building a new company HQ–a sign of trouble ahead?

This is a long-standing Wall Street belief.  The basic idea is that as companies expand and mature, their leadership gradually turns from entrepreneurs into bureaucrats.  The ultimate warning bell that rough waters are ahead for corporate profits is the announcement that a firm will spend huge amounts of money on a grandiose new corporate headquarters.

An odd article in the Wall Street Journal reminded me of this a couple of days ago.  The company coming into question in it is Amazon, which has just initiated a search for the site of a second corporate HQ.

What’s odd:

–why no comment on Apple’s new over-the-top $5 billion HQ building?

–the headquarters idea was followed by a discussion of research results from a finance professor from Dartmouth, Kenneth French, which show that publicly traded firms with the highest levels of capital spending tend to have underperforming stocks.

I’ve looked on the internet for Prof. French’s work, much of which has been done in collaboration with Eugene Fama.  I couldn’t find the paper in question, although I did come across an interesting, and humorous, one that argues the lack of predictive value of the capital asset pricing model (CAPM)–despite it’s being the staple of the finance theory taught to MBAs.  (The business school idea is apparently that reality is too complicated for non-PhD students to understand so let’s teach them something that’s simple, even though it’s wrong.)

my thoughts

–money for creating/customizing computer software, which is one of the largest uses of corporate funds in the US, is typically written off as an expense.  From a financial accounting point of view, it doesn’t show up as capital spending.

–same thing with brand creation through advertising and public relations.  I’m not sure how Prof. French deals with this issue.

Over the past quarter-century, there’s been a tendency for companies to decrease their capital intensity.  In the semiconductor industry, this was the child of necessity, since each generation of fabs seems to be hugely more expensive than its predecessor.  Hence the rise of third-party fabs like TSMC.

For hotel companies, it has been a deliberate choice to divest their physical locations, while taking back management contracts.  For light manufacturing, it has been outsourcing to the developing world, but retaining marketing and distribution.

 

What’s left as capital-intensive, then?  Mining, oil and gas, ship transport, autos, steel, cement, public utilities…  Not exactly the cream of the capital appreciation crop.

 

At the very beginning of my investment career, the common belief was that high minimum effective plant size and correspondingly large spending requirements formed an anti-competitive “moat” for the industries in question.  But technological change, from the 1970s steel mini-mill that cost a tenth the price of a blast furnace onward, has shown capital spending to be more Maginot Line than effective defense.

So it may well be that the underperformance pointed to by Prof. French has less to do with profligate management, as the WSJ suggests, than simply the nature of today’s capital-intensive businesses–namely, the ones that have no other option.

 

 

 

 

 

 

is 4% real GDP growth possible in the US?

the 3% – 4% growth promise

One of Donald Trump’s campaign promises is to create 3% – 4% GDP growth in the US.  Is this possible?

The first thing to note is that this is real GDP growth, meaning after inflation has been subtracted out.  I’m not sure Mr. Trump has ever clarified this–or that he wouldn’t be nonplussed by the question–but his appointees to head the Treasury and Commerce departments have said real is what they mean.  Also, 4% nominal (that is, including inflation) growth is about what the US has been churning out in recent years.  So promising 4% nominal growth would be like P T Barnum putting up his “This way to the egress” sign.

where does growth come from?

Simple models are usually the best (as in this case, feeling embarrassed when calling them “models” is a good indicator of simplicity).  Growth can come either by having more people working or by having workers be more productive, meaning churning out more output per hour.

more workers

Having more people working is a function of demographics.

Each year, the population of the US rises by about 0.8%.  Half of that comes from children being born to people already residing in the US; half comes from immigration.  If we take increases in the population as a proxy for increases in the workforce, then demographics can generate a bit less than 1% trend growth in GDP.

This also means that if Mr. Trump carries through on his threat to deport 3% of the workforce and restrict entry of immigrants, not only will the social consequences be shameful, he will make it that much harder to achieve his GDP objective.

productivity

Given that demographics will likely either not change, or will change in a negative way, getting to the low end of the 3% – 4% range will only be possible if worker productivity rises.   Let’s make the optimistic assumptions that the Republicans’ white supremacy rhetoric doesn’t discourage any potential immigrants and that there’s no increase in deportations.  If so, productivity gains would have to be at least +2.2% per year to achieve the low end of the GDP growth goal.

If +4% growth isn’t simply “marketing” in the worst sense of that word, the Trump camp must believe that productivity can be boosted to +3.2% per year.

An aside:  My first stock market boss was a vintage 19th-century capitalist.  He believed that increasing worker productivity meant boosting the workload–and making employees work longer hours for the same pay.  (No, there was no company store where we were forced to buy meals; yes, we had to basically provide our own office supplies.)

That’s not correct, though.  Productivity improvement comes through better employee education/training and by employers investing in labor-enhancing machines (back then, it would have been computer workstations, or in my firm’s case, pencils).

productivity today

Productivity today has been stuck at around +1% per year growth for about a decade.  During the housing bubble, when the US was furiously churning out many more new dwellings than the country could afford and banks were making crazy no-documentation mortgage loans (websites were also sprouting up to show low-income renters how to buy a house and scam the system for a year of “free rent” before foreclosure), we got to maybe +2.8% for a number of years.  But the last time the US rose above 3% was in the 1950s, when industry in Europe and Japan had been destroyed by war.

my take

I hope Wilbur Ross can do what he says.

I think +4% growth is simply hype–and that Mr. Ross, if not Mr. Trump, knows the situation.

The trend in manufacturing is to replace humans with robots. That’s the most straightforward way to achieve productivity gains. Output climbs steadily; output per worker goes up faster.  However, the number of employees shrinks drastically.   For many displaced workers supporting Mr. Trump, this may be a case of being careful about what you wish for.

 

 

 

 

 

human capital and the US presidential election

human capital

When we think of sources of capital, we typically imagine bank accounts, IRA/401ks, stocks, bonds, pensions, land/structures we can rent or mortgage…

For most people, though, the largest source of wealth they have is their human capital, a concept economist Gary Becker won the Nobel Prize in 1992 for articulating.

Basically, human capital is the collection of characteristics someone has that allows him to get a job and make money.  The three main ones, according to Becker, are: education, training and health.

The way human capital is generally quantified is by creating a present value of future expected earnings.  One implication of this is that an individual’s human capital gradually diminishes as he ages.  It’s often said that that figure reaches zero when he’s 65, although I think this is more because no one will hire you, rather than that you suddenly lose your skills.

investments and politics

Human capital is an important idea in managing our investments …as well as in politics today.

investments

The investment issue is risk and diversification.

A key employee in a tech startup who owns a house in Silicon Valley and a portfolio stuffed full of tech stocks has no diversification at all.  And, no matter what his faith in his skills, the circumstances that would cause him to lose his job likely also substantially impair the value of his dwelling and his stocks.

In contrast, a tenured professor at a top-10 university probably has a job for life (my philosophy mentor is retiring next year at 82–so much for human capital reaching zero at 65!).  Having a stock portfolio that contains only utilities is probably excessively conservative.

politics

The political issue is jobs.

For some years, China has been facing the problem that economic prosperity has made sewing t-shirts, and other simple, labor-intensive industrial operations, unprofitable there.  Affected companies are closing down and relocating to lower cost places like Bangladesh, creating substantial unemployment.

If all a person in China can do is make t-shirts, his human capital, no matter what his age, is reduced to zero as industry leaves the country.  Economically, this is devastating.

What to do?

The obvious, well-understood answer is for government to help retrain the t-shirt makers for another occupation.  This restores the value of his human capital, most likely to a higher level than before.  It’s good for the country as well as the individual.

Which brings us to the US…

We have a similar problem to China’s, except that we’ve had it for much longer.  Despite this, the US pays very little attention to worker retraining, spending about 1/6 per capita of what the average advanced country does.  If that spending is anything like the VA’s “service” for veterans, the government effort is even weaker than that low figure suggests.

The  deep discontent that this failure has produced is, I think, the nerve that Donald Trump and his scary, crackpot, Ned-Ludd-reads-Mein-Kampf ideas have touched.  Their sole merit is that they make clear the scale of the problem that Washington has brushed under the rug for years.

I was going to end this by comparing Trump to Silvio Berlusconi, the former Italian prime minister who did so much damage to that country’s economy during four terms.  Yes, Berlusconi promised to fix serious problems.  But he made them worse instead.  As I was googling to make sure spelled the name correctly, I found this article from Politico.