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. 

Saturday, January 26, 2013

Where Have All the Young Men Gone?

            A theme reiterated in many of my posts is that the only way for our economy to grow (in per capita terms) is for the percentage of people in the work force to grow or the productivity of people working to increase.  Both of these depend on incentives.  In that regard, an article by NicholasEberstadt published in the Wall Street Journal yesterday serves as a warning.  Mr. Eberstadt notes that:

As entitlement outlays have risen, there has been flight of men from the work force. According to the Bureau of Labor Statistics, the proportion of adult men 20 and older working or seeking work dropped by 13 percentage points between 1948 and 2008.The American male flight from work is so acute that more than 7% of men in their late 30s (the prime working age-group) had totally checked out of the workforce, even before the recent recession. This workforce opt-out, incidentally, was more than twice that of contemporary Greece, the poster child for modern welfare-state dysfunction. The share of 30-somethings neither working nor looking for work appears to be higher in America than in practically any Western European economy.

            Young men checking out of the work force is a disaster on numerous fronts.  Most obviously, they are currently doing nothing to expand the national pie.  Equally tragic, they are robbing themselves of the productivity-enhancing benefits of work experience.  As a result, many are on their way to a lifetime of marginal employment and reliance on the government (by which is meant working citizens).  Relationships are likely to be affected as well.  How successful as a father, spouse and role model is a person who has checked out of the labor force likely to be?  Even worse, unemployable young men are prime candidates to turn to crime.  If they become criminals, not only is their potential production lost, but society has to expend resources protecting itself from them.

            In short, the personal and societal costs of young men checking out of the work force are immense.  Any social program suspected of creating incentives for such behavior needs to be reevaluated.

Thursday, January 24, 2013

Apple's Future

            Though I am not a technology expert, the intense scrutiny of Apple makes it hard to resist talking about the company.  The main concern about Apple, and the reason its stock price has dropped so dramatically, is that Apple is becoming “just another device manufacturer” and hardware manufacturing is a low margin, cut-throat business.  What this overlooks is that Apple is also a major software company.  It is Apple’s software that has made their devices so wonderfully easy to use.  And it is Apple’s software that opens a new vista for the company.

            To begin, Windows 8 looks like a loser - adoption rates have been low thus far.  Second Android has the issue of running on a host of different devices.  Third, “smart TVs” have virtually no quality software whatsoever.  What this means is that Apple has an extraordinary opportunity in software – to improve OSX and iOS, to introduce iTV, and to further integrate all of them.  Furthermore, there are opportunities to develop software like iHOUSE, a system for managing your home, and integrate that with all the above using Apple hardware.

            The foregoing just scratches the surface.  The future is a host of integrated devices solving many of the day-to-day problems that individuals and companies face.  The key to successful solutions to those problems is integration.  Nothing is more frustrating than having a host of independent devices that fail to work together as an integrated unit.  As devices and their functions proliferate, no one will be in a better position to solve the integration problem than Apple.  Hardware will be part of the answer, but software will be the key.  And lest anyone forget, it is the integration of hardware and software, not either one alone, that has driven Apple forward since the introduction of the Mac.

            In short, Apple has a wonderful opportunity.  The real question is whether the company has the skill to exploit it without the leadership of Steve Jobs.

Monday, January 21, 2013

Supply Side Economics

            The phrase “supply side economics” brings to mind Arthur Laffer, Ronald Reagan and tax cuts, but the concept is much broader and more important than that.  The fundamental principle underlying supply side economics is that incentives matter and that the most important of all incentives are those to work and improve oneself.  Remember that national output is just the product of the number of people working times their average productivity.  For the economy to grow, and the standard of living to rise, there must be some combination of more people entering the work force or those already working becoming more productive.  Supply side economics is ultimately about providing the right incentives to reward labor force participation and self-improvement.

            To be sure, taxes are part of the story.  Given a certain revenue target, the government should attempt to collect the necessary taxes in a fashion that interferes the least with incentives for individual productivity.  As noted in an earlier post, our immensely complex income tax system comes nowhere near meeting that goal.  There is even a language barrier.  In the recent dispute over taxes, President Obama continually referred to higher taxes on the wealthy.  But we have an income tax, not a wealth tax.  A more appropriate phrase would have been to say that his goal was to increase taxes on the highly productive.  Such language makes the trade-off more clear and gives appropriate credit to the highly productive for their contribution.

            Beyond taxes, all government programs have incentive effects.  As those programs age they can become obsolete (can you imagine using a 10-year old cell phone?) and unintended consequences with associated perverse incentives can come to the fore.  Richard Vedder provides some good examples with regard to employment.  The point is that government programs need to be constantly reinvented, just like cell phones, with an eye toward creating proper incentives for employment and self-improvement.  Unlike cell phone manufacturers, however, governments face almost no competition and, there in, lies a problem that I will explore more in future posts.

Friday, January 18, 2013

Negativity and Innovation

            A wellspring of innovation that is often overlooked is the tendency to be disgusted.  As Walter Isaacson describes in his provocative book on Steve Jobs, one of Steve’s most commonly repeated phrases was “This is shit.”  Isaacson notes that Jobs apparently had a unique capacity to be disgusted by a great many of the people and things he came across in life from reporters, to artists, to hotels, to meals and most prominently to technological products.

            But there two sides to the coin as Isaacson explains with an example.  One day Jobs barged into the cubicle of one of Atkinson’s engineers and uttered his usual “This is shit.” As Atkinson recalled, “The guy said, ‘No it’s not, it’s actually the best way,’ and he explained to Steve the engineering trade-offs he’d made.” Jobs backed down. Atkinson taught his team to put Jobs’s words through a translator. “We learned to interpret ‘This is shit’ to actually be a question that means, ‘Tell me why this is the best way to do it.’”

            The simple fact is that those who find what currently exists to be acceptable will never be as motivated to innovate as those who often feel that “This is shit.”  This creates a tricky problem for organizations - which in order to be innovative - need to welcome people who think many of the things currently being done, and the products currently being produced, are "shit."  This is not easy and it is especially difficult for governments.  Bureaucratic organizations are far more susceptible to the mentality that this is the way we do it here.  Of course, if the organization keeps doing it that way, then increases in productivity and associated economic growth are likely to be glacial.  Steve Jobs was so effective in promoting innovation in no small measure because he was perpetually dissatisfied with so much of what he saw.

Tuesday, January 15, 2013

Government Productivity

         In previous posts, I stressed that the ultimate engine of economic growth is increased productivity.  It follows that aggregate economic growth depends on the rate of productivity increase in each sector of the economy weighted by the fraction of GDP accounted for by that sector.  In that regard, the chart below illustrates that over the last 50 years the share of government spending (Federal, State and Local) as a fraction of GDP has risen consistently.  This makes the rate of productivity growth in the government sector increasingly important.


Monday, January 14, 2013

Long-run Economic Growth

              In an earlier post, I talked about economic growth but did not do it justice.  Growth is not an economic issue, it is the economic issue.  It is economic growth that determines our standard of living.  Given the experience of the last couple of centuries, it may seem that economic growth is the normal state of affairs for human society.  Surprisingly, that view is completely erroneous.

              The chart below presents estimates of the rate of growth in the world economy (measured as expenditure per capita) over the last 500,000 years.  Over the vast majority of that period there has been virtually no economic growth whatsoever.  At first blush, you may think the chart is ridiculous.  How could anyone determine how fast the economy was growing 500,000 years ago?  Actually the calculation is quite simple.  Compare the standard of living of ancient hunter gathers (approximately 500,000 years ago) with the condition of humanity just before the adoption of agriculture about 10,000 BC.  For the sake of argument, let’s assume that by 10,000 BC the standard of living had improved tenfold.  What rate of compound growth produces a tenfold improvement in the standard of living over the course of 500,000 years?  The answer is an imperceptible sliver above zero.

              Furthermore, it is not as if the adoption of agriculture set off a burst of growth.  Growth remained anemic until almost 1800 when humanity finally began translating its burgeoning scientific knowledge into practical technology.  From there forward, growth has been dramatic.  Between 1800 and 2010, the standard of living improved more than it had in the previous 500,000 years!  The bottom line is that growth is not something characteristic of human society.  The process of incorporating scientific breakthroughs into practical innovations and then actually putting those innovations to use is a story of the last few centuries.  It is a wonderful narrative I think of every time I go to the restroom (a 19th century innovation), but it is not something to take for granted.

Friday, January 11, 2013

Valuing Apple - Again

              In a previous post on valuing Apple, I explained that the value of a company equals its book value ($126 per share in the case of Apple) plus the present value of all future expected excess earnings.  Excess earnings equal the difference between the rate of return the company is earning on its book value in excess of the cost of capital times its book value.

              The valuation model implies that if the market for the company’s products is competitive, so that the company earns only its cost of capital, the company’s stock should sell at about its book value.  The key to value creation, therefore, are barriers to entry – factors that prevent competitors from entering the market with comparable products.

              One barrier to entry, often associated with Apple, is superior technology.  Although superior technology may appear to be a great barrier to entry at first blush, research I have done over the years indicates that it is not.  The problem is that good ideas in software and computing are evolving so fast that technology quickly becomes obsolete.  The real barrier to entry is not having the best technology today, but having an organization that can continue to be a technological leader for years to come.  And that is where the concern about Apple creeps in.  The genius of Steve Jobs was not in inventing new products, but in motivating people who did and then making sure that those products made it to market in a form with which he was satisfied.

              There are now those, such as HenryBlodget, who are saying that Apple has lost its edge, that the organization is no longer innovating at the rate required to keep competition at bay.  If that is so, then the stock price is at risk.  The year 2013 will be a critical one for Apple.  Continued marginal improvement in existing products is unlikely to be a sufficient barrier to entry to maintain the current levels of return on equity.  To justify a stock price of $600 or more, the company will have introduce truly new innovations in 2013.

Tuesday, January 8, 2013

Investment Performance

              As we close the books on 2012, the financial press is rife with report cards on investment performance for the past year.  What information do these report cards convey with respect to common stock investing?  Virtually none whatsoever!  The stock market is sufficiently volatile that one year’s performance conveys about as much information as the first play of a football game conveys about the game’s future outcome.

              To be a bit more precise, consider how many years of data are required to conclude with 95% confidence that the return on the S&P 500 index exceeds that on ten-year Treasury bonds.  Of course, theory predicts that the riskier stocks offer higher expected returns, but how much data is required to confirm that prediction empirically?  The answer is close to 50 years!  Few investment managers have such long track records and those that do are unlikely to have followed the same investment strategy the entire time.

              Despite that fact that it conveys little reliable information, it is still fun to keep track of who wins and who loses on an annual basis.  The danger is the temptation to begin acting as if this information were meaningful.  More specifically, the risk is that individual investors end up chasing the performance guru du jour.  Such tail chasing is a mistake for two reasons.  First, moving money around can get expensive because of the transaction costs.  Second, recent big winners tend to respond by charging higher fees, so chasing winners means paying higher fees for, well, nothing.

              In short, as the year ends enjoy the avalanche of annual investment performance reviews.  Just don’t take any of them too seriously.

Saturday, January 5, 2013

"Short-termism" and the Stock Market

              I read again today about the negative impact of "short-termism" on the ability of the American stock market to allocate capital properly.  By short-termism is meant the tendency of stock market investors to focus on quarterly announcements rather than the long-term.  As a result, executives anxious to maximize their company’s stock price become obsessed, allegedly, with producing good numbers for the next quarter rather than doing what is best in the long run.  The result is a misallocation of capital.

              The article took it for granted that short-termism properly characterized American capital markets and went directly to examining its potential impact.  This is odd for three reasons.

              First, if you spend time reading the massive academic literature on market inefficiency you will find papers on all sorts of anomalies, but short-termism is not one of them.  This is not surprising.  If short-termism led to mispricing it would be relatively simple for long-term investors, like Warren Buffett and pension funds, to exploit it.

              Second, the entire technology sector provides a counter-example.  Many, if not most, technology companies trade at values far greater than can be rationalized on the basis of current earnings.  Facebook is a high profile example.  To explain the prices at which these technology companies trade, it must be assumed that the market is looking decades into the future.

              Finally, an intense interest in next quarter’s earnings announcement does not mean the investor is focused on the short-term.  Here I can speak from personal experience.  I have been an active investor in Apple for decades.  As such, I recognize that the value of Apple is determined primarily by its long-run prospects for continued innovation and growth.  (See a previous post on valuing Apple).  Of course, I can make projections on how Apple will do in the future – what products they develop and how those products will be priced and received by customers, but that exercise is by necessity somewhat speculative.  How do I get objective evidence against which to measure the accuracy of those long-run projections?  The source is short-run announcements regarding current products and earnings.  Apple, quite wisely, does not publicly release a detailed five-year plan describing all projects in the pipeline.  As a result, Apple investors must be content with “short-term” announcements as the source of information for evaluating their long-run projections.  For that reason, those short-term announcements are critically important to Apple investors, but not because those investors are focused on the short-term.  Rather, it is because short-term news is the only source of objective evidence with which to assess long-term evaluations!