apple - the table shows it does.  Because the primary determinant of the multiple is future long-run growth, the analysis reveals that the market is much more pessimistic as regards Apple than Microsoft.  The market is saying that if Microsoft is dying, Apple is moribund.
 

Saturday, April 13, 2013

Computer Technology and Valuation

            I admit to being a tech junkie.  In the last twenty years I have not gone three months without buying a new computer, tablet or phone – until this year.  This is not for lack of desire.  I have the money in bank and am as anxious to buy as I have ever been.  I feel like a mini Warren Buffett.  My gun is loaded, but there is nothing to shoot at.

            Last fall I did buy three new devices – an iPhone 5, an iPad mini, and a Microsoft Surface RT.  The RT made it two weeks before I donated it to Caltech.  Windows 8 on my PCs suffered the same fate.  I went to the trouble to install it on a couple of machines and then spent a weekend going back to 7.  The same was true of Office 365.  I bought it, installed it, and then spent a day going back to 2010.  This is the first time I have ever gone backward with office, but I hated the sliding cursor in Excel and the program seemed generally slower.

            The last new computers I bought were two retina display MacBooks.  The displays are beautiful and I still love the machines, but the computers are almost a year old - ancient by my standards.  Ironically, I run Windows 7 on both of them because I find it to be more flexible than OSX which also needs major innovation.

            TVs have even been worse.  I keep wanting a new one but hate 3D.  I can’t tell the difference between the Sony panel I bought two years ago and current models.

            Worst of all there is nothing I am dying for that is coming out soon.  Well Apple TV maybe, but that has been coming for years now.  I feel like Lucy, Charlie Brown and the football on that one.  I will buy the new iPad and mini iPad when Apple updates them, but I am not pining for either.  Unless the iPhone 5s is a meaningful upgrade from the 5, I may have to pass on that one. 

            So that’s the problem.  I am sucker for any new technology.  I have the money.  I want to buy, but the shelves are bare.  The point of all this is what does it mean for the valuation of computer and technology device companies?  If one the world’s easiest mark isn’t buying, what about people who are not such suckers?

Tuesday, April 9, 2013

The Stock Market Rally and the Fed


A common refrain in the financial press is that we are experiencing a “Fed induced rally in the stock market.”  According to this popular account, the Fed is drowning the market in liquidity resulting in low interest rates that have driven up stock prices.  Does that make sense?  The question cannot be answered in the abstract – it requires a model for evaluating the level of stock prices.  Whereas valuing individual stocks is particularly tricky, it is less difficult to value the market as a whole because the constant growth assumption is much more applicable to the entire market than to individual stocks.

The constant growth model implies that the level of stock prices is given by the equation,

 Stock price level = Next year’s expected earnings / (k-g). 

The Fed’s impact on the stock market comes into play via the denominator, (k-g), so let’s take that apart.  The g is the easier part.  It is the rate at which earnings are expected to grow.  As such, it includes two components.  The real growth rate in earnings plus expected inflation.  The discount rate, k, is the sum of three components - the real rate of return on long-term Treasury bonds, plus expected inflation, plus a premium for the risk of investing in common stock versus Treasury bonds.

            Notice first that when calculating (k-g) expected inflation disappears because it is included in both k and g.  In addition, there is no apparent reason why a loose Federal Reserve policy would alter the risk of investing in common stock compared to Treasury bonds, so let’s set that term aside.  Putting the pieces together, for the Fed to decrease (k-g), and, therefore, increase stock prices, it must either drive down the long-term real rate of interest or increase long-term expected real growth in earnings.

            First, as to real interest they are definitely low by historical standards.  Currently, the real yield on a ten-year Treasury TIP (an inflation protected bond) is -0.69% (yes, it is negative, that is not a typo), well below its long-run average of more than 1.50% prior to the financial crisis and the change in Fed policy.  However, despite all the Fed’s effort future real growth in earnings is also depressed relative to the time before the crisis.  The question is by how much?  It is hard to believe that expected real earnings growth has dropped more than a percentage point.  Assuming that the Fed is responsible for the substantial drop in real interest rates, then yes it looks like at least part of the current stock rally is Fed induced.  That should serve as a warning to investors.  Watch the ten-year TIP in conjunction with Fed policy.  If the Fed begins to tighten and the ten-year TIP starts to rise, it could be bad news.

Sunday, March 24, 2013

Does the Market Fail to Reward Long-run Managers?

        In the Wall Street Journal’s Intelligent Investor column, Jason Zweig reported on March 23 that the short-term focus of the stock market, measured by increasingly active trading and dramatic market reaction to apparently short-term information, was having an impact on executive decision making.  More specifically the article noted that,
This past week, Oracle's ORCL -0.99% stock lost 10% in a day after the company fell short of quarterly earnings expectations by one penny per share, and shares in FedEx  FDX +2.05% dropped by 9% in two days after a sharp decline in quarterly profits.  Investors with such itchy trigger fingers make corporate managers gun-shy—and that, in turn, might hurt profits in the long run. A survey of more than 400 senior corporate executives in 2003 found that 59% wouldn't invest in a project that would generate significantly higher long-term profits if it reduced earnings in the short run.
   Such an interpretation is unfair to the market.  Neither the price drops in response to earnings nor the active trading implies that the market is not attempting to assess the long-run value of a company.  In fact, the case of Facebook and many other technology companies is dramatic evidence of how far out the market looks.  Otherwise, how could Facebook have a market capitalization of more than $62 billion on the basis of its current, relatively anemic earnings?  It takes a little analysis to explain how a long-term oriented market could respond so strongly to apparently short-term information, but the key idea is the difference between projections, plans, and objective evidence.

    Presumably every major American company has a long-term strategic plan.  What’s more, management presumably has concluded that its current plan is the best one for creating value.  Otherwise why would that be the plan?  It should come as no surprise, therefore, that if managers are asked whether they have a plan for maximizing shareholder value, they will always answer, “yes.”  But since everyone will always say yes, the market cannot rely on what is said to evaluate a company’s long-term prospects and plan – it needs objective evidence.  The most important objective evidence to which investors have access is actual financial performance.  Unfortunately, that information arrives only in short-term quarterly installments.  There is no way for investors to observe the “long term” except via short-term increments.  What is critical to recognize is that the reaction to those short-term announcements reflects the market’s effort to use the objective evidence to reassess the company’s long-term outlook.  Oracle and FedEx dropped not only because they missed current earnings expectations, but because of what those misses implied about the earning power of the companies going forward.  A more dramatic example is Apple.  Apple dropped from $705 to $420 on the basis of apparently minor short-term news, not because the market is short-term oriented, but because that news led to reassessment of Apple’s long-run competitive position.  You might argue that the market overreacted to news regarding Apple, that the long-term implications of the news were not that significant, but that is a different argument the thesis of which is that the market does not properly assess the long-term implications of short-term news, not that it fails to consider those long-run implications.

    The foregoing can be demonstrated more formally by taking advantage of data on the revisions of analysts’ forecasts in response to earnings announcements.  In a comprehensive paper Bill Beaver, Wayne Landsman, Steve Stubben, and I show that when stock prices move sharply in response to earnings announcements, it is not the current earnings surprise that is the primary cause of the stock price movement; it is the revision of expectations for future earnings up to five years into the future.  This research makes it clear that the market is using short-term objective information to update its assessment of the company’s long-run outlook.

   In light of the foregoing, rejecting projects that offer long-term profits because of short-term negative impact on earnings is completed misguided.  Companies that adopt such a viewpoint have a long-term problem – namely managers who fail to understand how the capital market operates and penalize their shareholders and society as a result.

Friday, March 8, 2013

Property Rights and Incentives

            A constant theme in this blog has been that the key to successful economic policy is “getting the incentives right.”  One element of making incentives work is establishing that property rights are secure and well defined.  An obvious, but often overlooked, fact is that the incentive to produce requires property rights to the fruits of one's labor.  Without a legal system which fairly enforces property rights, the incentive to produce is greatly diluted by the incentive to become a “political lobbyist.”

           Recent work by Hernandode Soto demonstrates the importance of the interplay between incentives and property rights in the context of the Arab Spring uprisings.  Mr. de Soto notes that in Egypt, for example, 82% of the businesses and 92% of the land holdings are unrecorded and thus unprotected by the rule of law.  Such failure to secure property rights plays havoc with incentives.  Without objective and fair legal protection, the only way to safeguard the value of a business is by courting government officials, hiding from government officials, or attempting to overthrow government officials.  Unfortunately, none of the above makes for a productive economy or a stable society.

Monday, March 4, 2013

Apple, Buybacks and Einhorn

            A decade ago I published an article in the MIT Sloan Management Review arguing that the information that was most important for a company’s Board to discharge its duties was a carefully prepared analysis of the company’s fundamental value.  That is doubly true today for Apple.  Managers and boards are better able to estimate fundamental value because they know the company’s strategic plan.  In Apple’s case that means knowing what products the company plans to develop in the years ahead.

            In previous post, I calculated that if Apple could basically maintain its current position, even without substantial real growth, the stock should be worth around $600 per share.  If that is close to being true, then Apple management has an obvious thing to do with its cash – buy Apple stock.  No less than Warren Buffett has noted that doing so amounts to buying dollars bills for 80 cents.  (Actually 71 cents if the $600 valuation is correct.)  There is no need for complicated preferred shares such as those suggested by David Einhorn, just buying back the stock is the best thing that Apple can do for its shareholders.  Viewed in this light, the fact that the company has not announced a major buyback might be a warning sign.  If management believed the true value of the shares was $350, then buying them back today would be equivalent to paying $1.21 for dollar bills.  I don’t think Mr. Buffett would approve of that.

Sunday, March 3, 2013

House of Cards

            Netflix is airing an entertaining series about Washington entitled “House of Cards.”  It stars Kevin Spacey who is a sensational actor.  The 13 segment series focuses on the machinations of Washington life.  As the majority party Whip, Mr. Spacey engages in all sorts of nefarious schemes to increase the personal power that he openly covets.  Along the way, there are episodes with drugs, hookers, and infidelity, as well as the usual lying and cheating.  It is hard not to get hooked by the series.  It is very entertaining.

            On the other hand, consider Ben Bernanke.  As a fellow scholar, I have followed Mr. Bernanke’s career and research from the outset.  Mr. Bernanke’s professional life has consisted primarily of decades of studying the complicated details of monetary theory and policy.  When he rose to head of the Federal Reserve, Mr. Bernanke attempted to put his decades of study to work to help guide the central bank and the nation through a perilous time. 

            Now that does not mean I agree with all of Mr. Bernanke’s policies.  Nor do other economists more distinguished than I such as John Taylor and John Cochrane.  But that is not the point here.  The point is that Mr. Bernanke is not entertaining.  No mistresses, no cocaine, no hidden agendas.  What a bore.  There will never be a “House of Cards” about Mr. Bernanke.  The unfortunate fact is that entertainment will always be a biased depiction of reality because it must be entertaining.  The cultural implications of that fact would be interesting to explore.  But for now, thank heavens for boring people like Mr. Bernanke who spend a lifetime studying what they think is best for the country and then attempting to implement what those studies indicate.  Perhaps the most depressing fact about Mr. Spacey’s character is that he spends so much time pursuing power that he has no meaningful idea what to do with the power he achieves.

Sunday, February 17, 2013

Aging and Technology

            Let’s start with a thought experiment, which I admit sounds like a B science fiction movie, but illustrates an important point.  Assume that everyone is identical and that they are educated until 21, work until they retire at 65, and die at age 70.  What’s more, the world is the same every year.  There is no population growth or increase in productivity.

            Into this world introduce a genetic miracle that extends the life span to 85 while maintaining the same level of health.  What is the economic impact?  If people still retire at 65 the result is that everyone is 17.6% poorer.  The reason is that the working population, and thereby the national pie, stays the same but it now has to be divided among more people – specifically all the new seniors between 70 and 85.

            In this simplified world, there basic only two alternatives.  The first is to accept a lower standard of living.  This is not especially attractive to the working generation who are putting in the same effort as their predecessors and coming away with 17.6% less.  The second is to find a way to make the elderly productive.  If the elderly were to work until age 80, and then retire for five years, the standard of living would be maintained.

            Fortunately, technology has already gone a long way toward promoting productivity in later life.  Machines have taken over much of the back breaking work that was common in the 19th century.  The question is what about mental work?  It is an unfortunate fact that as you age the intelligence measured by IQ tests falls, particularly after 60.  More specifically, thinking slows, memory becomes more fragile, and logical problem solving is more difficult.  On the other hand, there is much to be said for the wisdom of age.  I look back on decisions I made in my early 20’s, the peak time for IQ type skills, and say, “How could I have been so stupid?”  The trick is to pass some of the mental quickness tasks to machines so as to help older people take full advantage of the wisdom.

            In this respect, the elderly are a prime challenge for our most innovative technology companies.  It is one thing to write game software and make cool devices that cater to young people, but an intriguing, socially beneficial, and potentially immensely profitable opportunity is helping the ever growing population of elderly become more involved, productive members of society.  As an early baby boomer, I am thankful for the medical advances that are helping me live a longer, healthier life, but I look just as forward to the new tools that technology can provide to help my “golden years” productive ones as well.

Tuesday, February 5, 2013

Market Efficiency and Individual Investors

            There is an old joke about two hikers who come across a bear.  One turns to run and the other says, “It’s no use, people can’t outrun bears.”  To which the first replies, “I don’t have to outrun the bear.  I just have to outrun you.”  This story has an application to investing and the concept of market efficiency.

To review, an efficient market is one in which market prices reflect all publicly available information.  In such a market, it makes no sense for an investor, particularly an individual investor, to try to beat the market by finding under- or over-valued securities because there aren’t any.  It should come as no surprise, therefore, that advocates of active investment management are always on the lookout for evidence of market inefficiency.  Quite frankly, there is a good deal of such evidence in published academic research.  There are even papers that prove, from a theoretical perspective, that stock markets can never be fully efficient.  So, does that evidence imply that investors ought to try to beat the market?

The joke about the bear serves as a warning.  To make active trading a folly for an individual investor, it is not necessary that the market be fully efficient, it is just necessary that the market processes information more efficiently than the individual who is trying to beat it.  (Remember that investors trying to beat the market can also run up significant transaction costs.)  And that is very likely to be the case.  The market may experience bouts of irrationality and over-reaction, but individuals are far more likely to fall prey to such foibles.  In short, the market may not be perfect, but it is almost certainly more perfect than you are.

Sunday, January 27, 2013

Equality of Opportunity

            One of the long-running, but still unresolved, debates in politics and the social sciences involves the relation between equality of opportunity and equality of outcomes.  It would be convenient if equality of opportunity produced, at least approximately, equality of outcomes.  In that case, the only required political step would be to level the playing field.  There would be no need for direct intervention to influence the distribution of outcomes (assuming that equality of outcomes is a desired goal).  However, what, if anything, should be done if outcomes turn out to highly skewed across different groups of people despite equality of opportunity?  That is the difficult question we often choose to avoid.

            I bring up this age-old question because of an article I recently read in Track and Field News.  You have to be a bit a track nerd to read this magazine because it covers the sport in what most people would find to be mind-numbing statistical detail.  The January issue, the one I was reading, ranks the top 41 men in each event for the previous year.  My favorite event happens to be the marathon, so I turned immediately to the marathon rankings.  The results for 2012 were astonishing.  The top 41 male marathon runners consisted of 21 Kenyans and 20 Ethiopians.  And even that amazing statistic overstates the extent of diversity.  Kenya and Ethiopia are both ethnically and culturally diverse societies.  Virtually all the world class marathon runners come from highland tribes that are ethnic minorities in each country.  In short, given a global population of over 7 billion, all the top marathoners come from ethnic minorities within two relatively small African countries.  This is hardly an equality of outcome.

            Unfortunately, the skewed outcome cannot be explained by inequality of opportunity because historically it was the Kenyans and Ethiopians who were denied the opportunity to compete.  In the early years of marathon running, a combination of poverty, a heritage of colonialism, and political instability made it virtually impossible for Kenyans and Ethiopians to compete at the Olympic level.  Ironically, marathon champions during those earlier years were a much more diverse group.  As the barriers to entry came down, and Kenyans and Ethiopians entered the competition, the outcomes became much more skewed leading to the present state of total domination.  Equality of opportunity lead directly led to inequality of outcomes.

            While marathon running may be a unique example, it nonetheless serves as a warning.  It is not safe to assume that equality of opportunity will lead, even approximately, to equality of outcomes.  Similarly, it does not follow that inequality of outcomes is necessarily evidence of inequality of opportunity.  Marathon running has such skewed outcomes precisely because of equality of opportunity.