World wide factory Activity

Here is world wide factory activity compiled by WSJ. Out of the 50 listed here only 8 were expanding. 1 was no change and rest were contracting. Interesting times these.

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Taxes vs. Penalties

As predicted the governments of developed world are responding with taxing legislation. The aim is to tax the rich. But the discourse has been simplified unreasonably. Here are some important points.

First, higher taxes are required. There is infrastructure to build, things to repair and government to run. This is legitimate expectation of government from the population that has capacity to bear the burden. Higher means higher than normal times. If taxes were taken below normal then increase will have to be in stages first up to normal and thereafter, if required, a little higher.

Secondly, the government has been defrauded because of the crisis, either directly (bailout going to bonus) or indirectly (economic impairment). The people who defrauded the government have gotten rich and they owe government more money than in first case. This money should come from prosecutions and penalties. Government cannot keep settling claims without clarification of guilt and facing shortfalls. The fraudsters must face penalties which are higher than cost to the government and economy. 

In the US the situation is worse. The taxes are reduced below normal, there are no prosecutions with penalties and claims are settled.

Thus, increasing taxes to the extent as described in first case above is rational, necessary and should be acceptable. Further, increasing taxes just to cover the fraud losses from second case, is irrational, unnecessary, unacceptable and can even be unconstitutional.

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The waning of Society

When I wrote the book "Subverting Capitalism and Democracy" (click the picture to buy it) I was more interested in understanding why we, as a society, were unable to foresee and then stall the crisis. In my inquiry I found that there was systemic rot that had taken place. The reasons for the systemic rot is what I aimed to explain in the book. 

The systemic rot impacts social fabric on many dimensions. It explains poverty, our helplessness or inability to change the system, how and why political system was compromised, how media was compromised, etc. I have detailed these concepts in the book. To understand the systemic rot, we must understand some basic issues.

1. We must see the economic-society as a network of transactions, not simply millions of transactions happening together, but a network connecting resources with needs. 
2. We must understand that each transaction has bargaining power equation embedded in it. Unlike what economist like to believe, people participating in transactions always have some burden weighing on them. Using this burden one party is able to command better terms than fair exchange would allow. Michael Porter's 5-forces analysis captures the principle behind this very well from a corporate standpoint.
3. Bargaining power is additive in nature. Thus, imagine a transaction chain A-B-C. A deals with B and B deals with C. Now, if A has higher bargaining power than B and B has higher than C, then C will have twice the burden. C will feel twice the pressure in the transaction with B. 
4. In our democracy-capitalism system, bargaining power slowing started accumulating with the financial industry. In fact currently, the bargaining power rests with the investors and occasionally goes to the inventor. Thus, apart from financial institutions, companies like Apple seem to be doing really well.
5. If bargaining power accumulates in certain places within the network of transactions, then it can give rise to a quasi-fiefdoms. It is incumbent on the government to ensure that this accumulation of bargaining power is broken down to allow a distributed system to start working again. 
6. The fiefdom cannot survive only because there is bargaining power accumulated within it. It needs one more dimension when it becomes tyrannical. That happens when there is a class where bargaining power is always low, where bargaining power is always suppressed. If there is no such class then internal forces prevent formation of fiefdoms or allows fiefdoms to be taken down if they are formed at all. But if there is a class that does not have bargaining power at all, then it becomes victim of the bargaining power accumulation.
7. Similarly there will always be poverty, because by definition, poverty is relative. However, if the poverty becomes permanent, then it is a sign that somewhere the bargaining power equations have gone awry.
8. The capitalism-democracy system is highly regarded because it provides for three mechanisms wherein bargaining power is available to all. One is voting, second is entrepreneurship and third is judiciary (which cannot act on its own without exceptional circumstances). For a feudal society to remain stable, it needs to impair both these processes. Sadly, the current society everywhere in the world, this is true. It is true of USA, of Britain, of India, of Myanmar and every other country.
9. The democratic system envisages a watchdog - the press. The role of press is to identify and call out any accumulation of bargaining power. The report of press has a lot of weights and can trigger a governmental response. However, even this part has been compromised. 

A revolution is not a solution. Traditionally, revolt works better if the new system is dramatically different than the old one. That is not the case. A functioning capitalism-democracy is the best system available currently. However, it needs to be populated with good people who understand the dilemma. The system needs additional checks and balances to ensure that this does not happen. The problem is any system we design will have forces that want to compromise it to their advantage, it will breed a set of incumbents who want to tamper it to their advantage, it will have its own set of power struggles. The solution is not another system but a refinement in system of checks and balances.

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Automation and implication for employees

New York times has a fabulous article about how robots are taking over skilled work (using pic alongside). As part of firms we need to understand the nuances. What work can we substitute by robots? What work needs humans? Why so?

Understanding Automation
As discussed in my book Understanding Firms, overall work can be classified in three categories using ESK profile. ESK profile refers to content of work in terms of Effort, Skill and Knowledge. In first phase of productivity, machines developed to augment "effort". We called them tools as they were sufficiently dumb. As profile of the work changed towards higher skill-oriented work, the machines have caught on replacing human intervention in high skilled jobs. Earlier, these machines performed specified tasks repeatedly but a change in task was difficult for them to cope with requiring down time and modifications (temporary and permanent). What has changed is that, new machines are super flexible requiring no downtime to adapt. These machines work on variety of jobs and switch between them effortlessly. 

Yet, knowledge remains exclusive domain of humans. 
At the moment we do not or cannot have automated surgery machines as there are lot of decision points within a surgery process. However, robots do augment the surgeon in his skilled work of cutting, stitching, grasping etc.

Workforce profile will change
As I discussed in the book, the ESK requirement of the work is fulfilled by worker and machines together (and sometimes by process and materials used). Naturally, the workforce has to adapt its education and learning to take more decision centric roles rather than actual effort oriented task. It also means that workforce needs to have a higher knowledge profile.

With decision-making at the center of human contribution, creativity assumes prime importance as against uniformity and repeatability that were mainstay of prior manufacturing eras.

It means we need a more educated workforce (though nature of education needs to be drastically different). Previously, education was focussed on improving conformity, new education must focus on improving creativity.

Notes:
Example of Material or Process contributing ESK is car painting where slight magnetic action allows uniform coating of paint. This work has contribution from material (a paint that has electro-magnetic properties) and by process (actually using that property to advantage). 

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Why your firm cannot innovate?

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Agricultural income vs. Industrial income

I have often wondered why Agricultural incomes are less than industrial incomes. Following are some of the reasons:

1. Agricultural incomes are not as tradable as industrial incomes because 
1. they are tied to the land, corresponding weather and topographical externalities and therefore limited by its productive constraints. Other industries have freedom to migrate to better assets with higher productivity.
2. they have low spatial availability as compared to industrial opportunities that are clustered. Thus geographically, agriculture is at disadvantage.
2. Agriculture has been around for longer than industrialism thus it has gone through various stages of productivity development and now the labour component is stabilized. As industry will go through with similar development cycle the wages will taper off.
3. The agricultural produce forms part of inflation basket and central banks make sure the value of basket does not grow rapidly thus capping the incomes from agriculture.
4. Industrial products are more globalized and specialized as compared to agricultural products. The demand for agricultural products depends on tastes and those are more tuned with local produce. Only staple foods are truly globalized. The perishable nature of the products also prevents wider distribution of the products. No so for industrial products.

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Some ways promoters withdraw money from their companies

Business Standard has an article how promoters are using royalty payments to move money from under the nose of shareholders. The article is very bare and except one tactic, don't seem to have any more details on tactics used. 

Incidentally, I discussed this as one of the forms way back with some people wanting to know some mechanisms that achieve this. Some, I have discussed in my ebook on Investing in Real Estate Developers. So let me discuss some here - some are ways and others are points of observations. And then you tell me some you know of. These may not constitute legal fraud but are definitely morally uncomfortable.

1. Some promoters use a brand or business mark as separate asset and house it in an separate business entity which is exclusively held by them. The group companies must pay to use this brand or mark at a price that is agreed to by the board. Kingfisher from UB group uses this technique. Tata also uses this technique.
2. Real estate developers use three or four different means:
• Some Real estate developers choose to deal with "exclusive sales agents" which are promoter held companies buying from listed companies. Naturally, the listed company has lower realizations that actual markets allow. In many cases I have found listed real estate developers sales (on per sq. feet basis) to be lower by 15-25% of rates prevailing the location of their projects. This allows developers to show that their pricing is reasonable and hence their pre-sales is 100%.
• Real estate developers also have related party land bank buying entities and their land procurement cost is significantly lower than that of listed entity. Naturally, the margin in this related party transaction can be adjusted as per situations. For example, when the listed company is likely to raise capital in next 3 years these margins are depressed leading to expanding margins in listed entity.
• Pricing extras separately also helps share of revenue to be directed into other vehicles. Thus, parking is sold separately to sales agent while apartments are sold separately, one by listed entity and other by closely held promoter company.
• Another way for developer is to sell to REIT and sell out the REIT at lower risk discounting factors. This inflates the asset values based on occupancy which is 90%+ at the time REIT is getting listed and drops significantly later. The key occupier is of course and exclusive rental-sales agent.
3. Some promoters build into their sales expenses "management oversight expense". This is generally charged as percentage of revenues and usually is very small figure say 0.5% and can be termed slightly differently.
4. Group Forex agency margins are another way promoters use. This is applicable for conglomerates or at least firms that have multi-geography locations with separate entities. The conversions on forex are routed through a separate group entity which is privately held. This agency marginally increases the cost and passes them to promoters. This used to be a viable approach in the past when there were lot of restriction on Forex dealings.

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Operational vs Financial leverage

Hugh Hendry made some points at the Milken Institute conference recently, I am sure you have already seen this but this is the link anyways. 

I want to highlight one comment he made. I paraphrase here "Germany has high operational leverage and when you have high operational leverage, you want to have very little financial leverage. That is why Germany is so averse to debt."

Then he mentioned Siemens vs. P&G. Interesting comment this.

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Growth creating complexity?

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How Low interest rate can be bad for small business

Summarized from the book (click to buy)

We are told that when interest rates are too low, they are encouraging entrepreneurs to take risk.

However, this impacts the business models differently. At one end are business models, like infrastructure projects, that cannot add threshold value in the initial years of the venture. The low interest rate regime, allows a valuable gestation period for such business models. Often, government artificially lowers interest rates for such projects. At the other extreme, there are weak business models, those that are viable only in low return scenario. These business models, however, die out once the interest rates start rising. In between, there are experimental and innovative business models. Some of these use the low interest rate period to forge better, more robust models. Such businesses thrive later. Others, however, end up going bust. The role of banks is to identify each of these business models and fund them while appropriately mitigating the risks. 

How low interest rate leads to mal-investment 

A bank takes risk by investing in a venture. Interest rate is also a reward bankers get, for taking the risk. Ideally, even in lower interest rate scenario, those projects with best risk-return trade-off should get financed. 

However, in reality, lower yielding large borrowings backed by reputed corporates get access to financing more easily than new ventures. This means, irrational mega-projects or mal-investments of large corporates get financed at the cost of genuine investments of new ventures. 

Typically, such irrational mega-projects consume a lot of credit requiring load syndication. This has twin benefits for bankers. First, there is a higher degree of comfort in being with the herd. Secondly, bankers do not have to go through credit appraisal of many small entities of questionable risk profile. This makes them assign a lower risk to these projects than appropriate. Intelligent investors will find that this contradicts with the "diversification as risk management" strategy. But being with herd has a stronger lure and is treated as risk mitigation (though wrongly).

Further, at lower interest rates, debt starts being used as an instrument to amplify equity returns.  

Thus the second blow to new ventures comes from crowding out. It implies that even in a low interest rate environment, small businesses and entrepreneurs may not have access to lower cost capital. Therefore this impacts the long-term strength of the economy. 

In high interest rate scenario, the irrational mega-projects seem less promising. Hence, contrary to popular belief, it may be easier for smaller businesses to compete in high interest rate scenarios. 

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Rant - Keynes is medicine - not food

I wish to restate that Keynesian recommendations are like medicine, to be taken only in dire circumstances when the economy is ill. It is not, I repeat NOT, a dietary recommendation for running a country in usual times.

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Tear all organization charts?

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Dow Jones Industrial Average since 1900

Barry Ritholtz links to this awesome chart from J.P.Morgan. It tells us so many things when you look at real long term. Have a look and my comments are below this:

The graph tells us so many things:

1. Before anything else, I must highlight that the average line for 1937-49, 1966-82 and 2000- present are drawn wrong. They have a positive bias. 1906-24 seems to have a negative bias.
2. More importantly, we seem to have ~20 years of stability and ~20 years of secular bull runs. By that measure, somewhere after 2015 we will see the start of the next bull run.
3. But we must correlate these with actual developments. If you draw some key developments on the charts we will see better picture. 
• Periods of technology development
• 1930s and 1940s period signifies the development of US highways and railroad. This is phase where Americans were still exploring new frontiers within their country.
• Similarly 1966-82 period was time when computing technology was taking shape.
• Similarly, 2000- present internet technologies are taking root.
• Productivity increase periods. These periods are different from technology development periods. Here known technologies are being exploited to create new thresholds for efficiency and productivity. Concurrently, new technologies are being incubated but those are not the dominant forces as yet.
• 1949 onwards was post war reconstruction. Here known things were required to be produced in ever increasing numbers to satisfy the demand in Europe and Americas itself.
• 1982 till 2000 was a period when IT came of age. Computing allowed wider management control, better designs, higher efficiency etc.

Overall quite an interesting chart. What do you think?

update: I made a appalling mistake of commenting on exponential line which I have deleted. The graph is in log scale.

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Understanding Car dealers

John Hempton asks why car dealers behave the way they do - fleece the customer. He has detailed the issue in that blogpost. I am going to attempt to answer this. But let me tell you it will be a convoluted answer.

First, you have to imagine the entire car business as a network of transactions. The transactions that make money for the car assembler (I refer to Fords, Nissans of the world) are way more upstream at supplier side based on economies of scale achieved in sharing parts etc. (where exactly depends on each assembler). Sales per se does not contribute the differential value and will not dramatically impact margin on the product as other drivers. Hence the recommendation is to reduce sales cost as much as possible. Let sales pay for itself. Invariably that means hiring people without testing their morals and skills.

Second, these types of people can turn against the company as well and fleece them. Hence strong processes are put in place to constrain them from fleecing the company. There is apparent lack of trust between sales person and the company (usually seen at the time cost is audited or controlled by finance people). For the salesperson, the only way to make extra money is to cheat the customer. The incentives are stacked that way. You can see the relative bargaining power stacking here. Bargaining power of company is higher than that of sales person and that of sales person is higher than customers.

Third, the incentives of sales person and that of company tie in well - sort of complement each other. Once customer buys the car, she is sort married to it for 4-5 years. That means parts, servicing etc. etc. 5 years of opportunity to milk the customer -  long-term fleecing. (ok I can use buzz word like customer lifetime value etc but you get the idea). For salesman the incentives match. He meets the customer once every 5 years and hence has no incentive to strike a long term deal. So short term fleecing happens here. Note the differences in Cash Flow Chain designs. The cash flow chain does not fully flow through sales network, it equally flows through service centers. This is what reduces the bargaining power of sales persons.

Fourth, if a sales person invents a new technique to enhance sales, then it is in the car companies and dealers interest to spread the idea to every other dealer and sales person. This nullifies the advantage that innovative sales person should ideally enjoy. The effect of any value add that spread across the entire product range, is that is ceases to be a differentiator. The only practices the company cannot promote are once it should actively demote. But even those do not remain differentiators.

Fifth, the buyer behaviour is not linked to salesman behaviour. When you buy a car, you buy the brand and particular model. You even have a specific colour in mind. You want a Honda Civic or you want a Toyota Land Cruiser or Specific colour in Mercedes E class etc. You are locked in to a certain extent. The salesman is not. I have said in the book that bargaining power extends right inside the customer's pocket. Here the branding and product differentiation and need segmentation has reduced the customer's power to a certain degree.

Sixth, there are few car dealers (hence collusion is easily possible). Further, the game happens within last 3-5% (usually) of the price. So customers give up as attraction of the product is higher than this. Sometimes sales person try to up the game to 10% (when they have done their target for the month/year or are confident of achieving the same). Scarcity in number of car dealers allows better bargaining power with dealers.

Seventh, at some points in the year the incentives of customer and car manufacturer match. For example at the end of financial year of the car maker. They want to push volumes and that allows customers to have a good deal. Similarly, slow months align the incentives of customer with those of the sales person.

It is convoluted but this is what I have concluded. Feel free to share your experience with car dealers and ask your questions in comments below. 

I discuss these issues in detail in my book "Understanding Firms - A Manager's model of the Firm". The book is available on amazon here. Now no longer free - but always valuable.

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Non-choice in next US presidential elections

First Matt Stoller has an amazing piece up at nakedcapitalism. He is highlighting how there is no debate on essentials in this election. His quote "the two candidates are speaking not to the voters, but to the big money". This is exactly what I wrote about in my book Subverting Capitalism and Democracy.  

Big money in politics

If you want to know how much big money is influencing the process, here is another discussion about money in politics by Hacking Society where the numbers given are as below (about 1.50minutes to 3 minutes):

1. 0.26% of Americans give more than $200 in election finance for congressional election.
2. 0.05% give maximum amount to any congressional candidate.
3. 0.01% give more than $10,000
4. 0.000063% or 196 people finance 80% of the superpack money in Presidential election.

These figures are astounding! Just imagine what are these 196 people getting for all this money. In their normal day job they examine microscopically ever dollar they spend and yet they are spending all this money for superpacks? 

What will be the policies of new President?

To understanding politicians and their actions, it is important to know who they put to work for them. If you have read or seen Harry Potter, you must have learnt how important house-elves are (Dobby and Kreacher). Many commentators cribbed how there was no change between the economic and financial advisors in Bush era and Obama era. Matt Stollers points out that "Obama appointed Erskine Bowles. - Clinton put Erskine Bowles, a conservative Democrat, in charge of the effort o work with Newt Gingrich to cut Social Security for recipients and pour some of the Social Security trust fund into the booming stock market".

So essentially, Americans are faced with nothing new in policy initiatives and at worst drastic cutbacks in social security and other benefits.

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Growth is not profitable?

[Now no longer free - but always valuable]

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Global Public Debt

Economist has, as usual, a great interactive chart about public debt. Here are two snapshots from that showing marked increase in the debt as % of GDP across the last decade. The last picture is for 2011.

Now it is interesting to note the following:

1. Some resource driven countries seemed to have reduced their debt. Some in Arabian peninsula and Russia come to mind.
2. Europe and US have increased their debts, as expected. Japan continues to have high debt over the entire decade. This could be because of two reasons - GDP falling and debt rising.
3. Britain has had it worse. It went from green to deep red. The reason again could be both GDP falling and Debt rising.
4. Now I want to have a corresponding chart of investment in drivers of GDP. I bet between 2007 and 2011 nothing has happened in this chart.

Debt is as good as the ability to pay

Debt is good if the ability to pay exists. The quantum of debt is immaterial so long as ability to pay is reasonably certain. When large amount of debt exists but ability to pay does not exist (usually it is merely broken), then creditors often offer more debt to strengthen the ability to pay. One can argue that in this case the answer to debt is more debt. More correctly, the answer to debt is a strong ability to pay.

If more debt is taken on without improving the ability to pay then it is sure a road to bankruptcy. A good way to start the process is to write down the debt acquired since 2007-08 crisis. I am sure ample data exists to understand how much was given to whom. It is no business of the tax payer to bear these costs. Corresponding treasury bills can be settled by raising equivalent debt liability on the firms receiving the money.

I am sure some will think this to be illegal. But it is not. It is just belated government action and can be ratified by respective parliaments.

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The story behind "Understanding Firms"

Today the book "Understanding Firms - A Manager's Model of the Firm" is available free for kindle users. So I thought let me share the story behind this book.

In my initial days, I was ready to work on any types of projects. I worked in warehouses, factory floors, maintenance shops etc. I was ready to take risks, but my supervisors were not. I found this to be one ridiculous problem. A person who was ready to work on diverse roles, who admittedly had done great work was not allowed to work. Initially I thought may be I did not do good work and supervisors were just being polite. But I realized that was not the case. Sadly, I realized this after I left the company and some of them told be the real reasons.

Then, I have agonized over loosing people who were such spectacular talents that losing them should be criminal. Yet, the company I worked for could not find a way to monetize the talent we had. Nor could they simply block this talent from leaving by paying them their worth. Watching them go to other companies was horrible experience.

I have lost many customers who were ready to take risk with us so that we could develop new products at their expense fully aware of the risks involved. But my firm backed out from such promising opportunities. It happened so many times that I became jaded and moved to other team. 

Then, my experience with cost managers is no less spectacular. I have seen managers approve of TV commercials scheduled at the time when the target audience was away at work on their farms far away from TV. At the same time, travel budgets were hard to come by for my team. I have seen cab bills being questions while the company was splurging on parties to build team spirit. I wanted to tell the bosses, if you don't trust your employees you are not going build team spirit by mandatory partying.

I know one firm was paying $1000 to shift desk three feet apart when all you needed to do was plug the computer in the next socket. I do not see any reason why this change should be classified as "desk change" and deserve $1000 for the shift. If this is not waste then I don't know what is.  In the same company I have seen managers ask their employees if they indeed ate as much as the bill they submitted when the bill was within allowance limits. I thought managers existed to reduce cost by reducing wasteful expenditures.

I have seen many companies sitting on gold-mine of products they just don't want to make. Trust me they don't want to make those products, I have tried breaking my head. I once asked a company will they take it up if I make a prototype with my own money and prove that it works.  

I have spent ages trying to rectify atrocious designs, seen compromised product specifications that don't solve customer's problem, good products priced out of customer's budget, bad products sold free, softwares that made the customer's cry (literally). Man-years spent on designing ERP systems that have no relationship with reality etc.  I can go on but you get the drift. 

The problem is not that these companies do such things. The problem is that these are very very successful companies, so imagine what happens at the unsuccessful ones. The problem is also that this is very widespread. So I thought, something more than pure economics is at work here. One thing led to another and another and soon here we are. 

These negative energies were the force that pushed me to explore. I write them here because you may have seen some of them. You may have also wondered why people do things they do. You may have also thought how come your very decent friend is hated as a boss. I hope to answer some of these questions. In the book I don't directly explain the above behaviors but I explain why some companies get away with it. I explain when these behaviors become threatening. 

I hope you enjoy the book and make your firm a better place, a more successful place. And if you need to discuss any thing with me, you can email me at rahuldeodhar [at] gmail [dot] com.

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