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.

My Media Consumption Habits with the iPad

I want to skip over reviewing the device, because its awesomeness has been acknowledged a million times over, with little unique to say.  Instead I’d like to jot down some notes on how the iPad 3 has impacted my web browsing and media consumption.  Over the course of the past month, there are some notable changes in my long-term habits that I have developed, which I think portend at least a little about the future of technology and media.  Please note, none of these points are supposed to be right or wrong, they are simply observations about how my personal habits have changed.

iPad and Video

By far the most impactful shift has been my embrace of web video.  I always watched the occasional video, and with my GoogleTV, I started watching a bit more online video content.  Now with the iPad, web-based video has chopped my TV viewing time in half, and has eroded a decent chunk of my web reading time allocation as well.  In fact, reading has been a far more significant loser since getting the iPad than anticipated.  Reading had always been the means through which I pursued my primary interests and my self-enrichment time, while video was primarily my escape time.  Even between cable, on demand and DVR, I didn’t have nearly enough video content that was “smart” and crafted for my desires.  Now with the iPad it is far simpler than ever before to seek out and consume interesting and informative content that meets my tastes. 

Now, I spend about 30 minutes a day watching TED Talks on different rewarding topics, and an additional 30 minutes of select YouTube content, ranging from old interviews, to lectures from some great thinkers, to cool videos of nature.  Altogether, I find that the video watching I do on the iPad is distinctly different from what I watch on TV, therefore it has only cut out of my mindless TV time, rather than my entertainment TV time

(Slight digression: to me, mindless and entertaining are distinct types of consumption. Mindless are those channels I put on because there is no other option, just to clear my head, while entertainment is the content that I am thoroughly addicted to seeking out.  Mindless TV for me is watching a Seinfeld rerun for the millionth time, while entertainment TV is watching the latest episode of Mad Men). 

To that end, the amount of mindless time I spend watching actual TV has shrunk substantially (i.e. watching something just for the hell of it, when there is little else to do, like the 45 minutes while in bed before sleep), and has been replaced predominantly with much smarter content.  I feel better for it at the end of the day too.  All this helps further confirm my belief that YouTube will be a big winner in the future of video.

iPad and my Computer

One of the biggest changes is on the bigger level, about how I use my computer.  My computer has become my exclusive domain for productivity functions, while the iPad, although not monopolizing consumption, has become the primary outlet through which I consume content.  It’s just so easy to read and watch on the iPad, while still relatively difficult to coherently build something.  I have used it in a complimentary role for my stock research, mostly as a 2^nd screen and an easy way to visually see something that I am manipulating in either Excel or Word. 

There are two important observations here.  First, while the iPad is great for consumption of information, it really isn’t all that good for productivity functions.  For this reason, I think all those who fear the imminent demise of the PC are overlooking the obvious—people use computers to both use stuff and to do stuff, and doing stuff isn’t going anywhere anytime soon.  For data analysis and writing, the iPad simply cannot compete with a computer, and there is no reason as of yet to make that transition.  Second, the iPad is much easier and more efficient for consumption, not because the screen is so shiny and pretty, but because the combination of finger flicks and taps is much simpler, smoother, easier and more fun than a keyboard and track pad, especially when making words out of buttons (aka typing) just is not necessary.  The simplicity and fun combined are a powerful force in driving said consumption to the iPad. 

The Future

The iPad alone brings cord cutting much closer to reality.  One of the real consequences is that quite a bit of my personal cable-watching time has shifted to the web, and that trend will definitely continue to accelerate.  With apps for each of the major networks, covering the majority of the shows I actually watch, the only real missing link continues to be live sports.  As soon as the day arrives that sports are available for streaming on the web (note to the cable companies: you can only fight the inevitable for so long) my cord will be cut and cable will be in my past.

Links for Thought -- March 2, 2012

Apple: Thoughts on bias, value, excess cash and dividends (Musings on Markets) -- Two weeks ago, Aswath Damodaran brought us his valuation analysis of Facebook, this week he takes on Apple.  Aswath is a long-time Apple investor and a valuation guru.  He is generous enough to share not only his thoughts on Apple, but also his model.  Go check it out!

Mapping Solar Grid Parity (Energy Self-Reliant States) -- This is a really cool interactive map that shows when solar energy will hit grid parity around the United States.  Importantly this chart is taking a look at solar WITHOUT subsidies.  

The Silver Lining to Scarcity: It Drives Innovation (Harvard Business Review) -- Necessity combined with scarcity are powerful forces in the drive for innovation.  Too often innovation is not anticipatory, but rather reactionary to need.  Herein lies the "silver lining to scarcity."  This is a particularly relevant piece considering the questions about scarcity with regard to the future supply of crucial commodities like oil amidst surging emerging market demand.

Big Market Worries: Profit Margins (A Dash of Insight) -- Jeff Miller takes his stab at debunking one of the oft-stated mantras of today's market valuation: that margins are mean regressing and high, therefore they are due for contraction.  This is an important debate in establishing whether we are dealing with the real long-term compression of valuations, or whether this is simply a temporary uptick that will inevitably fade.  My belief--I side with Jeff.

Let Your Winners Run (A VC) -- Fred Wilson of Union Square Ventures tells us all to ride our winners.  When people see they are making money, it's very hard to take that itchy trigger finger off the sell button, especially in these days of high volatility.  Yet, to build outstanding performance over the long-run, it's important to recognize that the benefits of winners that keep growing are greatly increased by the effects of compound interest.  This is one of Kevin Douglas' strengths.

My Reflections on Steve Jobs, by Walter Isaacson

As soon as I heard there was an authorized biography of Steve Jobs in the works, I knew I would be reading it ASAP.  As a semi-"fanboy" of Apple products, I had a special affinity for Jobs' ability to create beautiful, yet simple products that so clearly surpassed the competition.

Steve Jobs is inspirational to me as an innovator and businessman, and I always looked forward to his next Apple event.  Not many people could successfully earn the respect bestowed upon him by both the hippiest of the hippies and capitalist of the capitalists out there today like Jobs has.  The first iPod I got (a gift from my Mom for my college graduation) was a semi-spiritual event and shortly thereafter Apple was my first really good Tech investment in the dot.com bubble's wake.

I say a semi-fanboy, because while I prefer Apple products, and recognize their superiority, the closed ecosystem and lack of hardware scalability consistently pisses me off.  No product exemplifies my feelings more than the iPad.  I knew the concept was in the pipeline for a while, and I "knew" that I would be buying one rather quickly.  I even bought a large external hard-drive/hub and built my own internal home network in anticipation of the iPad as my computer replacement.  My vision was clear--with my newly created home network and hard-drive, a tablet (I was expecting the name iSlate, not iPad), and a tablet dock, I could theoretically build my own cloud-computer at home.  The tablet would be my CPU and monitor (the brains and eyes), while my network would be the memory (the central nervous system), enabling the liberation of my computing experience into my personal cloud.

Unfortunately, it wasn't meant to be.  The iPad, required adding an additional device to one's computing infrastructure, rather than liberating the user to do something new altogether.  Sure the iPad was new, and incorporated some amazing and groundbreaking features, but there was a major disconnect between my expectations and the level of enthusiasm that ultimately greeted the device.  Here's what I said at the time.

Needless to say, I felt let down.

After spending much of this past Thanksgiving weekend messing around on some family and friends iPads, I still want one despite my disappointment, and despite the fact that Apple never fully came around to the features I want.  Perhaps that's just my impatience about the fact that neither the iPad 2 nor any of its clones have come close to offering what I am looking for.  But really, I think it comes down to how amazingly awesome the iPad is to use, and in the context of what I was looking for in a tablet, if I settle, I better settle for the best (the Ipad).

I start my "review" of Steve Jobs, by Walter Isaacson with this little anecdote, because it is in some ways the perfect metaphor for my feelings towards the book, as well as my feelings towards Steve Jobs.  Reviews of the book are a dime-a-dozen, and therefore, I would like to focus my review not on the book itself, but on elaborating on my personal feelings towards the subject--Steve Jobs.

Immediately upon the book's release, all the juicy tidbits about Jobs personality and personal life were plastered all over the Internet. Before the book came to light, I was generally aware that Jobs had a prickly personality, and before reading much of the book, I learned a good chunk of the most shocking details from his childhood post-adoption to his intimate relationships to his business rivalries.  Much of the "drama" was conveniently extracted by a media blitz as one website after another attempted to beat their rivals at revealing the most shocking plot lines first.  And let me be clear from the start, the "juicy" stuff is interesting because it is what we already did not know; however, as I kept reading the book I became more annoyed (albeit not surprised) with how much of the focus in the press was on Jobs' personality and his private life rather than his ethos and achievements.  With that in mind, I purposely will forego reciting and commenting on many of these facts better left for the tabloids.

The media blitz forge an initial bias on my part: there was more to Steve Jobs than meets the eye, and he is not exactly the saint he was idolized as in the public eye.  My bias was further confirmed as I began reading the book.  The early parts moving from Jobs' childhood in Silicon Valley, through his college days and the founding of Apple don't really paint too attractive a picture of the man.  Jobs' genius clearly stands out from early on, but all of the striking parts in the beginning pertain primarily to demystifying Jobs role in the creation of Apple (Isaacson confirms the oft-stated critique that Wozniak was the brains behind Apple's technology) and highlighting the nature and depth of Jobs thorny personality.

As I kept reading, I said to myself, "sure he's done some great things and all, but what an asshole!"   Then something happened along the way.  It started even before the revelation of Jobs' cancer, at which time he became more of a sympathetic figure.  Where I really felt my inner transition in emotion towards Jobs was the sequence in which Isaacson takes us through the early days of Pixar and its rise.  I can't put my finger on what exactly it was, but in this context I really started understanding Jobs as a guiding visionary, who can almost will innovation to happen, rather than just someone who got lucky being around the most brilliant computer geek of his time.

Visionary probably isn't even the right word, but I said it there intentionally.  It wasn't as if Jobs set out to create something new altogether with Pixar.  Actually, he was navigating down a different path altogether when the CGI movie idea came to him, but it was he who recognized the promise and allowed the ship to steer itself towards its manifestation.  Where most other CEOs would never let the project get legs in the first place, Jobs encouraged the creatively inclined workers among him to embrace and indulge in their creativity, nurtured the project, and saw to it that at each step of the way success would be maximized.  Opening doors was not enough.  Nothing short of perfection was.

Maybe it's just that Pixar itself sounds more fun, but as that episode of Jobs' life played out, my personal Steve Jobs impression reflated rather quickly.  This accelerated as the story evolved into Jobs' return to Apple and eventually his battle with cancer.  The return to Apple contains much of the folklore we already know, but also in the context of Isaacson's narration, it turns Jobs from someone whose bubble had popped and builds him back up into the man we know today.  There are some clearly delineated self-improvement stories in there, but also we finally get the clear articulation of Jobs' brilliance--his ability to take something amazingly complex and make it beautiful and simple.  This holds true on the macro and micro levels, as Jobs built the company and each of its products around this principle.  Don't get me wrong, these elements were there from the beginning in Apple, but they are much more well-rounded and central to the plot at this point, probably because they are clearer in Jobs' own personal vision by then.

As for the battle with cancer, many have taken this as a real critique of a brilliant man.  The question "why would someone so smart do something so dumb" was asked throughout the blogosphere, and I very much see why people want to ask this question.  Yet, I think that view can only come when that fact is encountered in isolation from the rest of the book. While many have derided Jobs for failing to adequately treat his own cancer, and to a large extent, I agree, he wouldn't be Steve Jobs were it not for his ability to ignore hindrances while focusing steadfastly on his personal priorities--EVEN TO A FAULT!

Although the outcome sucks, it's hard to blame the man for it.  In fact, it makes him into more of the tragic hero I think he has become, in that the source of his strength, his so-called essence itself, was also the source of his downfall.  Therein lies the real source of my once-again reflated opinion.  Steve Jobs is your prototypical tragic hero in the Aristotelian sense, and this is exactly what humanizes his brilliance in the end.

The real climax of the book, and what pulls it all together are Steve Jobs' own words on what he thinks his legacy should be.  Whether one can truly ascribe each word to his life or not, the message in and of itself is one that all should take to heart.  To maximize one self, people need to be well rounded and have an understanding and connection to the humanities, but also knowledge of the technical.  People need to be hyper-honest, even to the point of being critical, while also being able to push aside their ego in order to accept criticism and use it constructively.  Lastly, people need to build things out of passion, aiming for the highest of quality, rather than for profits alone.

Be sure to read the book for yourself, it's well worth it.   What is interesting in the book goes well beyond what's juicy and leaves many lessons to learn for just about anyone.