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Captialism Mechanics
July 23, 2021
Let's review several necessary ingredients in a capitalist system.
1. Scarcity of capital. Capitalism doesn't function optimally with too much capital. There has to be competition for capital resources to flush out bad ideas and eliminate mediocre performers. With too much capital there is no competitive pressure improving the system.
2. Choices. The best decisions get made by those closest to the problem. This is why a parent can choose the best school for their child but a state agency cannot, or why you can design and structure your own life optimally. Freedom of choice matters.
3. Low barriers to entry. The lower the barriers to entry, the more democratic the system. An industry that allows market participants easy entry tends to attract bright, hard-working entrepreneurs. The more rules and regulations, or the higher the capital requirements of entry, the less efficient an industry becomes as there is no way to disrupt the established players.
4. Externality Pricing. If you don't price externalities into a market system, you are going to end up looking like the bottom of the Hudson River - it's cheap to pollute when there is no cost. While some externalities are worth accepting, others are not.
When you combine the forces above, among others, you create a wildly dynamic system that moves society forward through all kinds of innovative ideas, products, and services. What you do *not* necessarily do is make the capitalist wealthy, particularly in the case of the innovators who do not survive long-term. Partly due to competition, much of the value gets passed from the business to the customer, creating a better society but not a particularly good investment.
What is a hard-driving capitalist to do if society keeps ending up with the benefit and she has a shareholders meeting to run next Tuesday and needs to show profits? A modern (well, maybe not so modern) trend is to try to interfere with the principles above. If you can create barriers either through the market or through government, you protect your castle with a bigger moat. Let's look at some examples.
Wal-Mart
Retail is not a particularly profitable business on a percentage margin basis, but if you build it to enough scale, you can establish a barrier that competitors cannot overcome, driving other choices away. The buying volume becomes the protective moat. Wal-Mart became a no-commitment buying agent for rural Americans, and passed almost all of the benefit to the customer. It was all working well until this laugh-y guy named Bezos showed up.
Costco
Determined to undermine Walmart in price, Costco restructured the retail model to focus on few items, forklifts moving products, and critically, quietly assigning the last, most expensive leg of the transportation chain to the customer. This is why people from central Vermont drive halfway across the state to shop at our one statewide Costco location. This is a form of time externality transferred to the customer. In fairness to Costco, it is the customer's choice.
Microsoft
Software has low barriers to entry, making it a prime target for hard-working immigrants and ambitious smart people. Existing ambitious smart software people like Bill Gates knew this, so the competitive moat was built by using the network effects of operating systems. This is the same principle that keeps Facebook in power. The competitive advantage is the fact that there is little choice - you have to join the platform everyone else is on.
Pretty Much Any Large Financial Firm
The regulatory and compliance structures established by Dodd-Frank are difficult for a small but rising firm, as the costs are high, and large firms can spread the overhead over a larger client base. Many lawmakers have little understanding of the operational differences between small and large firms, so this is easy for a lobbyist to exploit. The disruptive up-and-comers are eliminated.
The list above is by no means exhaustive. The important point: in a fair capitalist system you create value by giving customers better choices. Capital flows freely to support those innovators. But that is not always the reality of today's landscape.
Dan Cunningham
Bird, Jordan, Hamilton, Jefferson: an American Fourth
July 2, 2021
I spent most of 6th grade defending Larry Bird.
But at the end of the year, I gave in to my classmates and became a Michael Jordan superfan. Larry just didn't have the numbers against Michael. He didn't really have the art. And he certainly didn't have the ups, especially from the foul line.
Looking back on this momentous turning point in my life, I've realized that the key thing was not basketball, but changing my mind. With varying levels of success, I've tried to do it ever since.
America, as we head into July 4th, is held hostage to two political parties that act as corporations protecting themselves, screening out new ideas so their duopoly survives. And media outlets have learned that it is *far* more profitable to reinforce their siloed users' views than it is to present challenging ideas, a business model made possible first by cable television and now more-so by the Internet.
Alexander Hamilton and Thomas Jefferson argued over this (political parties, not the Internet), and we're still arguing. But from an investment perspective, siloing is very bad indeed. Any great investor (or scientist, or executive, or chef, or you name it...) has to keep the door open to new ideas and consider them against baseline controls. The interesting ideas rarely originate from obvious sources.
Like a nation aging, as humans age this process gets harder. For people who have figured out a system that works, "creatively destructing" one's ideas and beliefs does not feel like progress. But changing your mind is how you move forward, and it has the side benefit of potentially being profitable.
Thirteen years ago, I didn't think people tweeting about their soon-to-be-eaten chocolate soufflé was progress, and watching other people play video games seemed like the definition of pathetic. Look at those industries today - new ideas that grasped enormous market share.
So keep those ears open, keep the mind changing, and have a great weekend.
Dan Cunningham
Interest rates = financial gravity
June 11, 2021
My grandfather was a great engine mechanic. He was less great at opening doors or windows when testing his engines. I'd try to learn about the gaskets and pistons from him, peering through the blue haze of exhaust, conscious that carbon monoxide was pooling around my knees. Eventually I'd make a break for it, running to open the garage doors, making a play for optionality so we could both repair things another day.
It didn't matter if the engine sputtered a little, or hummed in perfect form, if the oxygen had been chased from the room.
In investing, you have to put appropriate weight on the big, influential variables. One of those variables is interest rates. Warren Buffett recently used an excellent analogy when he described interest rates as "financial gravity." If interest rates, like gravity, are high, they pull the value of other assets down. If interest rates, like gravity, are low, other values float up (and away sometimes).
The risk-free rate defines the baseline for investing. If you are going to get paid X without taking risk, something that contains risk needs to return X+B for it to attract capital. The more risk, the larger B has to be.
Here is the daily update to the yield of various U.S. Treasuries bonds:
On Tuesday, November 13, 1990, the oldest known web page was constructed. On that same day, U.S. Treasury yields looked this this, matching columns with the graph above:
Relative to previous decades, you can see that today gravity has been removed from the financial system. Gravity, like oxygen, is not a small variable. Because of its, shall we say, gravitas, much of the financial system has inflated upward.
Much, but not all. Returns tied directly to this rate are not inflating. For example, banking deposits. On top of the low rates, American banks are swimming in money as the government floods the system. This has led to an explosion in banking deposits:
With cash deposits just below the value of the entire American GDP, banks have no incentive to pay more interest. This impacts a wide swath of Americans who use banks to save.
To invest well in today's world, you have to accept that a major variable operates differently than it did 30 years ago. That acceptance, that realization, will keep you out of the blue haze.
Dan Cunningham
1. Here is the web's oldest page, If you are curious.
2. Commercial bank deposit source: Federal Reserve Bank of St. Louis
3. Treasury daily yield curve rates
