Thursday, February 26, 2015

Opportunity and Diversity

           Recently concern has been expressed regarding the lack of diversity among the employees of major companies in Silicon Valley.  It is observed that the distribution of employees at these firms is markedly different, across ethnic, racial and gender dimensions, than the distribution of people in the population as a whole.  The implicit assumption is that the skewed distribution is result of unfair barriers, such as bias, prejudice, and cronyism that prevent there being equal access for all people.  The implication is that if those barriers are reduced, perhaps through political intervention, the distribution of employees will become more similar to the overall population.
           While such an assumption may be true in certain situations, as a general proposition it is clearly false.  Here is one example.
           In 1972, American Frank Shorter won the marathon at the Olympic Games.  In that year, Track and Field News ranked the world’s top marathoners.  The list was remarkably diverse.  In addition to Shorter and other Americans, it included Japanese, Mexicans, Europeans, Russians, Australians, a New Zealander and an African, among others.  But in 1972 there were barriers to entry in marathon running.  The lack of funding for marathon runners and the underdevelopment of the African continent prevented most Africans from competing at an elite level.  In the ensuing years, those barriers came down.  Elite marathons began offering prize and appearance money and African countries developed.
           When Track and Field News ranked the top marathoners in 2014 the list was dramatically different.  Diversity had disappeared.  Every one of the top forty runners was from Ethiopia or Kenya.  But even that overstates the diversity.  Ethiopia and Kenya are not homogenous societies.  With few exception, all the elite marathoners came from ethnic minorities than lived in the mountainous parts of the countries.
           In marathoning at least, the end result of removing barriers to opportunity did not result in increased diversity but in a remarkable degree of specialization.  In an activity open to virtually every human – running distance – all the elite men (and virtually all the elite women) now come from small ethnic minorities of two African countries.  Equality of opportunity, in this case, did not promote diversity, it destroyed it.  This example, though perhaps the most dramatic, is not unique.  There are many other instances throughout the world of sport, where performance can measured more objectively, in which opening doors to all people has led to increased specialization.
           Of course, the marathoning example is not a general rule either.  There are obvious instances in which removal of barriers increased diversity.  The entry of African Americans into professions from which they were previously barred is an example.  As the barriers were torn down, diversity increased.
           What the example does show is the removing barriers and increasing diversity are not the same thing.  Furthermore, in situations where barriers are removed and diversity decreases, attempting to enforce it is hazardous.  Doing so in marathoning would result in a bias against elite African runners and an increase in the mediocrity of marathon competitions.  Whether there is a similar risk in other professions is difficult to determine.  But one thing is certain.  Simply comparing the distribution of people in a given profession with the distribution of the overall population will not produce a meaningful assessment of the potential benefits and costs of attempting to enforce greater diversity.  Each situation will require its own fact intensive investigation.

Monday, February 16, 2015

Apple's Car and Barriers to Entry

               The rumor that Apple is considering entering the car business is one more example of a central issue this blog has addressed repeatedly regarding the valuation of Tesla (and other technology companies as well.)  There is a tendency to think that if a technology is fundamentally disruptive the companies that develop and exploit that technology will be huge creators of value.  Not necessarily so.
               One warning in this regard comes from Warren Buffett.  Consider one of the great disruptive technologies of the 20th century – the airplane.  Mr. Buffett notes that while the airplane dramatically changed the lives of most Americans, from an investment standpoint had it been at Kittyhawk he would have attempted to shoot the Wright Brothers down.  Mr. Buffett goes on to observe that despite all the benefits provided by air travel, investors in the airline industry (including Mr. Buffet) have almost uniformly under performed the market and frequently lost money outright.
               The problem is one that economists have recognized for centuries – competition.  Remember that in a perfectly competitive market producers create no new value.  They only earn their cost of capital.  Creating value requires keeping competition out.  Creating fortunes requires keeping competition out for a long time.  Technology is not a particularly good tool in this regard.  Yes, the innovations associated with it open doors, but those doors are opened to competitors as well.
               To return to Tesla, current competition and potential future entry are why Professor Damodaran and I have argued that Tesla’s current valuation is rich and that a valuation of Tesla comparable to Apple’s is ridiculous.  The automobile market is simply too competitive.  The entry of Apple, if it occurs, is just another example of that.  It is also worth adding that one should not assume that if Apple enters it will necessarily be a boon for the company for precisely the same reason.  Apple will not be immune from competition, including, ironically, competition from Tesla.  The bottom line is that the future of the automobile industry looks great from the standpoint of consumers, but not necessarily from the standpoint of investors.  Airlines 2?

Friday, February 13, 2015

Mr. Musk: Please Read Our Paper

              About six months ago, when Tesla was trading north for $250 per share, Aswath Damodaran and I published a paper arguing that a price of $250 per share was next to impossible to rationalize on a fundamental basis.  Even making optimistic assumptions, we arrived at a fundamental valuation on the order of $100 per share.  Since then, Tesla’s price has melted down to a less stratospheric $200.  Still high by our reckoning, but not ridiculous.  What is ridiculous is the recent statement by Mr. Musk that within 10 years Tesla’s valuation may approach Apple’s current $700 billion market capitalization.
              To see why, start with a simple calculation.  At $200 per share, the market capitalization of Tesla is $25 billion.  As a rough ballpark estimate, a fair risk adjusted rate of return on an investment in Tesla is about 10%.  Because Tesla does not pay a dividend, shareholders must earn all of this return in the form of stock price appreciation.  Assuming that Tesla appreciates at 10% per year for 10 years, the market capitalization will rise to $65 billion, less than 10% of Mr. Musk’s target of $700 billion.
              As a been stressed often on this blog, value creation on the order of that contemplated by Mr. Musk requires that a company earn returns far in excess of the cost of capital over extended periods of time.  That requires significant barriers to entry because every current and potential competitor will want to capture some of those excess returns.  In an industries as established as automobiles and batteries, it is hard to imagine that knowledgeable competitors, of which there are many, will sit back and allow Mr. Musk to earn extraordinary returns for decades at their expense.  If a new automotive design looks promising, they will adopt it.
              Of course, there is the example of Apple.  Apple’s market capitalization exceeds $700 billion because the company has been able to earn excess returns for more than a decade and the market expects it to continue for another decade.  But Apple is unique.  The company’s remarkable innovation, in conjunction with a strategy of coordinating software, hardware and design, has been brilliant.  Apple has also been benefited from a series of “butt fumbles” by its competitors that would make the New York Jets proud.  There is no evidence to date that Tesla is comparable to Apple in either respect.
              In short, for Tesla to be worth anything close to $700 billion in 10 years the company would have to move at “ludicrous speed.”  A potentiality that, from the point of view of any reasonable valuation model, is ludicrous.

Wednesday, February 11, 2015

Value Creation and Technology

              In previous blogs, I have argued that Apple was undervalued.  No more.  My opinion now is that it is fully valued, if not over-valued.  But with one crucial caveat that deserves attention.
              The caveat is this.  Value arises from satisfying human wants.  Solving hard technical problems will not produce much value if it does not address human desires.  And we human are not getting any smarter nor are our desires changing all that much.  As a result, the key to valuation creation in technology is the machine to human interface.  That interface, furthermore, is not just the technological aspects, but all aspects including how a device looks, feels, responds, interacts with you and so forth.  After all, look how much we humans spend on fashion and appearance.
              The caveat is that Apple, in the tradition of Steve Jobs and Jony Ive, is acutely aware of this while competitors have been dropping the ball.  If the competitors do not respond quickly, Apple’s valuation could even go higher.  Exhibit A of this problem is Samsung’s failure to produce phones that feel good and look good.  Exhibit B is Google wasting time on Glass, which is a fashion disaster, rather than rapidly improving and constantly marketing the look and feel of Android.  Pick up an Android device and I’ll bet you have no idea what version it is running or how that version relates to the current one.  Furthermore, the device is likely to feel uncomfortable in your hand and look ugly.  Apple routinely upgrades their operating system in a highly public fashion that produces a consistent experience across users.  Jony Ive obsesses over how the devices feel in your hand.
              As intelligence moves into all aspects of our lives, the interface will become even more important.  I know from my own efforts to build a smart home that the companies are only beginning to address the interface problems in that area.  Even GPS devices in cars remain ridiculously complex.  The GPS system ought to talk to you like a well-trained assistant.  Given that the things you and your GPS will be discussing are limited, this problem could be solved today with proper focus.
              To conclude, value creation in the technology space in future years will come down to interface design, including the incorporation of artificial intelligence.  Apple is getting that right and as a result is worth more than $710 billion today.  If the competitors fail to meet them head on then the value could go even higher.