Wednesday, July 13, 2016

Math Skills and Public Policy

         Math skills lie at the heart of understanding investments. If there is one thing I tell investment enthusiasts, it is to learn the mathematical models necessary to analyze an investment. Unfortunately, that advice is rarely followed. The aversion to "doing the numbers" is not confined to investing. It is a symptom of a more general problem that the media compounds by presenting public policy issues in terms of graphic images and flowery language while and leaving out the numbers. Such reporting may draw attention, just as splashy investment advice does, but as in the investment world it leads to muddled thinking.

         Consider, for instance, the Black Lives Matter movement. I doubt that anyone would quarrel with the basic sentiment. What is odd is tying the sentiment to police shootings. Whether or not police shootings are a problem with the police or a problem with a violent society is a complex issue and one in which I have no expertise. But I do know numbers. As Heater MacDonald noted in her Wall Street Journal editorial, "Through July 9, 2,090 people have been shot this year in Chicago, including a 3-year-old boy shot on Father’s Day who will be paralyzed for life, an 11-year-old boy wounded on the Fourth of July, and a 4-year-old boy wounded last week." A hugely disproportionate number of those victims and shooters were black. By comparison, there were 9 police shootings in the same time span. So if Black Lives Matter people are apparently protesting the wrong thing. But without the numbers who is to know. So when considering public policy, as when considering investments, start with the math. It may not give you the answer, but it will at least help you ask the right question.

Monday, July 11, 2016

Secrecy and Theranos

       My knowledge of Theranos and its dramatic fall from grace is limited pretty much to the popular media - a source of which I am typically skeptical.  One exception, at least some of the time, is the Wall Street Journal.  Today they ran an in depth article on Theranos that focused on secrecy which as you know is one of my hot buttons.  The article points to another problem related to secrecy that I overlooked in my posts on Apple.  It is internally corrosive.  If only a few select people are privy to the secrets, colloboration breaks down and the elite lose the critical feedback so necessary for refining their opinions.  If a company with a culture of secrecy starts down the wrong path they are much less likely to self-correct than one in which open discussion is encouraged.

Mr. Musk and Growth Options

        Repeatedly I have marvelled at Mr. Musk's ability to convince the market that Tesla has growth options with his words.  Well he did it again.  Tesla has been struggling with bad news in recent weeks.  Production was below expectations, the government announced an investigation involving an auto driving death, and there was widespread criticism of Tesla's offer for Solar City.  But at the opening today the stock was up over $1 billion in market capitalization to a relative high for the past month.  Why?  Because Mr. Musk announced he is going to reveal a new secret master plan.  Wow.

Monday, July 4, 2016

Growth Options and CEO Compensation

It is that time of year when CEO compensation is revealed and debated.  The Los Angeles Times just published its list of the 100 highest paid executives in California for 2015.  At the top of this list were co-CEOs Mark Hurd and Safra Catz of Oracle, each of whom received total compensation of $53.25 million.  A lot of money to be sure, but as most compensation analysts note, not unreasonable given the impact their decisions can have on Oracle shareholders.  But if shareholder benefits are to be the basis for evaluating CEO compensation, how are shareholder benefits to be measured?
It seems like an obvious benchmark would be the company’s stock price performance during the year in question in relation to the overall market to and to an industry index.  Unfortunately, such a comparison is highly misleading.  To see why remember that stock markets are forward looking.  Today’s stock price depends on investor expectations of a company’s future performance.  Suppose, therefore, that company X hires the LeBron James of management.  At the time of the hiring, the stock price will jump to reflect the increase in future performance associated with having LaBron as CEO.  Assuming that in the year ahead LeBron outperforms all his competing managers as expected, the stock price over the course of the year will not beat the market and industry indexes because it already jumped at the outset.
If stock performance is not an appropriate metric, does the stock market provide any other indication of the value of CEOs to investors?  In my view, the answer is yes – the distinction between assets in place and growth options.  (See my previous post on the value of growth options.)  If most of the value of a company is due to assets in place, it means that a majority of the company’s value comes from milking currently existing products and technology.  No doubt a difficult task at a huge company, but hardly as difficult as innovating and developing new products.  If most of a value of a company is due to growth options, it means that the market has faith in the ability of the company to innovate and create new products.  What greater kudo could there be for the CEO than such a market belief?  Viewed in that light, it becomes evident how valuable certain leaders can be.  The chart below compares Oracle, Amazon and Facebook.  It shows that the growth options of Amazon and Facebook both exceed the total market capitalization of Oracle most of which comes from assets in place.  This drives home how valuable Mr. Bezos and Mr. Zuckerberg are to their respective companies.  The innovations related to their leadership are assoicated with hundreds of billions of market value.  Nonetheless, compared to the $106.5 million paid the Mr. Hurd and Ms. Catz, Mr. Bezos, annual compensation is less than $2 million while Mr. Zuckerberg’s take home a lofty $1.  Talk about a bargain.

Saturday, July 2, 2016

What Mr. Buffett "Understands"

Warren Buffett frequently repeats that he only invests in businesses that he “understands.”  That is why he avoids technology companies.  What I have always found frustrating about Mr. Buffett’s statement is that he never clearly explains what it is he does not understand.  Surely he knows that the value of any company is determined by its expected future cash flows.  Technology companies are no different that way.
I think the last post on my blog contains the key.  What Mr. Buffett does not understand are growth options.  In this, he has a lot of company.  Growth options are by their nature vague and uncertain.  They depend on unknown future innovations.  This is in sharp distinction to the value generated by asset in place that is determined largely by the current earnings and the “moat,” to use Mr. Buffett’s term, that protects those earnings from competition.  These are things Mr. Buffett can see and “understand.”  However, for companies like Facebook, Amazon and Tesla such assets in place account for only a fraction of their value.  The rest comes from the markets expectations regarding the value of future innovations – the company’s growth options.

           Viewed in this light, it is not surprising that the two technology companies that Berkshire owns are Apple and IBM.  The value of both companies is based almost exclusive (in the case of Apple more than exclusively) on assets in place.

Friday, July 1, 2016

The Value of "Growth Options"

             Financial economists divide the value of a company’s equity into two components: the value of “assets in place” and the value of “growth options.”  Although unfamiliar to many investors, the division is a highly useful tool.  To see why, both components must be defined clearly.  The first component, assets in place, has two parts.  The first part of assets in place is the cash on a company’s balance sheet net of its debt.  The second part is value the company could derive from its current earnings stream if it milked that stream for as long as it could without introducing new products and services.  The second component, growth options, is everything else.  Growth options represent the value of all the innovative things the company will do in the future.  This includes the new products it will sell, the new services it will offer, and the new ideas it will develop.  As such, it incorporates the value of innovations that, as of the current time, are not even imagined but which the market believes the creative people at the company will hit upon in the future.
            To actually divide the value of a company’s stock into the value of assets in place and the value of growth options requires making a number of assumptions and doing some financial mathematics.  For those who are interested, the process is described in leading MBA level finance textbooks such as Brealey and Myers.  I applied those techniques to six major technology companies: IBM, Apple, Facebook, Google, Amazon and Tesla as of the end of April 2016.  The results are presented in the chart below.
            Several observations are worth making.  To begin, virtually all of IBM’s $145 billion market capitalization is accounted for by assets in place.  This is what you might expect for a mature company that is expected to grow and innovate slowly.  Apple is more surprising.  The value of the assets in place is greater than the stock market capitalization by $135 billion.  This means the market expects Apple will be unable to effectively maintain its current position.  In contrast, for Google and Facebook much of the market value is accounted for by growth options.  At Facebook, more than 60% of the stock market value is attributable to future innovations that the market expects Mr. Zuckerberg and his team to produce.  Finally, at Amazon and Tesla virtually all of the market value is attributable to growth options.  That means if the companies fail to deliver on expected innovations, the market values will fall dramatically.
            The bottom line for investors is be aware of what you are paying for.  If you buy Apple, you are paying for a current earnings stream that is expected to decline.  If you buy Amazon or Facebook, you are paying for, in the large part, future innovations that have not yet seen the light of day.

Immigration by the Numbers

             Brexit has added an exclamation point to the realization that immigration is a critical issue to a growing fraction of people in the developed world.  Despite the vast amount of commentary on the issue, there is almost a total dearth of numbers.  What makes immigration such a critical issue, and a very different issue than it was in the past, are the numbers.  In 1850, when American immigration was booming the world population was 1,262 and America’s was only 23 million.  The population of Europe was 276 million which was 21.9 percent of the global total.
            Today the situation is dramatically different.  By the end of 2015, the world population had jumped by factor of six to 7,243 million.  The European fraction of had fallen to less than 10 percent.  In the last 50 years, European population growth has been essentially zero while the population of the Middle East and Africa have grown at 2.6 percent per year.
The internet has shown poor people throughout the world how nice it would be to live in a country such as Austria.  But Austria currently has a population of less than 9 million.  Syria alone has a population of almost 22 million.  There are an additional 78 million in Iran and 35 million in Iraq.  In Africa, the populations of Nigeria, Ethiopia, the Congo, and Tanzania are 179 million, 97 million, 69 million and 51 million, respectively.  Most of those people are poor and hoping for a better life.  Many would choose to move if they had the chance.  The numbers are even larger in Asian countries like Pakistan at 185 million and Bangladesh at 159 million.  Finally, there is India whose population of 1,267 million is equal to the total world population of 1850.  If even a small fraction of India’s poor were to emigrate they would quickly overwhelm virtually any host country.  The entire population of the UK is only 63 million.
In light of these numbers, and there are hundreds of millions of other potential immigrants I have not accounted for, it is not hard to understand why public opinion in Austria and the rest of Europe and North America is being transformed.  To complicate things further, the math just gets worse over time.  Population growth remains highest where people are poorest and political unrest is greatest, particularly in the Middle East and Africa, and slowest in the developed countries that are potential hosts.  In another generation, the situation will be even less stable.  Furthermore, given the limited number of people that host countries can possibly absorb, how will the select be chosen?
            The bottom line is that it makes little sense to speak of the immigration problem generically - it depends on the numbers.  And the numbers today are qualitatively different than they were a century or two ago.  It is no longer feasible for a sizeable fraction of the world’s poor to move developed countries.  As more citizens in developed countries become aware of this, resistance to immigration will surely grow.  It is unfair to call this Xenophobia.  It is recognition that in light of the number of people involved there is no “solution” to the immigration problem other than improved governance, faster economic development and slower population growth in the developing world.