Risk Adjusted income and certainty of employment

Mike Kimel has a post Reproduction, Income, and the Future where he quotes comments from breadth of political spectrum and cites his own experience as under:

my wife and I got married late and had one child (one and done) very late. Economic worries were a big part of the decision making process. On paper, my wife and I are doing relatively well financially, but we are extremely aware that a job loss - something that has become extremely common in recent years - or one financial mis-step could mean the difference between whether our son will have far greater opportunity in life than either my wife or I did growing up, or far less opportunity. There doesn't seem to be much in-between. In talking with my parents, they also seem to believe outcomes are more stark for families today. Many of my friends tell me the same thing. And when I talk to people ten or twenty years younger than I, in general, their costs seem to be higher than those I faced, and the potential opportunities fewer.

Yves Smith also weighs in on similar issue - in Disposable workers: Why throwaway employees are bad policy? This post covers a slightly different angle. However, the central issue remains the same.

Now we know that the incomes have grown over the generations but we fail to notice that correspondingly risks to that income have also increased. Thus in general language, while the earning has shot up, the stability of the earning or certainty of earning over long periods has declined. If we truly use risk adjusted income, we will realize new generations are worse off than previously thought. Similar line of argument is followed by Elizabeth Warren in her book Two-income Trap.

This also gives us a corresponding corollary with reference to macro-economic recovery. A recovery is sustainable when there is reasonable certainty about some level of income. That level income, which is certain, forms our debt carrying capacity - not the fluctuating actual income number. Thus, unemployment numbers by themselves do not convey anything about recovery but certainty of employment over most of working life should signal recovery.

I have written along similar lines in my book "Subverting Capitalism and Democracy - Systemic faults that caused the financial crisis."

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NYT Chart GDP, stock markets for key countries 2008-2012

Super chart from NYT about GDP, stock markets for key countries between 2008-2012. Following points of interest:

1. Remarkable correlation between markets with different GDP movements. To me that points to singularity in source of money pushing the markets.
2. Indonesian markets are substantially bullish. Someone must have made a ton of money there. Conversely, it signals time ripe for reversion.
3. Britain stands out among those countries with declining or negative GDP and stands with US and Germany rather than Japan, Italy or Spain. Again remarkable correlation between Italy and Spain surprised that there is no time difference in the moves since their economic future will not be as coincidently timed as their markets.

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How a buy order get processed?

Bloomberg Businessweek has a super infographic about how stock market orders get filled. Courtsey The Big Picture - Barry Ritholtz.

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Of Pizzas and quantitative easings

Bill Black takes on P.J. O'Rourke's Pizza critique of Obama. Prof. Black does it well so I simply quote him here and then add some of my comments below:

O’Rourke has gotten his pizza metaphor reversed. Obama’s positive-sum policies produced economic growth while the eurozone’s negative-sum austerity programs caused a recession. Under O’Rourke’s metaphor, it was Obama who made more and bigger pizzas. Had the members of Congress who, like O’Rourke, favor the negative-sum policy of austerity not diminished and warped Obama’s proposed stimulus Obama would have created even more and larger pizzas with better toppings available to a broader group of diners.

Simply put, the problems in terms of the pizza example during adverse economic conditions like we are facing are following:

1. Without government intervention, the number of pizzas produced declines leading to pizzas being available only to wealthy thus skewing the pizza availability in favour of those who already have some.
2. If government intervenes, it can make as many pizzas as before or more. However, in making them, government must spend money which it must borrow. Further, government cannot sell pizzas at profit as people cannot afford them even at cost price. Thus, government must incur losses. It can truly recover these losses when it no longer needs to produce pizzas and it can tax the profits of others who are able to profitably make and sell pizzas.
3. If government already has some money due at the time pizza production falls, and it decides to reduce its debt burden, then number of pizza available falls drastically - more than in first case.

Now, A correctly executed stimulus will yield more pizzas and need less money. The need for stimulus is undoubtable and so is the fact that such stimuli will cause rise in deficit. The focus of debate should be ways to improve the effectiveness of government stimuli rather than the need for stimuli itself. Such a debate would have been more productive in keeping the increase in deficit as small as possible. Unfortunately, 70 years after Keynes explained all this we are still at the same point having learnt nothing.

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2013: Images from the crystal ball

Around this time of the year I take out my crystal ball and peer into the future.

The China conundrum

I think a major theme in China will be the post-investment driven economic growth. As I explained in 2010, I think China will find that it is quite difficult to move to a consumer driven model. The new leadership is the first which has no links to Deng's development focus. It is possible, and this I hope, that new leadership is quite pragmatic and that should help the world economy in a big way. I think we need to watch what steps China takes over next few years.

Possibility of War

I think there is a distinct possibility of a war in near horizon say ~2015-2017. I have been seeing a war possibility for some time now since 2009, though now I think we are closer to it than then. It is still too early to say who will be the warring parties.

The other Problem of Japan

Kyle Bass has been vocal about problems in Japan, however I reflected on in 2010 that is the other problem of declining and even reversing Japanese investment in the world. I believe this force will have major repercussions on global equity valuations equally. 

US Dollar, gold etc.

I don't see US dollar equation getting upset in 2013 though I think future will be quite a different story. The overall direction US dollar should take over the long term is down. However, the decline will not be steady decline it will be a sharp fall over a few weeks followed by financial markets turmoil. Conversely, gold will experience new highs in the long term but will be ambivalent this year. While US dollar may not decline steadily, gold can appreciate steadily and we may see this trend in 2013.

US Fiscal cliff
I don't think US Fiscal cliff is a major issue as it is made out to be - it is rather a slope than a cliff as Yves Smith and Bruce Barlett say. There is good sense for Obama to wait till January 1 actually comes to better his own bargaining power. I don't see Fiscal cliff actually materializing into a disaster. Equity markets though may make mountain of a mole-hill.

A question of India

India will continue to see uptrend till around middle of 2013 after which Indian markets will decline secularly. This theme is continuation of my forecast of June 2012 wherein I explained the policy paralysis. I hope to get out of the markets between late May or mid-June.

So quite an eventful year ahead I must say. My best wishes to you all and I will see you next year. Merry Christmas, Happy new Year and happy holidays. Cheers Rahul!

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The story behind my book "Understanding Firms"

From tomorrow my book "Understanding Firms - A Manager's Model of the Firm" is available free for kindle users (Saturday 17th to 19th) for three days. 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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Yen Vs. RMB - China crippling Japanese companies?

Yves Smith asked "Has Chinese Currency Manipulation Succeeded in Breaking Japanese Manufacturers?" bringing out the effects of currency management. You can read the sorry strategic choices facing the Japanese regulators.

China is buying yen forcing appreciation that renders Japanese companies less competitive. China is also buying Japanese bonds. Now Japan must buy US Dollar to keep their exports competitive. Now, both countries are dependent on US/EU/developed world demand and hence they are fighting amongst themselves to capture the reducing developed world consumption share.

This is a problem you face when the market country undertakes QE. The supplier country has no choice but to undertake its own QE without which it suffers loss in competitiveness. The quantum of QE the supplier country must undertake is not merely equivalent to QE undertaken by market country but must also adjust for QE by other supplier countries and relative competitiveness between suppliers inter se. Thus, the supplier countries must do a lot more and therefore must face correspondingly lot more risks.

Thus, my advice to Japan would be to print till balance is restored. (This is not my optimal recommendation but I believe this will be best way to achieve their intent.

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What is speculation?

Don Boudreaux, in a smart alecy way tries to equate oil speculators with families stocking up in anticipation of Hurricane Sandy. David Henderson adds his own two cents on the matter but to his credit asks a question about what is real speculation. The defense of speculation is classic example of misdirection. Both are notoriously guilty of this in quite a few of their posts. Though I attribute it lack of understanding of personal method rather than actual mala fide intent as Don also leans against anti-dumping duties.

Argument by misdirection

To understand the misdirection, imagine where speculation as a scale. To its leftmost end, it was a response to an event that does not affect the event itself while to its right the speculation is so large that it was an event in itself. 

People who decry speculation aim towards right and attack there. People who defend speculation aim toward left and voice traditional arguments applicable to that side. And when I say both are right, people get confused with my stance.

Understanding Speculation

Now all households stocking up en masse for calamity (such as Hurricane Sandy) will be an event in itself so this type of speculation comes somewhere closer to the middle but slightly to the left of middle.

On the extreme right, speculators intend to create the shortage and price push because of scarcity. Now the question is can we say that group of investors following technical trading strategies piling on a rising price trend are "intending to cause shortage"? The answer in most cases is no. This phenomenon falls in middle-right but not extreme right.

In rare cases speculation moves to extreme right by group-think and intellectual capture and results in harm to general public.

Regulating Speculation
Purist view is that speculation on extreme right must be banned while those at extreme left can be allowed. Now preventive regulation will start at extreme right and stop long before it reaches right of middle. However, relatively, the speculation in second part can be more justifiable than speculation in first part.

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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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