Why both profit centers and bankruptcy are important

May 17, 2024

I want to discuss two effects that often are misunderstood in American business. Both are critical to the functioning of a market system, and hence the indexes that you own. The effects are at opposite ends of the success spectrum.

On the positive side, you can see the giant profits Nvidia is generating. The gross (gross, not net) margin is coming in at 76%, and because the firm smartly does not run its own fabrication plants, every incremental chip sold drives that margin slightly higher. Nvidia invested for over a decade, taking huge risks to establish its AI infrastructure. In this case the gamble worked, and they are being rewarded.

The important thing to observe is how everyone else is reacting to Nvidia's windfall. Notice the flood of competitors trying to chip into that profit pool. AMD and Intel are furiously innovating. ARM is outsourcing designs for its customers to help them speed up their processes. Most of the big tech firms are designing their own processors, partly in an effort to pay Nvidia less. Startups are back into chip design, putting the "silicon" back in "Silicon Valley." (Sorry DoorDash).

People do not let these profit pools sit around, they go after them, trying to take some for themselves, and in the process the profit pool is competed away. This drives innovation forward.

We discussed this previously, but notice that there is a problem here with the indexer. The indexer (that's you) doesn't necessarily care if Nvidia or AMD wins the battle. The indexer owns them both. This is why I believe the index holders should not get voting say in the running of corporations. Only active shareholders, including active fund managers, should get to vote.

On the other side of the success spectrum is bankruptcy. Like profit pools, this is critical to the economy functioning well. Without bankruptcy, assets get tied up in poorly run firms, and something has to be the wildfire that burns out the dead wood, that reignites the new seedlings from the pine cones on the economic forest floor.

This is important, and you can take it to the bank: no system is going to run well that doesn't have the ability for participants to fail.

As an example, one of the reasons religion is so nominal in Europe is that for hundreds of years the church was hooked to the state. Despite Martin Luther running around nailing stuff to doors, the church couldn't really fail, and it would say pithy things but not be responsive to its members. There was no way to improve the system, so it dwindled but could not be killed off. In contrast, over the course of the American experiment, religion has been quite competitive, and churches fail all the time. This has kept them more responsive to current day needs and higher American churchgoing participation reflects that.

Back on the corporate side, the bankruptcy system in the United States is well designed, in that it is intended to preserve jobs, potentially protect bondholders, and wipe out equity holders and management teams.

By the time a firm is near bankruptcy, it generally has been removed from the index, so it's not affecting your investments directly. But well-run firms that are in the index might be buying assets from bankrupt firms and trying to refactor them, which adds value. And it matters to overall economic health.

- Dan Cunningham