troika

The Troika Of Ebola Speculation

In the last week we have witnessed a few low-float stocks become Ebola speculation targets as the first confirmed case in the U.S was announced September 30th, 2014. It is fascinating to watch these narratives unfold and low-float momentum plays be ignited as pools of capital cohesively and strategically buy-in. Understanding how the market operates, how media cycles affect expectations and how market participants influence each other asymmetrically are key characteristic of understanding the manic-depressive nature of Mr. Market.

First you may be asking what in the world is a Troika. It is a harness used for three horses to pull a sled in the 19th century.

[Figure 1: Troika Example]

What is speculation exactly?

Speculation is: “the forming of a theory or conjecture without firm evidence.”

VOLUME

That is exactly the dynamic that seems to be unfolding over the last few days in the personal protective gear makers, Lakeland Industries, Versar Inc., and Alpha Pro Tech Ltd. When a company trades its entire float a few times in one day, it is a sure sign speculation is brewing. Since Oct. 7th, (eight trading days ago) all three of these companies have risen over 150%+ while the float was traded an exuberant amount of times.

Company Float Size
LakeLand Industries (LAKE) 4.2M
Versar (VSR) 8.04M
Alpha Pro Tech (APT) 14.77M

In the last eight days Lakeland Industries float has traded 30+ times and the 30-day average daily volume is now 4.86M shares or 120% of the float. The last example of a low-float momentum theme that is quite similar is Digital Ally, a manufacturer of police cameras. Digital Ally had a 2.24M share float and from Aug. 19th to Sept. 2nd (during the Ferguson fiasco) there was cumulative volume of 114 million shares or 51x the float in 11 trading days. The share price during the period went from $3.70 to $33.50 and is currently trading for $10.60 as of this writing.

chart-3
LAKELAND

The narrative at play seems to be Hazmat suits are needed for the Ebola epidemic, there are bagged shorts in these low-float names and there are concentrated hands holding back supply. The media frenzy does not help and the lack of education behind how the disease is spread (direct fluid contact versus airborne) also fuels the fire. LakeLand Industries put out a PR and the president and CEO Christopher J. Ryan explained:

“With the U.S. State Department alone putting out a bid for 160,000 suits, we encourage all protective apparel companies to increase their manufacturing capacity for sealed seam garments so that our industry can do its part in addressing this threat to global health.” 

And PCI Global VP went on to say…

“There’s a very short supply around the world.  We were able to procure these 276 suits through a medical supply company in California, so we bought them up as soon as we could.”  The suits that were procured and shipped were sealed seam garments manufactured by Lakeland Industries.”

So apparently there were only 276 suits available from Lake Land but 160,000 production volume is what is being construed by the market.

The company jumped from 40 million-market cap to 126 million because they sold 276 suits? Unlikely. What is more plausible, is the expectations changed and the market thinks Lake Land will sell 160,000 suits at 6% operating margin (with no CAPEX) using imaginary production capacity. The selling price would need to also be at the maximum of estimates ($10,000 a suit).

In 2014 FY Lake Land Industries had $93 million in sales, a negative operating margin and a loss of just under $4 million. In the last 10 years they have lost a total of about $4 million.

VERSAR 

Does Versar even have Ebola exposure or did speculators mess this one up?

When you word search Versar 10-Ks for “health”, “biological”, “ebola” or “disease”, nothing related is returned. Versar purchased a U.K subsidiary, Professional Protection Systems, ltd that services the nuclear industry. The 2014 sales of the company (bolstered by the Olympics says management) were $2.6 million and included in the Professional Services Segment (PSG). Versar grew $35 million in market cap in 3 days as a result. The argument is that Nuclear suits are a substitute product.

ALPHA PRO TECH

·      The Disposable Protective Apparel segment consists of a complete line of shoe covers, bouffant caps, coveralls, gowns, frocks and lab coats.

·      The Infection Control segment consists of a line of facemasks and eye shields.
These two segments DPA and IC, had combined revenue of $17 million in 2013. The two segments before taxes had earnings of $2.6 million. The company grew $70 million in market cap in the last five days.

chart-4

COMPETITORS 

These three companies also compete with Kimberly Clark, Cardinal Health, Dupont (Tyvek and Tychem) and 3M, among others. Why didn’t these companies jump 5%+ during the same period (they are all negative since Oct.7th) if they are the most likely beneficiaries of protective equipment sales? Because they do not have a low float and are not easily manipulated.

All of these competitors have much higher production capacity and if Hazmat suit supply was a serious issue we would witness production utilization kick up and suit prices adjust upward in the mean time. These competitors have the working capital to finance the growth of the production capacity and they have the ability to buy any of these speculative companies with less than one quarters income.

COMMON THEME
I won’t name any names but it is very likely that the same group that was behind pumping up Digital Ally is also behind the pump in these names. I am not here to condemn people for participating in low-float momentum stocks or for orchestrating the rise. What I am doing is shedding light on the fragility of these underlying narratives. Low-float momentum stocks (on the long-side) have 1 similar characteristic each time they run.

1.     It is about supply and demand, controlling a large portion of the float prior to the share price running. As controlling hands (or market makers) are aware of their influence they watch and test the supply/demand strategically through “nibbling” and level 2. (as shorts accumulate, covers are harder to find, increasing price volatility). Low floats are easier to control with fewer dollars, hence the role of supply and demand. Shorts end up trapped and a short squeeze commences. There is also a narrative underlying why the product will instantaneously be in very high demand, whether Ebola, police brutality or 3D printing overthrowing large batch manufacturing.

Pump-and-dump and low-float momentum stocks are interesting to study and remind me of 19th century Wall Street with Jay Gould, Jim Fisk, Daniel Drew and Cornelius Vanderbilt during the railroad mania days. What can be learned here is that price volatility in the short-run is a function of supply and demand of the float, while long-term value is created through return on invested capital exceeding the weighted average cost of capital. This is what Benjamin Graham meant when he proclaimed “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Ebola won’t disappear overnight and I do want to see the crisis solved as much as everyone else. What will disappear over night is half of the market capitalization of these companies. Which night is up to the market…

Further Reading: A very interesting case study on another pump and dump

Pivoting within the Value Chain: Vanderbilt, Rockefeller, Carnegie and Beyond

Brief History: 
American culture is built on the backs of Cornelius Vanderbilt, John D. Rockefeller, Andrew Carnegie, J.P Morgan, and Henry Ford, among others. These are the men that helped build America and transform it into what it is today. How were all of these early tycoons all so wildly successful one may ask? Some may say timing had everything to do with it. Others luck. I believe as we begin to peel back the onion, examining these men from a historical business context, one striking reoccurring strategy runs deep through them all. They were all adaptable, hyperopic thinkers that dominated one industry and moved to the underdeveloped and underserved segment in the value chain where expectations were not being met and installed capacity had not met demand.

Cornelius Vanderbilt started his business adventure as a regional steamboat entrepreneur actively working in the Boston, Albany, New York, California and New Jersey areas. He soon discovered railroads were being built to transport goods from these coastal areas inward toward the west. Because Vanderbilt served so much of the market by the 1850s he was able to compete directly with New York, Providence and Boston Railroad (Stonington) by dropping fares, but he had much larger plans than a price war. Vanderbilt was able to gain control of the company as
the stock dropped in value and took over as president shortly after, the first of many railroads he would control. He began to sell his interests in steamboats and continued to buy railroads, eventually ending up with a near monopoly on the Northeast freight.

Vanderbilt was able to adapt to change, seeing a potential threat as an opportunity. He was able to shift upstream to the underdeveloped segment (from steamboats to railroads), and underserved segment in the value chain where expectations were not being met and installed capacity had not met demand.

Vanderbilt moved from the point of inbound logistics to the point of outbound logistics, understanding the common theme of westward expansion and that he belonged to the transportation industry, not just the shipping business.

John D. Rockefeller saw the oil revolution unfolding, electing to build a refinery instead of joining the wildcatter’s exploration and drilling endeavors. Rockefeller was moving towards where the puck was going, not where it was. He began refining oil into kerosene, chasing his vision to light every home in America and beyond. He made a deal with Vanderbilt (as well as the other railroads) for freight rebates on both his own shipments and his competitors, consolidating the Cleveland refineries in the process. The railroads knew how important the oil freight was, allowing themselves to be played against each other in the process. John D. placed himself in the position of the bottleneck and began to use it to its full potential. In the meantime railroad mania had been unfolding (reason behind the panic of 1873) and John D. Rockefeller knew that the railroads had been overbuilt. He used his muscle (50%+ of the railroads freight volume) to enact further price cuts on his freight while receiving rebates from his competitor’s freight. John D. was able to control over 80% of the kerosene market in the U.S, but the birth of the automobile motivated him to pivot. John D. moved upstream in the operations segment, beginning to refine gasoline for America as Edison began wiring American houses with electricity and constructing the central station generation facility, an obvious threat.

Carnegie started in the railroad business and moved upstream into iron working, supporting the railroad industry through the service segment in the value chain. He made steel for railroad lines and bridge girders while vertically integrating all raw material suppliers. It was the birth of the Bessemer converter (new rolling process) that allowed Carnegie to leapfrog early competition. He brought production time down from two weeks to 12 hours and by the later 1880s, Carnegie Steel was the largest producer in the world.

Michael Porters Value Chain
value chain

Elon Musk announced he would be building a Gigafactory to support lithium ion battery production the day after he also opened all current Tesla patents for use to the public. This is another example of moving to the underdeveloped and underserved segment in the value chain where expectations are not being met and installed capacity has not met demand.

 

Owners or investors should examine their strategy from a holistic perspective, analyzing what value is available to the value chain and how it can be improved going forward. Are there bottlenecks that can be improved on? Bottlenecks are usually waiting points reliant on a previous input that has not been fulfilled and within the operations, inbound and outbound logistics segments.

Apple Teardown and Supply Chain Value

Below is a graph representing the estimated costs of an Apple iPhone by component. It seems as though an Apple iPhone 6 Plus will cost $242.50 in intermediate goods. We need to also include Foxconn’s gross margins of roughly 12%, brining Apples intermediate material cost to about $272.

The selling price of the phone is $860 in Canada for the iPhone 6 Plus, or roughly $780 USD. Looking at these numbers we may jump to the conclusion that Apple is making over $500 per phone sold, but this is misleading. Apple must also pay for transportation and labor costs, post sale services (warranty), capitalized R&D, marketing, advertising, sales, administration etc. while selling at a wholesale price to distributors who in turn sell it for a mark-up. Apple uses over 200 suppliers, all of which earn a markup on components provided.

 tear down apple

The point being, there are many different levels in which inputs of value are provided and revenue shared by many different players working together. Apple is a world-class company and has diversified the suppliers it uses as demand grows, standardizing components and auditing production factory’s for both TQM and efficiency reasons. Where can Apple improve? Where can Apple remove bottlenecks that are inhibiting value and add ones that create value? We see that Apple currently believes IT is moving in a general trend towards new payment transaction technology and digital healthcare diagnostics, both underserved with minimal expectations. Would vertical integration of hardware suppliers be beneficial or should they continue the organic software build out? Apple nonetheless dominates the value chain.

Hindsight is 20-20, How Can We Forecast Value Chain Movement?

Divergent problem solving and thinking about how industry segments intertwine as well as where the convergence is likely to take place, using history as our guide, is a starting point. Divergent problem solving is exploring many possible solutions and picturing the scenarios of each but within a limited scope, much like chess or poker. It is best to probe many alternatives opposed to probing one or two in great depth.

For example, the solar industry went through a point of manufacturing saturation where panels were differentiated primarily by price as standardized supply flooded the market. Both the manufacturing point of panels in the value chain as well as the primary service of installing the panels have become commodity businesses with the odd exception. There are now three areas within the value chain that are underdeveloped, underserved, and have low expectations going forward.

1) Pre and Post Installation Services (Energy usage monitoring and evaluation systems)

2) Storage, distribution and battery technology (Maximizing capacity of energy that can be held and minimizing energy loss)

3) PV panel conversion efficiency (new technology)

Installed capacity versus demand

We can see using the example above that SolarCity is currently the only integrated provider and is moving upstream aggressively to alternative 1 while Chairman Elon Musk takes Tesla into alternative 2. The spread between demand and actual performance for battery technology is massive, a clear bottleneck within the value chain framework. Pre and post installation services are also actively being sought by consumers that are moving off the grid, using renewable energy sources or simply looking to save money through subsidies.

What is underdeveloped?

Underdeveloped meaning very little competition, a small market that is growing quickly and where quality is poor. Competitors are not enticed by below average ROIC (above average does not exist yet) and when competitors do begin to enter the market, the intensity of rivalry is mitigated by the capacity-demand spread. When installed capacity meets or surpasses demand and the quality demanded begins to continually rise, the market is likely developed.

Where is the Industry Currently?

Using Porters 5 forces framework and adding growth, size of the industry and complements is a great way to conceptualize the “starting state.”

  • Size of the industry?

  • Growth of the industry?

  • Substitutes and compliments?

  • Bargaining power of suppliers
    - Concentration of suppliers (dominated by one or two large companies or spread out?), are the goods supplied critical to the buyer’s success? Are substitutes available? Is the product standardized? Is forward vertical integration a plausible threat?
  • Bargaining power of buyers
    - is a large portion of industry output bought by a few individuals? Are switching costs high or low? Is the industry product standardized? Is backward vertical integration a plausible threat?
  • Intensity of rivalry
    Numerous or equally balanced competitors? Growth of the industry? Cost structure (high fixed costs and storage?) Low switching costs? Exit barriers? Reliance on performance or strategic stakes.
  • Threat of new entrants
    Barrier to entry, economies of scale, product differentiation, capital requirements, switching costs, access to distribution channels, expected retaliation, government policy, cost disadvantages independent of scale.

 

Canadian Solar Industry: 16 Billion Addressable Market ?

Photovoltaic Energy: Is the Tipping Point Approaching?

Introduction

The renewable energy industry is not new, nor is most of the processes used to convert renewables into useable energy new. What is new however is the adoption by consumers at an impressive pace, driven by compelling forces such as climate change, ecosystem destruction, or other tragedies pertaining to exploration, development and transportation of non-renewable energies.

Solar technology was invented in the middle of the 19th century during the industrial revolution to heat water that fuelled steam engines. Edmond Becquerel discovered the photovoltaic effects in 1839 while Russell Ohl was awarded a solar cell patent in 1939 and is credited for discovering P-N junction, which is used as a diode to control the electrical current flow in one direction. (PBS, 1999)

 

How Solar Panels Work

 Photons are emitted from the sun in waves that travel towards earth eventually striking glass, conductive material and metal compounds known as solar panels. Silicone is a common chemical used as a conductive layer and when the photon strikes the tin dioxide and silicone the photon becomes excited, emitting an electron into the positive layer. The electron then travels from the positive layer into the negative layer and into the wired current creating what we call electricity. During the process the photon travels through a catalyst that allows the process to be reset and accept new electrons.

 

We will be focusing most of our research attention towards the solar industry specifically but due to the “lumped” reporting of renewable energy and the energy industry as a whole, some guess work will unfortunately be made. The renewable energy industry is classified as wind, geothermal, solar, tidal, and biomass or other sources of energy that can be replenished naturally within a human’s ordinary lifetime.

Global

 The year over year growth of the OECD renewable energy consumption from 2011 to 2012 was 13.2% while North America grew individually by 11.6%. OECD counties accounted for 71.3% of the global consumption, while the U.S alone made up 21.4% of global consumption. (BP Statistical Review, 2013) This bodes well for Canada who exported virtually all energy that was not domestically consumed to the United States.

 

Solar City the leading provider of solar panel installations in the United States expects 70% annual growth from 2013-2018, targeting one million customers. At the end of 2013 the United States overtook Germany as the leader in solar panel installation and new available capacity. (Solar City 10-K, 2013)

 

Tariffs and trade restrictions on solar PV between various countries produce short-term strengths for domestic manufactures but impose higher costs to consumers. It would be expected that boarders open up further and tax benefits are scaled back as the industry reaches a self-catalytic tipping point. We are seeing the process unfold as large integrated oil companies expand their renewable presence because of the threat of niche entrants. The International Energy Agency estimates that PV could supply 33% of the world’s electricity as soon as 2060 while it currently only supplies about 1%. (IEA, 2013)

 

 

Domestic

The Canadian market accounts for 1.8% of the global consumption of renewables and grew consumption 10.5% YOY. Canada’s energy sector employs over 280,000 people, contributing to roughly 9.5% (about 107 billion) of the 1.124 trillion GDP. (NRCAN, 2012)

 

  • 98.4% of Canadian energy exports are to the U.S (NRCAN, 2012) 
  • 16.9% of primary energy supply is from renewables (NRCAN, 2010) 
  • 8,200 people were directly employed by the solar industry in 2012 with expectations of 74,000 employed by 2018, an employment CAGR of 37% (CSA, 2011) 
  • The average Canadian uses 4,500 Kwh a day at an average cost of 0.10-0.15/Kwh (Ontario Hydro, 2012) 
  • In 2010 a total of 588.9 terawatt hours of electricity were generated while solar contributed roughly 3% or 17.667 billion Kwh. (NRCAN, 2010) 
  • Ontario is a major player in the North American Solar industry, ranking top 5 (by state or province) for solar capacity installations since 2010.
  • Total solar PV capacity in Canada is expected to increase from 291 megawatts in 2010 to 12,000 megawatts in 2025 (CanSIA, 2011)Canada’s installed capacity for solar has seen average annual growth of 9.5% since 2000, reaching a capacity of 819 megawatts of thermal power in 2011. The 2008-2011 period however experienced catalytic and robust growth of installed capacity for solar power, reaching an annual average growth rate of 147.3%. (CSA, 2011)

 

Based on 17,640 GWH produced by PV and a sale price of 10-15 cents per Kwh when converted to electricity, we find a contribution of about 2-3 billion dollars towards GDP, roughly 0.18-0.27% of the total. Solar City estimates that the total current addressable market in North America is about 63 billion in U.S dollars, using a 14-cent per Kwh assumption. The Canadian electricity market under our assumptions is slightly smaller at 15.75 billion using the assumptions of 0.10/Kwh, 4500 Kwh consumed daily by all Canadians (35 million).

 

Investments

The solar industry has large upfront capital costs as well as on going maintenance. The capital costs are associated with financing inventory, customer leases, on-going operations, technological changes, and the skillful labor that is required for research, development and installation. Currently the Canadian government allows accelerated depreciation of 50% on solar panels, photovoltaic producing assets and costs incurred including feasibility, environmental and site approval studies. (CRA, 2012)

 

The solar industry is unique regarding the stakeholders as the capital suppliers are also primary customers of the product market and are partial owners of the organizations assets creating an opportunity for complete synergy or dysfunction. The government of Canada has also implemented strategic policy under the headline banners of REDI (Renewable Energy Development Initiative) and LTEP (Long Term Energy Plan) to spur investment, fueling supply and quicker consumer adoption rates as costs and margins are reduced. Because of the long term life of the useful asset an opportunity is created for residential consumers inclined to finance the debt over 20-30 years using the cost savings of their utility bill or cash flow from resale of electricity.

1

(Figure 1: CSA, 2011)

2

(Figure 2: CSA, 2011) 

The jobs created by investments in PV are more efficient in terms of jobs produced per GWh and the initial cost of that job shown in both figure one and figure two (above).

The renewable industry as a whole and the solar industry specifically cater to a relatively new trend, the triple bottom line. The triple bottom line is the product of p cubed, or people, planet and profit. Consumers are willing to pay more for the utility that is gained from sustainable purchasing methods, which is evident judging by today’s consumer trends. As consumers continue to adopt disruptive technologies the dynamics of the external market are changed and as Christensen notes in his renowned book Innovators Dilemma, markets that do not exist can’t be measured.

An industry’s profitability is a function of interactions between: 1) Suppliers 2) Buyers 3) Competition 4) Product Substitutes 5) Market Entrants. Studying the dynamics of game theory (prisoners dilemma) and the asymmetric payoffs of convexity are sure to lead to a more even playing field, quite possibly even a competitive edge.

Appendix (A) – Conversion Chart

 

W = Watt 1000 W = 1 KW
KW = Kilowatt 1000 KW = 1 MW
MW = Megawatt 1000 MW = 1 GW
GW = Gigawatt 1000 GW = 1 TW
TW = Terawatt

Timeless Virtues from Seneca the Younger

“There is no enjoying the possession of anything valuable unless one has someone to share it with.” – Seneca

Seneca at present times, may be called a forgotten author. Names of great philosophers like Plato, Socrates and Aristotle are ones of household stature and can be identified with ease.

I encourage studying Stoicism and more importantly, putting into practise the timeless virtues that are dispelled in wondrous brevity. Doors that were not visible become apparent when one is not coerced by the blinders of hope and fear. Seneca and Marcus Aurelius are the right place to start.

The Stoics saw the world as a single great community in which all men are brothers, ruled by a supreme providence which could be spoken of, almost according to choice or context, under a variety of names or descriptions including the divine reason, creative reason, nature, the spirit or purpose of the universe, destiny, a personal God, even (by way of concession to traditional religion) ‘the gods’. It is man’s duty to live in conformity with the divine will, and this means, firstly, bringing his life into line with “nature’s laws” and secondly, resigning himself completely and uncomplainingly to whatever fate might send him.

 

Only by living thus, and not setting too high a value on things which can at any moment be taken away from him, can he discover that true, unshakeable peace and contentment to which ambition, luxury and above all avarice are among the greatest obstacles.

 

The stoic Hecato of Rhodes writes “cease to hope, and you will cease to fear.” Seneca, in a letter to his dear friend Lucilius writes that they [fear and hope] are bound up together. Although they may appear to be unconnected, they march in unison “like a prisoner and the escort he is handcuffed to.”  

Fear keeps pace with hope. Nor does their moving together surprise me; both belong to a mind in suspense, to a mind in a state of anxiety though looking into the future. Both are mainly due to projecting our thoughts far ahead of us instead of adapting ourselves to the present. Thus it is that foresight, the greatest blessing humanity has been given, is transformed into a curse.

Wild animals run from the dangers they actually see, and once they have escaped them worry no more. We however are tormented alike by what is past and what is to come. A number of our blessings do us harm, for memory brings back the agony of fear while foresight brings it on prematurely. No one confines his unhappiness to the present.

Seneca advises that a mass crowd be avoided. The crowd should not be rejected externally, but rather internally, avoiding alienation from the very crowd you seek to influence. He states inwardly, we should be different in all respects, but our exterior should conform to society.

You ask me what you should consider it particularly important to avoid. My answer is this: a mass crowd. Avoid I cry, whatever is approved of by the mob, and things that are the gift of chance.

A single example of extravagance or greed does a lot of harm – an intimate who leads a pampered life gradually makes one soft and flabby; a wealthy neighbour provokes craving in one; a companion with a malicious nature tends to rub off some of his rust even on someone of an innocent and open-hearted nature – what then do you imagine the effect on a person’s character is when the assault comes from the world at large?

Our merits should not be outward facing and we should scorn the approvals from the majority. You must not hate nor imitate the world. You should not become like the bad because they are many nor make enemies because they are not like you. Seneca advises we retire into ourselves as much as we can, associating with people who will improve you. No man was ever wise by chance. We are in control of our emotions and our thoughts, ignoring what is outside our realm of control.

From what you tell me and from what I hear, I feel that you show great promise. You do not tear from place to place and unsettle yourself with one move after another. Restlessness of that sort is symptomatic of a sick mind. Nothing, to my way of thinking, is better proof of a well ordered mind than a man’s ability to stop just where he is and pass some time in his own company.

You should be extending your stay among writers whose genius is unquestionable, deriving constant nourishment from them if you wish to gain anything from your reading that will find a lasting place in your mind. Nothing is so useful that it can be of any service in the mere passing. A multitude of books only gets in one’s way. So if you are unable to read all the books in your possession, you have enough when you have all the books you are able to read.

And if you say, But I feel like opening different books at different times, my answer will be this: tasting one dish after another is the sign of a fussy stomach, and where the foods are dissimilar and diverse in range they lead to contamination of the system, not nutrition.

Each day, too, acquire something which will help you to face poverty or death, and other ills as well.

It matters not what we say but how we feel. Specifically not how we feel on one particular day, but how we feel at all times and about our life. The Stoic also can carry himself/herself unimpaired through cities such as Sodom and Gomorrah; for he is self-sufficient. Perception of emotion and memory of ones experiences are two of the bounds to which we set our own happiness. [Kahneman: The Riddle of Experience vs. Memory]

Chrysippus (A philosopher Seneca quotes) was known to say,

that the wise man is in want of nothing, and yet needs many things.On the other hand, nothing is needed by the fool, for he does not understand how to use anything, but he is in want of everything. The wise man needs hands, eyes, and many things that are necessary for his daily use; but he is in want of nothing. For want implies a necessity, and nothing is necessary to the wise man.

Continue reading:

Charlie Munger: Whats Wrong With Economics

“Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step-by-step you get ahead, but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. Slug it out one inch at a time, day-by-day, and at the end of the day – if you live long enough – like most people, you will get out of life what you deserve.” – Charlie Munger



[Ed Wexler, Poor Charlie’s Almanack]

Charlie Munger is a brilliant man and I cannot believe how neglected he is in the shadow of Buffett and Berkshire. Charlie gave an insightful lecture titled Academic Economics: Strengths and Faults after Considering Interdisciplinary Needs and gave it on Oct. 3rd, 2003 to the Herb Kay Undergraduates at the University of Santa Barbara Economics Department.

It is the 9th talk in the (Must Read) book, Poor Charlie’s Almanack. Charlie gives much deserved praise to Adam Smith, John Maynard Keynes, Riccardo and Paul Krugman in the beginning of the lecture, although he clearly favored Smith.

Adam Smith was so good a thinker and so good a writer that, in his own time, Emmanuel Kant, then the greatest intellectual in Germany, simply announced there was nobody in Germany to equal Adam Smith. Well, Voltaire, being an even pithier speaker than Kant, immediately said, Oh well, France does not have anybody who can even be compared to Adam Smith.



As Charlie always does, he leaves the apprentice to reach for the answer, explanation, reasoning and judgment. [Hint: Read Wealth of NationsThe Principles of Political Economy and Taxation, and General Theory of Employment, Interest and Money.

  • He explains he has this tendency of leaving questions unanswered because of the way his father taught him, leaving analogies open to interpretation and attribution.



So What’s Wrong With Economics?



Charlie puts forth nine simple ideas to help the economics discipline progress in the years to come and obtain a multidisciplinary attitude along the way.

1) Fatal Un-Connectedness, Leading To “Man With A Hammer Syndrome,” Often Causing Overweighing What Can Be Counted



Simply stated, Overweighing what can be counted, an excessive reliance on quantitative measures leads to and causes fallability. 

As Einstein once said famously “All that can be counted, does not count.”

And Charlie added . . .

[Humans] (1) overweigh the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and (2) doesn’t mix in the hard-to-measure stuff that may be more important. 

One of the most important factors in business cannot be counted. Culture.

Sure you could make up some asinine balanced scorecard, fitting the model to the mood, or you could use your multidisciplinary knowledge in history, biology and psychology to develop an intrinsic model of what has worked and why

What makes a strong culture? What kind of culture does your dream job entail? Why?

Who do you not want to work for? Why? What makes a weak culture? Why? 

2) Failure To Follow The Fundamental Full Attribution Ethos of Hard Science



“What’s wrong with the way Mankiw does economics is that he grabs from other disciplines without attribution. He doesn’t label the grabbed items as physics or biology or psychology, or game theory, or whatever they really are, fully attributing the concept to the basic knowledge from which it came. If you don’t do that, it’s like running a business with a sloppy filing system. It reduces your power to be as good as you can be.”



Attribution helps memory retention through structural recognition of the problem and relates to ones own experience and knowledge for better understanding.

3) Physics Envy



The envy of physics can be simplified into mistaking soft science for hard science and attempting to oversimplify what is dynamically complex. Everything should be made as simple as possible, but no more simple.

Charlie illustrates the point with Washington Post. Washington Post in the early 70s was trading at “a fifth of what an orangutan could figure was the plain value per share by just counting up values and dividing” but because some partner at McKinsey had been educated in capital asset pricing model, beta, efficient market theory and even worse, believed what he was taught, a stock buyback program was neglected.

At the time it was conventional wisdom that companies should not buyback shares on the premise that the market is efficient. This means there is no advantage in buying shares. Luckily for Washington Post shareholders, Warren Buffett (TradesPortfolio) came along and convinced the board to buy 50% of outstanding shares, creating over a billion dollars in value in the process. The rest is history.

The moral of the story being soft sciences are not governed by laws but rather plausible rules or heuristics that are easily broken. The second example of physics envy is of a rustic legislator that attempted to have a law passed to round Pi to 3.2, allowing school children to make computations easier. Luckily the law did not pass, as architects and quantum physics will agree.



4) Too Much Emphasis on Macroeconomics



“There’s too much emphasis on macroeconomics and not enough on microeconomics. I think this is wrong. It’s like trying to master medicine without knowing anatomy and chemistry.”



Charlie gives us a problem to solve to illustrate the lesson at hand.

Business: Tire Chain, Les Schwab

Sales: Hundreds of Millions from zero in 50 years

Founder: No formal education and is now age 80.

How did he do it?

Well, let’s think about it with some microeconomic fluency.

Is there some wave that Schwab could have caught?

The minute you ask the question, the answer pops in. The Japanese had a zero position in tires and they grew rapidly. So this guy must have ridden that wave some in the early times. Then the slow following success has to have some other causes.

“He must have a very clever incentive structure driving his people. And a clever personnel selection system, etc. And he must be pretty good at advertising. Which he is. He is an artist.”



Charlie explains extreme success is likely to be caused by some combination of the following factors, surfing the wave being the most important:

A) Extreme maximization or minimization of one or two variables.

B) Adding success factors so that a bigger combination drives success, often in non-linear fashion, as one is reminded by the concept of breakpoint and the concept of critical mass in physics. Often results are not linear. You get a little bit more mass, and you get a lollapalooza result.

C) An extreme of good performance over many factors.

D) Catching and riding some sort of big wave.

Microeconomics and smaller subconscious cause and effect relationships are the governors of macroeconomics, much like quantum physics governing macrophysics, macrophysics meaning visible and measurable to the naked eye.



5) Too Little Synthesis in Economics



This section can quickly be explained by a problem that Charlie had proposed in combination with the Riccardo comparative advantage and Smiths pin factory observation.


  • Comparative advantage states, it is beneficial for two countries to trade, even though one of them may be able to produce every kind of item more cheaply than others.
  • Adam Smiths pin factory is an observation he made and detailed in the wealth of nations. Smith found that ten workers were able to produce 48,000 pins per day because of the divided and specialized labor. If each worker handled all the steps required to make a pin, he could only make twenty per day. It pays to embrace specialized labor.

Charlie provides an example of a delinquent hotel property, in a bad neighborhood, that had caused nothing but problems and losses in the past. The previous owner (like most of us) encountered the problem of functional fixedness, a problem solving inhibitor. It took a new chap with very little conventional knowledge to turn the ship around. Of all things he needed the hotel as a hub, to store elderly travelers overnight. A shuttle bus picked them up and dropped them off (at Disneyland) so there was no need for the parking lot.

Breaking the functional fixedness of a typical hotel revenue model and turning the parking lot into a putting green solved the problem. Specialization and comparative advantage at its finest.

6) Extreme and Counterproductive Psychological Ignorance



Here I want to give you a very simple problem. I specialize in simple problems.

You own a small casino in Las Vegas. It has fifty standard slot machines. Identical in appearance, they’re identical in the function.

They have exactly the same payout ratios. 

The things that cause the payouts are exactly the same. 

They occur in the same percentages. But there’s one machine in this group of slot machines that, no matter where you put it among the fifty, in fairly short order, when you go to the machines at the end of the day, there will be 25% more winnings from this one machine than from any other machine. What is different about that heavy winning machine? 

Male: More people play it. 

Charles Munger: No, no, I want to know why more people play it. What’s different about that machine is people have used modern electronics to give a higher ratio of near misses. That machine is going bar, bar, lemon. Bar, bar, grapefruit, way more often than normal machines, and that will cause heavier play. How do you get an answer like that? Easy. Obviously, there’s a psychological cause: That machine is doing something to trigger some basic psychological response. 



7) Too Little Attention to Second and Higher Order Effects



This fallability is quite understandable, because the consequences have consequences, and the consequences of the consequences have consequences, and so on. It gets very complicated, very quickly. 



Higher order effects can attributed to cause and effect relationships as well as posterior probabilities. Thinking about the 2nd and 3rd level order effects in a “fish bone” style is a great way to train. 

- New incentives cause expected behavior to deviate because it is based on past incentives (Medicare exuberantly underestimated by over 1000%)

- Investing in textile looms. How much of the proceeds from capital investments will stay at home (in the owners pockets) versus the consumers pocket (in the form of lower prices).

Game theory or dynamical systems are also a great place to start to understand higher order effects.

8) Not Enough Attention to the Concept of Febezzlement



If you have embezzlement that is not known to the embezzled, it has a wonderful Keynesian stimulating effect on the economy because the guy who’s been embezzled thinks he is rich as he always was and spends accordingly, and the guy that has stolen the money gets new purchasing power.

Although anyone with background knowledge in algebra will understand this effect is quickly cancelled out upon discovery of the embezzlement. Essentially a legal, yet unethical, juiced up wealth effect.

Febezzlement = the functional equivalent of embezzlement.


9) Not Enough Attention to Virtue and Vice Effects



The last point Charlie made is best taught with the story he used regarding the differences in attitude, integrity, culture and how social proofing/envy take hold in his speech to Stanford University Law School Address.

“I have a friend who made an industrial product at a plant in Texas not far from the border. He was in a low-margin, tough business. He got massive fraud in the works compensation system – to the point that his premiums reached double-digit percentage of payroll. And it was not that dangerous to produce his product. It’s not like he was a demolition contractor or something.

[The friend wasn’t able to convince the workers to stop the fraud]

So my friend closed his plant and moved the work to Utah among a community of believing Mormons. Well, the Mormons aren’t into workers’ compensation fraud – at least they aren’t in my friend’s plant. And guess what his workers compensation expense is today? It’s two percent of payroll – down from double digits. 

Letting the slop run causes this sort of tragedy. You must stop slop early. It’s very hard to stop slop and moral failure if you let it run a while.”





The last point can be distilled or simplified into four main points.

  • Trust, Virtue, Honesty and Integrity.

Keynes once said: “It’s not bringing in the new ideas that’s so hard. It’s getting rid of the old ones.” And Einstein said it better, attributing his success to “curiosity, concentration, perseverance and self-criticism.

By self-criticism he meant becoming good at destroying your own best-loved and hardest-won ideas. If you can get really good at destroying your own wrong ideas, that is a great gift.

Always look for disconfirming evidence.