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Biotech: Popping the Allegations of a Bubble

There’s a popular view going around these days that biotech is in a bubble. Jim Grant was the first that I know of who publicly expressed this view, and he rationalized his argument asserting the Fed’s zero interest rate policy was distorting markets without even a cursory mention of the specific developments which have transpired in the biotech sector over the recent past. Several smart market participants who I respect greatly have echoed this perspective. I want to use this post to dispel that notion.

I’m a humanities, not science guy. I also am a generalist, not a biotech investor. I have some exposure to the sector and don’t plan to increase or decrease that exposure any time soon. That being said, I will leave the science vague and hope someone more knowledgeable and with more skin in the game can expand on this argument. As recently as the late 1980s, the drug discovery process was entirely centered around literally sifting through dirt in order to find molecules that may hold some therapeutic power. The science was simply a matter of “leaving no stone unturned” in a quest to find anything that just might work. In the late 1980s, there was a pivotal moment where drug discovery evolved to a process of learning how diseases and ailments operated on a molecular level and then working backwards via inversion to find proteins which could positively change the active mechanism of the problem. If you are interested in this development and its business effect, I strongly recommend the book Billion Dollar Molecule by Barry Werth.

Today we are undergoing another profound change and the catalyst was the mapping of the human genome. Not long ago, Peter Thiel and Marc Andreessen debated whether there was real innovation happening in our economy today. Surprisingly not even Andreessen who took the “yes there is innovation” side of the debate even mentioned genomics and the impact it’s having on people’s lives around the world. The only real mention of biotech was Thiel’s complain about the FDA getting in the way too much, though if anything, this is not borne out by what has transpired these last few years. The problem for biotech is that its impact is very intangible compared to the Smartphones we all carry in our pockets everywhere. Genomics has greatly accelerated the process and efficiency of drug discovery. The results are evident, though people don’t see or feel it. In 2012 new drug approvals by the FDA hit a sixteen year high. Although 2013 did not see a new high in approvals, it did see the largest aggregate market opportunity for new approvals. I will oversimplify to make the point very clear: let’s say the average drug development timeframe was 10 years and has now accelerated to 5 years. Drug development inherently becomes worth more money if the time to earning first cash flows is cut in half.

This above provides some justification for why “this time is different.” Things can be different and still a bubble though, so to try and further dispel this notion I want to point out two anecdotal examples for why the bubble assertion is wrong. Again I want to qualify that overvalued and/or overextended does not mean something is a bubble. For starters, let me borrow Robert Shiller’s definition of a bubble: (as paraphrased by me from Shiller’s panel at the Economist’s Buttonwood Gathering) a bubble is a price-mediated feedback between prices and market participants, with excessive enthusiasm, media participants, and regret from those who are not involved. The “psycho-economic phenomenon” is a defining characteristic that becomes ingrained in a culture and is related to long-term expectations that cannot be pinned down quantitatively. Let me offer the following chart, and you tell me where there's a bubble:

Simply put, we see none of this. Biotech has barely reentered the market participant’s conscious despite the big players returning to top line growth for the first time in years following their patent cliff. There are few if any stories in mainstream media about biotech billionaires at all. If you want to see hype, look no further than social media companies. Do we see anything remotely resembling an awareness in the masses that biotech has been a strong sector? I get asked all the time by clients about Tesla, Bitcoin, Twitter, etc., and I’ve never once been asked about biotech. And yes I think Tesla, Bitcoin, and Twitter prices comfortably fit Shiller’s definition of a bubble.

So let me offer two anecdotes on price and valuation in biotech to provide some context to this discussion.

1) Regeneron: In 1991 is considered common knowledge that Regeneron was a bubble, was insanely priced and was unsustainable. Here’s what the pundits were saying at the time (and do read that link for it's quite telling how similar the complaints are today): “Regeneron is a real long shot for investors: With no potential products even slated for clinical trials, the company is a good 10 to 12 years from delivering a marketable product…. ‘These are companies that have no product, and no prospect of revenue for three years or more. It only makes sense for them to make money when investors are in a feeding frenzy.’”

Fast-forward to today and an investor in Regeneron’s IPO is up ~1,789% in 23 years compared to ~390% for the S&P 500. This alone does not prove biotech is not a bubble but it highlights an important point that is fairly unique to this sector: even if you pay a high starting price, when you are right you will make multiples of your money. Simply put: bad investments in biotech will be worthless and successful investments will be worth multiples. The starting point matters little.

2) Incyte: This company is experiencing a wave of success, up a cool 207% over the past 52 weeks. Their first approved product, Jakafi earned $235.4 million in revenue in 2013 and is still growing today. In the pipeline, Incyte is working on one of the first treatments for pancreatic cancer which actually improves patient survivability. This first big spate of commercial success and big pipeline expansion would have a rational observer expecting this company to be way above record high levels, especially if we are in a bubble, right? Wrong.

In 1999 a shares of this stock were changing hands below today’s prices, though well above where INCY was upon earning its first real evenues. Back then there weren’t any signs of imminent success to be found. It’s definitely much easier to call something a bubble in hindsight, but the magnitude of the differences between then and now is striking. The fact that 1999 is still so fresh in many market participants’ memories is probably a powerful force in the proliferation of bubble assertions today.

Preclinical biotechs are valued based on odds of approval, the size of the market opportunity, the percent of the market the treatments can capture and discounted to today based on the time it will take to earn positive cash flow. It is unquestionably silly when biotechs surge in unison riding the wave of one company’s success. What happened in the wake of Intercept’s NASH primary endpoint success is not rational, and many companies did not deserve the pop they received. But that happens all the time in markets even when there is no bubble.

This is not a great time to pile into biotech, as some of these favorable developments discussed above have been reflected in prices. A bubble means run for shelter and seek cover, and that too is inappropriate right now. Something that is overextended is not necessarily also a bubble. It’s very possible, almost probable that biotech will go down 15% before going up from here. The fact of the matter is that biotech is the same as it ever was. The big boys are priced in-line with the market and have no premium attached to their multiple, and the small companies that investors get “right” will be worth multiples of what they are today, while the wrong ones will be worthless.


Thanks to my buddy who helped me pull this together so quickly today, you know who you are!


Disclosure: No position in any of the stocks mentioned, though a small portion of the portfolio is long specific biotech stocks.



Lucky to Live in this Era of Indexation

Last week we were greeted with writings from two of the best investors and thought-leaders: Howard Marks of Oaktree and Murray Stahl of Horizon Kinetics. The decades of wisdom acquired by both Marks and Stahl now share with us youngens via these readings is a gift we must all take advantage of. I am about to grossly oversimplify the points from both of these greats in order to riff off of it into a point of my own. I give this warning both to preempt any complaints about my simplification, and as a suggestion to do yourself a favor and read what both of these gentlemen have to say before going one sentence further here. If you are kind and/or interest enough to return to this site, once done with those piece, please feel free to do so.

Since I received a link to Marks’ memo first, my evening reading started there and proceeded to Stahl’s piece. This was a fortunate coincidence. Marks lays out the case for the role luck plays in living life and attaining success in financial markets, tracing it to the idea markets are mostly efficient, but for those areas with a “lack of information…and competition.” Meanwhile, Stahl examines what he believes to be one of the single largest sources of market inefficiency today in what he calls “indexation.” After reading both pieces, I couldn’t help but think: “we are lucky to be investors in markets in this era of indexation.” This one thought struck me as the perfect conjunction between the two pieces.

Stahl has used the word “indexation” to explain the phenomenon whereby more assets and managers are investing in indices and ETFs which are designed to “provide portfolio exposure to very specific criteria, such as an asset class, an industry sub-sector, a growth metric, a stock market capitalization band, and so forth.” Over time, Stahl has discovered and invested in several of the inefficiencies resulting from such a phenomenon, including the “owner-operator” whose major stockholder manages the company, spin-offs designed to streamline business operations, etc. I recommend reading Stahl as to why these opportunities arise in today’s market.

Why do I say we are lucky to invest in this era of indexation? Because, as Stahl argues, indexation is an incredible source of market inefficiency. As more and more dollars seek out exposure in the broadest of ways, there is ample opportunity for those of us who seek to “turn over as many rocks as possible” to find the right opportunity. Two of my favorite setups fit this bill, although I never specifically delineated these ideas in writing as an outgrowth of indexation. This is so because both setups existed as long as there have been markets, and are in many respects traceable to behavioral traits of human beings. What has changed is that indexation provides a natural outlet through which these behavioral weaknesses are even more pronounced than in years past. I have named these setups “Guilty by Association” and “I’ve got a Label, but I don’t Subscribe.” While there are similarities between the two, they deserve to be thought about separately.

"Guilty by Association"

When a company is “Guilty by Association” they are treated in the same way as another, more identifiable peer group or index solely by some kind of perceived proximity. These tend to be situations that are more macro in nature, where a broader problem is reflected upon a specific company or sector. Some examples might be helpful.

During the crisis period in Europe, all European stocks were hit with equal force. The market “threw the good out with the bad” so-to-speak. One particular class of opportunities we spent considerable time on (and ultimately made significant investments in) was businesses listed in Europe, with a revenue base that was largely global. In other words, these were companies that traded in Europe, though they did the majority of their business outside of Europe itself. In these situations, there was selling, even from investors not situated in Europe, due to fears about the Eurozone’s viability. Yet, these companies themselves were in a position where if the Euro actually collapsed, they were unlikely to be significantly impacted in a negative way. In other words, they were “Guilty by Association” with the currency in which their shares were priced.

Another example would be the hatred of muni bonds in today’s environment. This entire asset class is hated due to concerns about Detroit’s bankruptcy and Puerto Rico’s solvency woes. Because Detroit and Puerto Rico are municipalities, conventional investment wisdom beholds that municipal bonds in the general sense must therefore be in trouble. This kind of extrapolation is abundant and wrong.

Indexation impacts these areas because people who invest in broad-based ETFs or indices sell their exposure entirely, in order to avoid the perceived fear. In doing so, the selling of the basket forces mechanical selling of all the subsidiary components without consideration for which specific constituents are and are not impacted on a fundamental level by the fear. Thus, the good that gets thrown out with the bad and is “guilty by association.”

"I've got a Label, but I don't Subscribe"

This is the micro twin of “guilty by association.” Since so much money is moving into ETFs, and ETFs are trading with all kinds of sector and niche labels, there is pressure to fit each and every company into some kind of cookie-cutter genre. These labels impact how analysts and investors alike think about specific companies. Stocks get assigned to analysts based on the “sector” they cover, and many investors invest in sectors or companies that are in accordance with a specific mandate. I had been planning a blog post for a while called “Beware of Labels,” but I think all of those points would better fit the context of this post. One of the biggest misnomers in today’s markets is the “technology” label.  Mr. Market today dumbs "technology" down to mean: a) any company that is on the Internet; and/or, b) any company that makes hardware.

In my opinion, there simply is no such thing as an Internet company. There are retail companies who operate on the Internet (and at this point is there a single retail company who doesn’t operate on the Internet?), there are B2B companies who use the Internet to offer their services, there are financial platforms who provide web-based platforms. To ascribe the label “Internet” to one company and not another is merely referential of the fact that some companies are old and some companies are new. And even that is an oversimplification, for there are older Internet companies that are still called as much, despite being more analogous to marketing companies. And yet somehow, all these various, wide-ranging businesses end up with the “Technology” label despite the fact that their differences are far more pronounced and abundant than their similarities.

In a perfect world, we would throw away the technology label and call these companies what they are, whether that be media, retail, etc., but this isn’t a perfect world and that creates opportunities for us investors seeking out inefficiencies. Heck the “Telecommunications” sector is somehow a sub-sector of “Technology” and includes a company as old as AT&T (though I am aware AT&T today was actually one of the Baby Bells who ended up swallowing Mama whole). The biggest impact labeling has is in how analysts model these companies and the types of investors who are drawn to (or pushed away from) different sectors. We all know how popular comparables analysis and that too gets incredibly misleading when similarities and differences are conflated with one another.

An example of this would be my investment experience with Google. Over the past few years, Mr. Market has called Google an “Internet stock” and a “one-trick-pony” at that. To that end, analysts and investors alike oversimplified in comparing Google only to other Internet stocks, and in a perceived battle against Apple, this same community viewed the company as out of its league (See GigaOM, CBS News and HBR on the "one-trick-pony"). I took a different perspective: Google is more akin to a media company whose advantage lies in the infrastructure and distribution side. Wikipedia describes media as “the storage and transmission channels or tools used to store and deliver information or data.” This certainly seems like an apropos description of Google, and it’s more clearly reflective of who pays Google money at the end of the day--advertisers, much like how we think about “traditional” media. If you think about Google this way, and realize one of the company’s crucial advantages is in how it stores, aggregates, categorizes and distributes information, it’s clear that Google does and can do far more things than “just” search. YouTube is a natural fit in this type of company, more so than just an Internet or search company, and as such, it leverages the advantages of Google’s platform while also leaving open the opportunity for Google to naturally segue into other areas altogether. Within that context, Google looks far less like a one-trick-pony, YouTube’s valuation becomes increasingly important (see my writeup on the importance of YouTube), and the company is in fact more diverse and capable beyond “just” search.

Labeling is a human endeavor; something we do in many disparate fields. One of the most well-known is the biological taxonomy (I think every adult still remembers “King Phillip came over for good spaghetti”), which is an organizational hierarchy. While labels have always been used in stock markets, only now are they actual forces behind the mechanical allocation of capital. This is so due to the proliferation of ETFs and “indexation.” Even in biology, there are blurred lines between different species, etc. This is but one reason why we have seen a great increase in spin-offs: when some companies who are thought of and thus modeled “that” way, have a subsidiary that doesn’t fit the bigger mold, that subsidiary tends to be “underappreciated” by Mr. Market.

Market Inefficiencies

A lot of people, myself included, like ripping on the Efficient Market Hypothesis. This is certainly not without merit; however, as Marks emphatically argues, there is much truth and wisdom in the idea that market participants are in fact really good at incorporating known information into the price of securities. When we look to make investments, we must then do what Marks’ implies in another of his spectacular memos, by asking ourselves “what is the mistake that makes this a mispriced investment opportunity?” With these two examples based on the problems associated with Stahl’s “indexation” we have two areas in the abstract within which we can identify mistakes. To that end, we are lucky to live in this era of indexation for how it exposes the market to repeatedly and mistakenly misvalue companies.


Disclosure: Long Google


Our RGAIA 2014 Investment Outlook

Happy New Year to everyone out there! The blog here has been quiet for a few weeks, though that is about to change. My recent writing efforts have been focused on our RGA Investment Advisors' 2013 year-in-review and 2014 Investment Outlook and I wanted to share that here: 


Our 2014 Investment Outlook by RGA Investment Advisors


The Panama Canal and why Public vs Private is the Wrong Debate

This is the story of the financing behind what at separate points in time was once the world’s largest IPO and the largest real estate deal ever. Even more, this is the story about an undertaking which actually changed the course of world history. This is also the story of French capitalism and American socialism. Let me explain, drawing heavily from The Path Between the Seas, an excellent book, one I highly recommended, by David McCullough on the construction of the Panama Canal for the relevant history.

On November 17, 1869, the Suez Canal opened to remarkable fanfare. The event instantly made Ferdinand de Lesseps an international hero. de Lesseps work wasn’t done with this one accomplishment. To that end, he used his position of fame in order to attempt to conquer an even bigger task: building a canal to connect the Atlantic Ocean and Pacific Ocean in Central America.

The Suez Canal had been built with private money and existed as a publicly held corporation (public as in freely liquid ownership amongst private citizens, not government ownership). de Lesseps saw the Central American project similarly, and felt its financing via private money was an important and “American” way to pursue the undertaking. Private financing was a strategic move, for at the time, the U.S. government still took the Monroe Doctrine declaring the Western Hemisphere the American domain very seriously. It was also a sentimental move which de Lesseps spoke about tying the importance of private capital with the notion that it would merely facilitate him as “but an executor of the American idea.” (McCullough, David (2001-10-27). The Path Between the Seas: The Creation of the Panama Canal, 1870-1914 (Kindle Locations 1754-1757). Touchstone. Kindle Edition.)

This made sense on several levels. The U.S. stood to benefit substantially from the completion of a “path between the seas,” as the book bearing that title explains:

A Wall Street man named Frederick Kelley calculated that a canal through Central America could mean an annual saving to American trade as a whole of no less than $ 36,000,000— in reduced insurance , interest on cargoes, wear and tear on ships, wages, provisions, crews—and a total saving of all maritime nations of $ 48,000,000. This alone, he asserted, would be enough, irrespective of tolls, to pay for the entire canal in a few years, even if it were to cost as much as $ 100,000,000, a possibility almost no one foresaw. (Ibid, Kindle Locations 457-460)

Americans had plenty of experience with private capital invested in Panama. At one point, the Panama Railroad was the highest priced stock on the New York Stock Exchange, and its shares paid an average 15% dividend over its publicly traded period (here's a fun list of "amazing facts" on the Panama Railroad). When de Lessing commenced the Panama Canal project, it was to be the single largest financing in the history of the world, up to that point. Much was on the line alongside the money, including de Lessing’s legacy as a man who could build the impossible, and French pride as a global engineering powerhouse. Further, this was about capitalism and democracy, two ideas rapidly changing the world at that time, and the “limitless expectations associated with venture capitalism—pionnier capitalisme. The talk was of ‘the poetry of capitalism’ and of ‘the shareholders’ democracy.’”

As history would have it, the French, capitalist version of the Panama Canal wasn’t meant to be. For the French, the financial losses were drastic, as was society’s backlash. This is embodied in the aftermath of the Panama Canal Company’s failure, which today in France is known as “L’Affaire Panama.” Over 100 French legislators were accused of corruption and several governments collapsed. In the aftermath, anti-Semitism spiked sharply due to various conspiracy theories, ultimately climaxing in another French affair, “L’Affaire Dreyfus.”

Amidst the chaos in France, a successor to the Panama Canal Company was established in order to dispose of the company’s remaining assets, including its equipment, land rights, railroad ownership and digging completed to-date. The U.S. government emerged as the best, most logical buyer, eventually completing a deal with historic implications:

The purchase of the French holdings at Panama was the largest real-estate transaction in history until then. The Treasury warrant for $ 40,000,000 made out to “J. Pierpont Morgan & Company, New York City, Special Dispensing Agent,” was the largest yet issued by the government of the United States, the largest previous warrant having been for the $ 7,200,000 paid to Russia for Alaska in 1867. Participation by the house of Morgan had been agreed to by both the buyer and the seller and in late April, prior to receipt of the Treasury warrant, J. P. Morgan sailed for France to oversee the transaction personally. His bank shipped $ 18,000,000 in gold bullion to Paris, bought exchange on Paris for the balance, and paid the full sum into the Banque de France for the account of the Compagnie Nouvelle and the liquidator of the Compagnie Universelle. On May 2, at the offices of the Compagnie Nouvelle on the narrow, little Rue Louis-le-Grand, the deeds and bills of the sale were executed. On May 9 in New York the United States repaid the $ 40,000,000 to the house of Morgan. Morgan’s fee for services, charged to the Compagnie Nouvelle, was $ 35,000. With the $ 10,000,000 paid to Panama and the $ 40,000,000 to the Compagnie Nouvelle, the United States had spent more for the rights, privileges, and properties that went with the Canal Zone— an area roughly a third the size of Long Island— than for any actual territorial acquisition in its history, more than for the Louisiana Territory ($ 15,000,000), Alaska ($ 7,200,000), and the Philippines ($ 20,000,000) combined.” (Ibid, Kindle Locations 6847-6851)

Since this is the story of the financing of the construction of the canal, we’ll willfully ignore some of the “diplomacy” and its associated costs. The U.S. commenced construction in 1904 with the government overseeing a team of private contractors. One such contractor that emerged as an important American industrial power was Bucyrus Corporation (now part of Caterpillar). Bucyrus’ steam-shovels became the standard during the construction of the Canal and they did their job magnificently. A second contractor with massive success was the General Electric Company:

For the still young, still comparatively small General Electric Company the successful performance of all such apparatus, indeed the perfect efficiency of the entire electrical system, was of the utmost importance. This was not merely a very large government contract, the company’s first large government contract, but one that would attract worldwide attention. It was a chance like none other to display the virtues of electric power, to bring to bear the creative resources of the electrical engineer. The canal, declared one technical journal, would be a “monument to the electrical art.” It had been less than a year since the first factory in the United States had been electrified” (Ibid, Kindle Locations 10237-10242)

Unfortunately, the vast majority contractors the government hired couldn’t do their jobs all that efficiently. In 1907, the Army Corps of Engineers, under Major George Washington Goethals (yep that’s where the bridge got its name), took control of oversight and construction of the canal.

Let’s take a step back and think about where things were here. What started as a privately financed enterprise collapsed miserably, taking down the entire French economy and nearly the entire French empire with it. In the wake of this collapse, the American government took over the project and outsourced its completion to private contractors. Over three years, these private contractors failed to meet their deadlines, effectively forcing the U.S. government to take over the project entirely. When this happened, the military’s oversight of the project worked so well that some feared this would tip the U.S. towards socialism. These fears were discussed openly in prominent intellectual circles, with complaints like the following:

When these well paid, lightly worked, well and cheaply fed men return to their native land [warned a New York banker], they will form a powerful addition to the Socialist party . . . . By their votes and the enormous following they can rally to their standard they will force the government to take over the public utilities, if not all the large corporations , of the country. They will force the adoption of government standards of work, wages and cost of living as exemplified in the work on the Canal. Yet how could it be socialism, some pondered, when those in charge were all technical men and “little interested in political philosophy,” as one reporter commented. “The marvel is,” wrote this same man, “that even under administrators unfriendly or indifferent to Socialism , these socialistic experiments have succeeded— without exception.” (Ibid, Kindle Locations 9562-9568)

Instead there was to be no such thing as Socialism in America, but there are many lessons we can learn from today, here are just a few:

1) de Lesseps, the Frenchman behind their canal effort, was a figure reminiscent of the likes of Steve Jobs and Elon Musk for his capacity to “do the impossible” and change the world. Before de Lessep’s started the Panama Canal project he was a man who “could do no wrong.” People who buy into that mentality blindly, based not on sound economics, but rather a combination of nationalist pride and belief in an individual are setting themselves up for financial problems. This immense, almost super-natural belief in the capacity of French engineering to overcome all problems led to crucial blind-spots that Mother Nature exploited.

2) One of the decisive differences with the American and French efforts was William Gorgas’ initiative to rid the Canal Zone of malaria. Many viewed the fight against malaria and yellow fever as costly wastes of resources in an expensive undertaking. It was not without conflict that Gorgas was able to undertake his nearly “impossible” task of eradicating the mosquito-wrought region of these illnesses, yet without this colossal effort the Panama Canal itself would never have been built. For these cost-based concerns, a focus on public health was inconsequential to the private endeavor, until the problem became too severe and the entire project collapsed under this weight. Meanwhile, for a government to send its own emissaries to a region rife with deadly illness meant the potential for severe backlash from various groups. Truth be told, a healthy environment and a healthy workforce is crucial for large-scale successes.

3) The question of public vs private is the wrong one altogether, as efficiency matters first and foremost. The French went about the project privately. The U.S. went about it largely privately at first, and then with complete government oversight and execution. Today’s discourse here in the U.S. would have one believe the Americans are born capitalists and the French are born socialists, but that was not always true. American success happened independent of any public vs private debate, with both significant public and private rewards as a result.

4) Public benefits are also private and vice versa. The completion of the Panama Canal had an unquestionably awesome effect on the rise of United States in the 20th century--both militaristically and commercially. But, even with the project under control of the U.S. government, American industry benefitted tremendously. This was a major catalyst in General Electric becoming the behemoth it is today.The Panama Canal was one project, and it alone helped the United States become the dominant global naval power. It is not an understatement to say that without the Panama Canal, American history would be decisively less grand. At the same time, American industry used the canal to buy and sell goods into the global market at an accelerating rate. Though its opening was followed by World War I, the Great Depression, the rise of protectionism and then World War II, so this commercial benefit of increasing global trade was not evident for decades down the line. Time and subsequent innovations were important factors in perceived failure turning to success. Today, as it undergoes its largest renovation to date in an attempt to double the volume of goods which can pass between the Atlantic and Pacific, the Panama Canal remains a vital artery for global trade and its benefits are enjoyed by both the public and private alike.


The Profit Margin Debate: A Look at Capitalism and Competition

Over the past two years there’s been a lot of talk about the mean-reverting nature of margins as a crucial source of the market’s “overvaluation” today. John Hussman and Jeremy Grantham have been two vocal advocates of this point. Here is Hussman’s chart to that effect:

In this debate, Bulls have pointed out a relevant counterpoint: that mean reversion can be to the trend, which has been higher due to more capital lean businesses, greater productive efficiencies, and international diversification, rather than simply to the longer-term average (here's a good post from Joe Wiesenthal which covers this point and more). This trend/mean distinction is important, for a reversion to trend would imply margins still move higher over time, albeit only after a move back to and most likely beneath the more recent trendline.

Mean Reversion in Markets

Mean reversion is a powerful force in markets. One of the reasons why it works so neatly in is that when certain spreads divert from their long-run means, there is an economic incentive in the form of arbitrage for position takers to drive the spread back down to its normal level. An anecdote would be helpful. The following is a chart of the spread between West Texas Intermediate (WTI) Crude Oil (ie the “American” oil supply) and London Brent Crude Oil (ie the rest of the world’s oil supply):

We can see that over the long run, this spread exists within a relatively narrow channel; however, something happens in 2011 that sends the price of London Brent shooting upward relative to WTI. We’ll forget about why and focus on how this spread ultimately reverted back to its normal confines (though it does seem to have perked up again). While there are logistical challenges in sending crude from North America to Europe and vice versa, when the price of oil gets too high in one place relative to another, arbitrageurs can make free money simply by buying oil where it’s cheap and selling it where it’s too high. This is the definition of riskless profit. As more and more arbitrageurs engage in this activity, what is a large spread gets whittled down until there is no more “free lunch” as they say. This is how efficient capitalist markets work.

Capitalism, Economic Profit and Competition

In the latest GMO Commentary, Ben Inker makes the following point about margins, market valuation and corporate investment: “The pleasant way we could be wrong is if the U.S. is about to embark on a golden age of corporate investment and economic growth that will gradually compete down the current return on capital such that overall profits manage to grow decently as the P/E of the stock market wafts slowly down.” What I find ironic is that corporate investment is the most common way margins can and do come down in capitalism, therefore, the most likely way for GMO to be right requires that they are wrong. Let me explain.

In a capitalist system, economic profit is not supposed to exist. Economic profit is the difference between returns on investment and the cost of capital for a business. When economic profit does exist, it is supposed to be followed by a period of economic loss, such that over a cycle, there is no economic profit. This is where the idea that margins mean revert comes from. Here’s Wikipedia’s explanation for how economic profit results in competition and no winners (ie excess profiteers) over the long-run:

Economic profit does not occur in perfect competition in long run equilibrium; if it did, there would be an incentive for new firms to enter the industry, aided by a lack of barriers to entry until there was no longer any economic profit. As new firms enter the industry, they increase the supply of the product available in the market, and these new firms are forced to charge a lower price to entice consumers to buy the additional supply these new firms are supplying as the firms all compete for customers. Incumbent firms within the industry face losing their existing customers to the new firms entering the industry, and are therefore forced to lower their prices to match the lower prices set by the new firms. New firms will continue to enter the industry until the price of the product is lowered to the point that it is the same as the average cost of producing the product, and all of the economic profit disappears. When this happens, economic agents outside of the industry find no advantage to forming new firms that enter into the industry, the supply of the product stops increasing, and the price charged for the product stabilizes, settling into an equilibrium.

This is good explanation, but I have presented it in the form of an oversimplification. Some kinds of companies are able to generate economic profit for long periods of time. These are the so-called quality companies with a moat (aka a sustainable competitive advantage) that Warren Buffett looks for. Since such firms are the rare exception, not the rule, it’s worth studying them and learning about the traits they share. This is something I do on a regular basis, though for the purposes of this essay, it’s a digression. I bring up this point because considering how rare such firms are, it’s safe to apply the concept of zero economic profit to the economy at large, and in doing so, assuming that margins do in fact mean revert.

In essence, high profit margins revert to the mean much the same way as the spread between WTI and London Brent Crude Oil, though the subtle differences are important. Whereas the WTI/Brent spread is brought down with arbitrageurs, the economic profit of high margins is brought down with entrepreneurs. When entrepreneurs see high profit margins, they see an opportunity to undercut those margins, and in doing so, capturing some of the profits for themselves. However, entrepreneurs can’t buy something and sell it elsewhere to capture this profit opportunity. They are called entrepreneurs as distinct from arbitrageurs because they actually have to engage in the “process of identifying and starting a business venture, sourcing and organizing the required resources and taking both the risks and rewards associated with the venture” (the definition of entrepreneur from Wikipedia).

To paraphrase, in order to capture the excess economic profit born of a too high profit margin, entrepreneurs need to raise capital, they need to make tangible investments in building the infrastructure of a business, and they need to hire people on the ground to make the business work. Simply put, margins don’t just go down, they get competed down and eroded over time through factors and forces that actually improve the economy at large, with the benefit at the end of the day being lower prices and better supply available for end consumers. This reversion in margins is always a process, never a one-off event, and it surely happens faster in some areas than others (Clayton Christensen’s Innovator’s Dilemma is a great example of the forces of competition and innovation in the rapidly evolving hard disk drive industry, see my post on The Essential Mental Model for Understanding Innovation).

Two Tales of Margin Erosion Today

Sometimes these entrepreneurs are startups with a cheaper, more scalable way of capturing the margin, and other times they are large competitors with lower margins who see an opportunity to grow their own business. Two anecdotes would be helpful. Let me note, for the purposes of these comparisons I’ll use only operating margins.

First is the case of RadioShack losing to Best Buy who in turn is losing to Amazon (it’s worth mentioning that Circuit City would be a nice addition to this chart, for it was competed into bankruptcy).

In some ways Amazon is not the perfect example, because its own margins are virtually unprofitable, but if we can see past that for a second it becomes clear why they are a fine example. RadioShack started with the highest margins of the bunch, but the longer Best Buy and Amazon stayed beneath them in margin, the more pressure there was building on RadioShack’s own business model to cut prices. Sadly for RadioShack, the company doesn’t have the infrastructure to compete on today’s playing field. While Best Buy held up admirably during the initial assault on RadioShack, we see clear signs that Amazon’s own low-margin model has been pulling Best Buy down with it.

How was Amazon able to drive the margins down of some of its biggest competitors (note: this happened in books with Border’s and Barnes and Noble having experienced Amazon’s rath before the consumer electronics companies)? They did this with massive amounts of investment. If you total Amazon’s investments over the past 5 years (capital expenditures + acquisitions + technology and content) you see that Amazon invested $21.1 billion. Compare this to Best Buy and RadioShack’s combined market cap of $13.5 billion and you can see why Amazon is a feared competitor. Again, it’s important to point out: Amazon was able to drive down Best Buy, RadioShack and Circuit City’s margins, much to the detriment of those companies, one of whom no longer exists and another of which is on the brink. In doing so, Amazon experienced tremendous growth in its own revenues of about 33% compounded over the past 5 years, all resulting from the company investing substantial sums of money and hiring a whole lot of workers. This is how capitalism is supposed to work.

Some might counter that this obviously won’t end well for the economy too, because Amazon makes 0 profit and any multiple of 0 is inherently 0 (ie 0 profit for the S&P multiplied by an average P/E of 15 equals $0). My counter would be a) Amazon could make a whole lot more money than they do, though we can never be sure exactly how much, but they choose to invest in future growth instead; and, b) that’s why I have this next example for you.

Here are Apple and Samsung’s respective operating margins over the past either years:

Apple wowed the world with its innovative iPod, iPhone and iPad. This trifecta launched Apple’s operating margins up from a puny 3.94% in 2003 to a high of 35.3% in 2011. The problem for Apple was that it’s profit margins became too juicy. They were so juicy they were practically begging competitors to steal some of their profits, and in the chart above, we can see clearly how as Apple’s margins fall from peak levels, Samsung’s shoot up. Up to this point, Samsung was only a bit player in the handheld phone business, and did most of their business in more commoditized, low-margin consumer electronics like TVs. With such a huge opportunity to undercut Apple in price and to improve their own margins in doing so, Samsung jumped in with great success. While Apple’s margins took a hit in the past year, their revenues continued to grow, as Samsung’s revenues surged (Apple’s revenues grew 9.2%, while Samsung registered 22% yoy growth). All in all, the size of the smartphone market pie grew tremendously over the past year, though the margins earned by its earliest, most profitable player declined. Meanwhile, both in aggregate and individually, Apple and Samsung were tremendously profitable.

Macro Applications of Micro Lessons

If we compare this to GDP and corporate profit margins, the GDP (ie smartphone market size) increased tremendously, the aggregate profits earned also increased, but the average margin across the market dropped. This is a win/win for the market, for consumers and for the competitors, though is not necessarily ideal for some of the status quo players. Again though, this is how capitalist markets work: things evolve and move forward, with growing greater good in aggregate. And this is how profit margins inevitably will decline.

Using microeconomic examples is a worthy exercise in order to extrapolate what should happen on the macro level. Who knows exactly when/where/how margins will decline, if they do. There is every reason to believe they will at least eventually regress towards the trend of the recent past, which is towards higher profit margins but at a more tepid pace than has been seen of late. Most importantly though, microeconomics teaches us how it is that margins contract when they do. High margins are an important component of the capitalist process. They are one of the most obvious factors which openly invites new market entrants, ultimately encouraging new investment and new hiring.


Disclosure: No position in any company mentioned in this post.