Articles that made me think (March 2, 2019)

Markets are Eating the World

Many internet pioneers in the 90’s believed that the internet would start to break up corporations by letting people communicate and organize over a vast, open network. This reality has sort-of played out: the “gig economy” and rise in freelancing are persistent, if not explosive, trends. With the re-emergence of blockchain technology, talk of “the death of the firm” has returned. Is there reason to think this time will be different?

Transaction costs can be subdivided into trust costs, transfer costs and triangulation costs. Technology drives down transaction costs. In general this increases the prevalence of gig work and incentivizes renting instead of buying.

Technology increases coordination scalability which is key in understanding how this all changed from the Neolithic to the Blockchain eras. Mechanical clocks and cryptocurrencies are both useful examples to understand the impact of technology on the economy.

Would be interesting to develop a framework for shocks caused by a sudden increase in transaction costs. Revolutions and natural disasters can cause a break down in trust in society. This of course does create an opening for crypto that can be overlooked by people’s whose experience consists of stable monetary regimes. Crypto has played a larger role in Argentina and Venezuela recently.

Ultimately, what we call society is a series of overlapping and interacting ledgers. In order for ledgers to function, they must be organized according to rules. Historically, rules have required rulers to enforce them. Because of network effects, these rulers tend to become the most powerful people in society. In medieval Europe, the Pope enforced the rules of Christianity and so he was among the most powerful.

Should I hire someone or outsource this role? Should a business vertically integrate? Why are CPG brands being upended by upstart product designers? Transaction costs is the datapoint that can answer all these questions.

Going for broker: Remittances to North Korea
Speaking of high transaction costs and low trust economies, its risky and expensive for North Korean refugees to send money home to relatives.

If a refugee in south South Korea wants to make a transfer, she may contact a broker in the North who owes a smuggler in China. The refugee may offer to pay some portion of the broker’s debt; in return, the intermediary gives an equivalent amount the the refugee’s family in the North, usually in dollars or Chinese yuan. The system is based on trust — and extravagant fes. The broker who facilitates the transaction takes a cut of around 30%.

Actually I’m kind of fascinated by how robust this market actually is all things considered.

Bond Illiquidity And LIBOR

Financial markets’ failure to solve the LIBOR replacement problem is the result of a misunderstanding of the reasons for the LIBOR problem. Understanding of LIBOR suffers from journalistic misdirection, on one hand, and a misunderstanding of the root problem that the LIBOR brouhaha exemplifies, on the other.

….In short, any satisfactory LIBOR replacement must be a form of debt that doesn’t exist now. We could throw up our hands and use the hazardous SOFR, but this seems to be a negative way of looking at the situation.

This is an obvious opportunity to seize an enormous chunk of the financial markets in one fell swoop by addressing bond market illiquidity more generally. Moreover, it is an opportunity that anybody with the courage and the capital could pursue. The problem is one of creating a new debt market with a different structure. Such a new market would have no incumbent oligopolies and no reactionary regulators. Capital, a few hotshot IT professionals, and some people with skills of persuasion would be enough ammunition to get the job done. Island overwhelmed the incumbent stock exchanges with less.

Enrique Abeyta has four pieces of advice for Jorge Paulo Lemann

The story of 3G’s value creation — buying a big brand and cutting costs to generate high equity returns — worked for ten years, “but they sailed in the direction of a storm they did not forsee. They overleveraged the ship in search of returns and lost their flexibility.” …


Rule thinkers in, not out

Imagine a black box which, when you pressed a button, would generate a scientific hypothesis. 50% of its hypotheses are false; 50% are true hypotheses as game-changing and elegant as relativity. Even despite the error rate, it’s easy to see this box would quickly surpass space capsules, da Vinci paintings, and printer ink cartridges to become the most valuable object in the world. Scientific progress on demand, and all you have to do is test some stuff to see if it’s true? I don’t want to devalue experimentalists. They do great work. But it’s appropriate that Einstein is more famous than Eddington. If you took away Eddington, someone else would have tested relativity; the bottleneck is in Einsteins. Einstein-in-a-box at the cost of requiring two Eddingtons per insight is a heck of a deal.

Basically its the framework of high upside convexity applied to ideas and people.

The fall of America’s “Money Answers Man”
This guy was simply promising 6% risk free. But it was too good to be true. Early Ponzi schemes usually promised outlandish returns with no risk. Perhaps after many years of millenium low interest rates, the bar for return promises on ponzi’s has been lowered.

America is obsessed with Theranos and Fyre Festival
The insatiable appetite for all things Holmes is part of an overarching obsession in America right now: We can’t get enough of scams and scammers.

Why hipsters all end up looking the same
Mimetic desire is a powerful force- even(or especially) for those who claim they don’t care.

In a vast range of scenarios, the hipster population always undergoes a kind of phase transition in which members become synchronized with each other in opposing the mainstream. In other words, the hipster effect is the inevitable outcome of the behavior of large numbers of people

For some reason this also reminded me of the movie SLC Punk.

RIP culture war thread
Slate Star Codex creator was subjected some of the crazier human tendencies that come to surface in the cultur war. Painful to read. Which is why it is essential reading.

In praise of work

The reason for the emergence of workism was that the jobs of banking and consulting were fundamentally about signaling intelligence, competence, credentials, hard work and availability. They were not about what sliver of work was being done, or how much meaning anyone invested in it. The job was – and is – almost wholly abstracted from that work. That is the soul of workism: that the job is, in every meaningful respect, to look like you are doing the job.

The Paradox of Alternative Data

“My God, they’re purple and green. Do fish really take these lures?” And he said, “Mister, I don’t sell to fish.

Informational edge can drive fantastic alpha while it lasts. This explains the increasing investment industry focus on non-traditional data sources, aka alternative data. If you are the first to acquire a new alternative data set, you might be able to develop insights no one has.

Yet once a lot of people are using it, it is less likely to drive alpha. It might be table stakes to not get screwed, or it might be already be instantaneously reflected in the price of assets.

Furthermore, most opportunities really hinge on a couple factors- more info isn’t always useful. That won’t stop the alternative data industry from doubling to $400 million by 2021, as a widely cited Tabb Group report predicts This is worth considering while one is caught up in an alternative data arms race.

Yet some data sets genuinely will provide an edge.

Perhaps a data set that no one else is looking at provides the edge you need. If a data set isn’t established as useful, the provider of that data will probably offer it cheaper in the early days of their business. There are so many alternative data providers out there, that marketing strategy is important for startups.

Ironically, the provider can charge higher price once word about its value gets out among investors.. So later adopters might pay more for an edge that is already gone.

Of course eventually someone will put all the data online for free and meta data of how investors use that alternative data can also be useful.

Now can I interest you in an alternative data feed that will make all your dreams come true?

See also: https://ockhamsnotebook.com/2016/09/18/the-hard-thing-about-finding-easy-things/

The ecological consequences of hedge fund extinction

Investing goes through fads.  Investing strategies and fund structures(1) go in and out of style.  Nowadays long/short hedge funds are out and infrastructure funds are in.   Within the public equity markets, value is out, growth/momentum is in. Each time this happens, people forget how the cycle repeats.  

In fact, one CIO contended that if he brought a hedge fund that paid him to invest to his board, the board would dismiss it without consideration — simply because it’s called a hedge fund, and hedge funds are bad.  

Institutional Investor

Hedge funds may have to do a name change if they want to raise capital.

Remember last time?

And yet people forget:

Allocators woke up craving the next rising hedge fund star and couldn’t invest enough at high and increasing management fees after the widespread success of long-short funds in the weak equity markets of 2000-2002. Board rooms back then castigated CIOs for not having long-short equity hedge funds in their portfolios.

This isn’t the first time:

People forget that 40 years ago, officials such as Paul Volcker of the Federal reserve wanted an active hedge fund industry to absorb the risk that was not well managed by state-insured banks.

Financial Times

Each investment strategy picks up a certain type of risk(and potentially earns a profit in doing so)- if a strategy disappears that particular risk can become a systemic issue.  Fortunately, around this time it also becomes more lucrative to bear the risk others are unwilling to bear. Eventually the risk reward tradeoff starts to make sense again.

Different, different, yet same

In the 1960’s Warren Buffett put up ridiculous returns, and Alfred Winslow Jones proteges profitably exploited anomalies in markets.  By the mid 1970’s of there were many articles about hedge funds shutting down though. Industry AUM declined ~70% peak to trough. Nifty fifty boom and bust followed by the long nasty bear market.  But as the institutional architecture of international trade and currency shifted we entered glory years of global macro/commodities traders. Then the 80’s were great for Graham deep value and Icahn style activist investing after the 70’s bear market left a huge portion of the market selling below liquidation value.

Likewise late 90’s again saw the death of hedge funds as day traders in pajamas earned easy returns from the latest dot-com- until the crash. Yet out of the rubble of the tech bubble rose a new generation of great hedge fund managers. There was rich pickings for surviving value hunters- and those with the guts and skills to execute became household names a few years later.   Many value managers that nearly went out of business during the tech bubble put up ridiculous numbers 2000-2002 and through the next financial crisis. (See: The arb remains the same)

The greatly exaggerated death of a style gives rise to an environment where there is a plethora of opportunities for something similar to that style to work.   Each time the narrative in the greater investment community favors some type of uniform strategy, and LPs give less capital to other strategies- causing them to nearly die off.  But then the lack of people pursuing the out of fashion strategy makes its return potential more lucrative. Eventually someone finds a new method to pick up those dollar bills on the ground that shouldn’t exist.

Economics emphasizes rational actors and equilibrium.   Yet the messy reality is far more complicated. Ecology is a far more useful  mental model.

A giant self over-correcting ecosystem

There is in ecological function to speculative capital and over time there should be some excess returns to those willing to take mark-to-market losses

Financial Times

Like biological species, financial strategies can have competitive, symbiotic, or predator-prey relationships. The tendency of a market to become more efficient can be understood in terms of an evolutionary progression toward a richer and more complex set of financial strategies.

Market force, ecology and evolution

Ecology emphasizes interrrelationships between different individuals and groups within a changing environment, and indentifies second order impacts.  

Thinking like a biologist

One can develop a useful framework by replacing species with strategy, population with capital, etc

Flows and valuation interact, self correct, and overshoot.  

….capital varies as profits are reinvested, strategies change in popularity,and new strategies are discovered. Adjustments in capital alter the financial ecology and change its dynamics, causing the market to evolve. At any point in time there is a finite set of strategies that have positive capital; innovation occurs when new strategies acquire positive capital and enter this set. Market evolution is driven by capital allocation.

Market evolution occurs on a longer timescale than day-to-day price changes. There is feedback between the two timescales: The day-to-day dynamics determine profits, which affect capital allocations, which in turn alter the day-to-day dynamics. As the market evolves under static conditions it becomes more efficient. Strategies exploit profit-making opportunities and accumulate capital, which increases market impact and diminishes returns. The market learns to be more efficient.

Evolution

When an ecoystem is overpopulated with a certain species, it eventually overshoots and results in mass starvation. Populations fluctuate wildly across decades, and sometimes species go extinct or evolve into something that seems new.  

New conditions give rise to new dominant species.

See also:

George Soros on disequilibrium analysis
The arb remains the same

Book:
Investing: The Last Liberal Art
Hedgehogging
More Money than God


(1) Although I am frequently pedantic about the differences between structure, strategy, and sector, many in the media seem to use these interchangeably when discussing reversion to mean situations.  Fortunately they all exhibit the same boom/bust phenomenon, so I am using them interchangeably here.

The arb remains the same

Imagine if Warren Buffett of 1960 puts down the deadtree 10-K he got in the mail and time travels forward to 2019. Then he looks over the shoulder of an analyst at present day O’Shaughnessy Asset Management. He would find the scene unrecognizable.

Or, if the original Jesse Livermore time traveled from the 1920s stock exchange to the present day trading floor of DE Shaw or Renaissance. Again, completely unrecognizable.

Back in the day people went to the SEC office in the Washington DC to access annual reports faster. That was how one got a fundamental edge.  Now people scrape filings the minute they come out. Or use satellites and credit card data to get an edge on information before it hits regulatory filings. People used to gauge momentum by looking at the facial expressions of other traders, now they use complex computer models. People mine market and fundamental data around the globe looking for a bit of an edge.  New techniques, same thing.

Over time there is the change in the physical activities, and words we use to describe the process of identifying and exploiting market inefficiencies.  Nonetheless the ecological function is the same. Investors are just looking for mispriced risk, and exploiting it till its no longer mispriced.

Around the world there are unfair coins waiting for someone to flip them. Arbitrageurs will need to use weirder and weirder methods to find and exploit them. Methods change, but the arb remains the same.

See also:

The hard thing about finding easy things
Riches among the ruins

Books I kind of liked in 2018

Non-Fiction

Fiction

Non-Fiction

Technological Revolutions and Financial Capital did more to advance my understanding of the modern economy than any other book I read in 2018.  Traditional economics treats sudden changes of technology as a separate exogenous factor.  This mode of thinking is pretty much useless for anyone forced to allocate capital under uncertain conditions.   In reality there is strong empirical evidence that financial markets and technology interact in repeated cycles .  Carlota Perez shows the pattern in these cycles by breaking them down into Installation and Deployment Phases. She identifies four main parts of each technological cycle: Irruption, Frenzy, Synergy and Maturity.  The book illustrates these patterns in the most important disruptions in economic history, including: the industrial revolution , steam engines/railways, steel/electricity/heavy engineering, automobiles/mass production, and information/telecom. Marc Andreesen hailed Technological Revolutions and Financial Capital as the single best book for understanding the software industry.  Since software is eating the world, its probably also the best book for understanding any industry.

Capital Returns is about how competitive advantages change over time, and how changes in capital availability can alter industry dynamics.  It covers a fund manager’s thoughts and activities from 2002- 2015, including periods of disruption and volatility in a variety of industries.    Ultimately the book is about how mean reversion occurs and and impacts investors.

Modern Monopolies deserves most of the hype that it has received.  Many business decision makers were schooled in “linear” business models, but the most valuable and disruptive businesses are platforms, business model that facilitate the exchange of value between two or more user groups, a consumer and a producer.  This book covers how technology has enabled more platform business models, and what the implications are for investors and entrepreneurs.

How the Music Got Free tells the story of how streaming music and piracy upended the music industry.  It also covers the story of how the MP3 format struggled to gain acceptance for many years before becoming ubiquitous.  The contrasting attitudes and actions of the winners and losers in the story are an entertaining juxtaposition , and a useful case study.     As a teenager I had been one of the early pirates, but was less aware of what was going on inside the old line music companies, and had not zoomed out to consider the broader industry implications.  

Laws of Human Nature is an essential guide for understanding how people act and how society functions. It teases out key lessons from psychology along with successes and failures throughout history.  Reading one Robert Greene book provides a reader with the benefits of reading dozens of business biographies and history books. It provides ideas for avoiding certain problematic tendencies in oneself and exploiting traits in others.   Laws of Human Nature looks at the dark reality of patterns in thought and behavior that don’t conform to an idealistic rational expectation:

As long as there are humans, the irrational will find its voices and means of spreading. Rationality is something to be acquired by individuals, not by mass movements or technological progress. Feeling superior and beyond it is a sure sign that the irrational is at work.

 Debt’s Dominion: A History of Bankruptcy Law in America, is a bit wonkish, but well worth the slog for the insight into the American bankruptcy system.   Its easier to understand the subtle nuances of the bankruptcy process and navigate opportunities in the distressed debt market when I think about how the system evolved. Indirectly the book is also about the slow process of institutional change.  

Thinking in Bets   is basically a long essay on behavioral economics, with one valuable message.  Under a plethora of entertaining anecdotes about professional poker it provides an immediately applicable  framework for functionning in an uncertain world. Basically its a slightly less nerdy and less nuanced companion to Fortune’s Formula. It also fits in well with some of the more important behavioral finance books, such as…. Misbehaving, and Hour Between Dog and Wolf, Kluge, etc. (more notes here)

Fiction

The Coffee Trader is historical fiction taking place in 17th century Amsterdam, when coffee was first brought to Europe and the modern concept of stock and derivative markets were just beginning to form.  It tells the story from the vantage point of Miguel Lienzo, a small time speculator who must navigate complex social structures, and deal with shady counter parties and aggressive creditors and competitors while trying to get rich in a nascent market.  He is also a Jewish refugee who fled the Portuguese inquisition but then struggles with overly conservative Jewish leaders in Amsterdam, who constantly threaten to shun him. Complicating matters further, he has a conflict with his brother, who is at the beginning a far more successful and respected member of  the community.

The first person narration includes gems like this one:

There was no shortage of my kind in Amsterdam. We were as specialized as taverns, each of us serving one particular group or another: this lender serves artisans; that one, merchants; yet another, shopkeepers. I resolved never to lend to fellow Jews, for I did not want to travel down that path. I would not want to have to enforce my will on my countrymen and then have them speak of me as one who had turned against them. Instead, I lent to Dutchmen, and not just any Dutchmen. I found myself again and again lending to Dutchmen of the most unsavory variety: thieves and bandits, outlaws and renegades. I would not have chosen so vile a bunch, but a man has to earn his bread, and I had been thrust into this situation against my will.

Three Body Trilogy is a deep character study of humanity itself in the form of an epic science fiction story spanning multiple centuries. It ultimately focuses on the way people act in situations of duress and conflict, both within and between different countries and groups. The Three Body Problem starts slowly, opening during the Chinese Cultural revolution, and tells of the initial contact with alien civilizations. The Dark Forest explores the paradoxical alignment of incentives in high stakes inter galactic diplomacy. The ultimate conclusion for the future of civilization in Death’s End is pessimistic, but getting there is thrilling.

Pattern Recognition is a thriller set in the early 2000s that feels like a science fiction take on modern media. The protagonist is a branding consultant/corporate spook who gets sent on a mission to uncover the anonymous creator behind a series of video clips that have spawned an obsessive subculture of fans. She tracks people and clues down in London, Tokyo and Moscow meeting many bizarre and unseemly characters along the way.

As with all Gibson novels, the dialogue and descriptions are fantastic.

“Of course,” he says, “we have no idea, now, of who or what the inhabitants of our future might be. In that sense, we have no future. Not in the sense that our grandparents had a future, or thought they did. Fully imagined cultural futures were the luxury of another day, one in which ‘now’ was of some greater duration. For us, of course, things can change so abruptly, so violently, so profoundly, that futures like our grandparents’ have insufficient ‘now’ to stand on. We have no future because our present is too volatile.” He smiles, a version of Tom Cruise with too many teeth, and longer, but still very white. “We have only risk management. The spinning of the given moment’s scenarios. Pattern recognition.

Meta-Reading and the value of fiction

In 2018 I refined my reading habits in a manner that drastically improved my overall experience. I sought out more books with big ideas that had stood the test of time, and started more systematically filtering and skimming newer non fiction. I also started reading more fiction.

Nonfiction

I read the Financial Times and the Economist regularly, monitor key topics on Google News, and regularly peruse reliable curators on blogs and Twitter for news and essays. I ignore most “breaking news” that isn’t immediately relevant to me, and instead look for carefully researched work.   Some of this is necessary because I need to stay up on what is happening with capital markets and technology. News is often bullshit, but its entertaining, and I often get useful ideas piecing together trends.

For actual books though publication date isn’t quite as important. I generally choose non-fiction books three ways: (1) Focused on a particular topic (2) timeless deep reading (3) timely speed reading.

Random topics

When I’m interested in a topic, I’ll skim whatever book I can find about it, and sometimes find a few valuable ideas. This applies not just to business, but life in general.  In the past year this has included topics as wide as gilded age businesses, securities law, uranium mining,  and child psychology.  I like to see not just what the “accepted wisdom” is, why and how it came to be widely accepted, and if it is likely to be correct.   Reality is rarely black and white.

Timeless deep reading

When I hear smart people talking about books that are a few years old, I listen closely. Often the most valuable books are those that have stood the test of time. Core concepts stay relevant, even if the technological specifics change. Information Rules by Hal Varian and and Technological Revolutions and Financial Capital by Carlota Perez are prime examples of this category that have become important influences on my thinking.  Similarly, historical biographies are almost always relevant decades after publication.

Timely speed reading

Many newer non-fiction books, have a couple key ideas that make them worth reading. Yet sometimes authors stretch a great potential blog post into a long fluffy book. Sometimes I can get the key point from listening to podcast interviews with the author.

If I listen to an interview, and it seems like there is more depth than can be captured in an interview, I’ll consider getting the book.Often I’ll first see if I can get an audio book version from the library via Libby.  Then I’ll download the key ideas(at 2x speed) into my head while working out or walking to work. If I listen to the audio book, and I find myself needing to pause and take notes, or wanting to capture quotes, then I’ll look at getting a kindle or dead tree version of the actual book.

I’ll skim through books that present well known ideas in unique ways, but reserve my deep focused reading for life changing insights. Of course sometimes being presented with a familiar idea will have more salience based on new experiences or just my subjective perception.  So this isn’t an objective filter, even though I sometimes try to make it so.

There are of course exceptions to this filtering heuristic. There are a few familiar authors whose books I’ll buy right when they come out.   I keep a lot of random books all around the house, so sometimes I’ll just pick one up and read it.   And often serendipity leads me to find good books randomly on Twitter, in the library, or a bookstore.

Fiction

Reading is definitely my thing, too, and I think you have to read not just business stuff but also history, novels, and even some poetry.: Investing is about glimpsing, however dimly, the ebb and flow of human events. It’s very much about breasting the tides of emotion, too, which is where the novels and poetry come in.

Barton Biggs, Hedgehogging

I went through a phase as a non-fiction snob. Who has time to read fiction, I thought? I have since done an almost complete 180 on this thinking. Fiction is more challenging to read and is generally better written than non-fiction. My day job involves reading a lot of dense regulatory and legal filings. There is usually an obvious structure to any given piece. But the broader meta game is piecing together disparate parts into a coherent narrative.

Fiction challenges the reader more because one has to spend more time thinking about what is important, understanding character development, and anticipating a story as it develops. Plus after a day of reading dense legalese and staring at screens, sometimes I want to engage my mind in a new way.

Besides, sometimes you have to refresh your mind and soul by consuming some crafted, eloquent writing.When I get home at the end of a business day, after being absorbed in investment babble and dull, plodding writing, replete with trite phrases such as make no mistake, which is my pet peeve, I am stuffed with babble. My gorge rises at the thought of more business carbohydrates. So I sit down with a nice big glass of wine and immerse myself in something I want to read. I always have at least one book going, and my taste is eclectic, but the sine qua non is that it has to be well written

Barton Biggs, Hedgehogging

I have been reading 3-5 non fiction books for every fiction book I finish, but to start reading fiction again was a major change in this past year. I still don’t have a good heuristic for filtering fiction. I mostly rely on recommendations from smart and interesting people. So send me your recommendations!

Ideas, people and detachment

“To Destroy the Ego,
One Must First Find it”

-Wu Hsin, Aphorisms for Thirsty Fish

One ego suspension trick I find useful is to separate myself from my ideas. Once I think of and share an idea I mentally treat it as this thing that is different and separate from me.

So if someone says the idea sucks- I can view their feedback objectively. They’re not attacking me.   The way forward is not a choice between “my” idea and someone elses idea.  Its just a choice between ideas.

The same goes for actions already completed. If someone questions a move I made in backgammon, or someone I hired at my company, or a major life choice, I can view it objectively and potentially improve in the future.

Its kind indirect way to achieving the benefits of Kipling’s call to:

“… trust yourself when all men doubt you
But make allowance for their doubting too. “

I just make it easier by stepping outside and not being attached to the “you”. The criticism and criticized are in the distance.

Sometimes this leads to better insight. There is no need to preserve an identity that may be attached to a particular idea. Just find the idea that is better according to some criterion and go there.

This isn’t a perfect system. There is only human software operating here. But it helps. Its a cruder version of what many great thinkers in the past have known.

Borrowing the east wind

Around 200 BC Chinese strategist Zhuge Liang first used a sales trick still re purposed by consultants and lawyers today.

Zhuge Liang was an amateur meteorologist, and he used this fact to convince people that he could control the weather. His knowledge of meteorology was very basic, something any farmer who paid attention would have known. Nonetheless his enemies didn’t have this knowledge. So it was easy to bamboozle them.

During one battle , he realized that the wind was likely to switch direction in a manner that was highly favorable for his army.

He made sure the enemy saw him do an elaborate ceremony that looked like black magic. He kept at it until the wind changed direction. As a result his reputation as a fearsome indispensable strategist grew massively.

This was featured in the historical fiction Romance of the Three Kingdoms  . The phrase “Borrow the East Wind (借东风) refers to this story.  Its sometimes used to described taking advantage of a situation.

A bit of dancing, drumming and smoke. Zhuge Liang took basic observation skills and sold them as black magic.

Modern knowledge work

I think of this anytime I see a knowledge worker selling their work makes it look more complex than it really is.

Jargon, chartporn and powerpoint replaces dancing drumming and smoke. Or alternatively with legal and compliance work, fear of regulatory risk leads to a company paying high fees to avoid problems. Even if all that is needed is filing a simple form at the right time.

There is a risk of a similar phenomenon in any business where there is a huge knowledge gap between seller and customer.  Will the seller take advantage of that gap in a way that harms the buyer?

Honest selling

It may seem like there is one fundamental problem with this comparison: Zhuge Liang was a diplomat/military strategist. A sales call isn’t a war. Its not supposed to be adversarial!

That might actually be the problem. An honest sales process is about helping the client see the value. The battle is against any misperception not against the client. A dishonest sales process is about taking as much from the client as possible.

Zhuge Liang’s life was on the line. And warfare (against sentient opponents) is all about deception. Deceiving competitors is justifiable. But deceiving customers is not. Some businesses may feel their life is on the line, but I bet they could make a good living by reducing complexity rather than playing it up.  I know I’m willing to pay up for reduced complexity!

Meta-Game

Dealing with this issue has proved to be a major challenge in dealing with lawyers, compliance consultants and technology contractors. I’ll ask around and get quoted absurdly large price ranges for the same set of work.

I’m getting better at asking the right questions in order to see what services are really worth.

I place great value on lawyers, consultants and developers who can cut through the bullshit.

Cheap stuff and cheap capital

Two main factors drive an upsurge in entrepreneurship: cheap stuff and cheap capital. Cheap stuff is primarily a long run secular trend. Cheap capital is cyclical.

By cheap stuff I mean the inputs to a business, mainly technology. This has gone consistently down over time. One can build a website or an app for a few thousand dollars that is better than what they could have done for millions of dollars a decade ago.

Even if capital becomes scarce, cheap stuff will still be a positive factor driving entrepreneurship.

By cheap capital I mean the flood of venture capital. This is primarily cyclical. Consider this quote:

“There’s so much money chasing these deals that venture capitalists are in competition with each other. They spend their energies marketing themselves instead of screening the deals. It’s gotten silly”

Think it applies today? Or maybe to the late 1990s tech boom? This quote is from the WSJ in 1981, and referenced in this excellent article about 1980s venture capital.

During a boom its easy for most ideas to raise capital, regardless of business viability(as long as they fit with theme of the times). Indeed they can keep raising rounds in hopes of a profit decades in the future. After a bust its hard to raise capital, even for a great idea. Entrepreneurs need to bootstrap and get revenue a soon as possible.

Right now it seems there is a ton of venture capital financing companies that are losing money.

Cheap stuff and cheap capital are partly entangled. You might be reading this from within a WeWork. If they couldn’t keep raising cheap capital you think your rent is going to stay the same? Or maybe you are building a business on top of a money losing social media platform, or somehow benefiting from a thriving open source ecosystem.   On the other hand, its harder to source talent when there is a flood of capital, and certain commodity based goods can have their own production cycle.    Yet you can run your business from a garage and the new inventions of the latest venture boom aren’t going away.

Which is most important- cheap stuff or cheap capital ? I don’t know, but we’ll get to find out when this cycle turns. Creative entrepreneurs will still take advantage of technological improvements to bootstrap groundbreaking ideas, even if they can’t raise venture capital. Sometimes they do it out of choice, other times they do it out of necessity.

Once this cycle turns, we’ll go through a few years where most new businesses have no choice but to bootstrap.

This idea generally applies across all industries, not just venture funded. However in commodity based industries the cyclicality functions differently.  Cheap capital often leads to inflation in hard assets.   See also: Capital Returns: Investing Through the Capital Cycle

Thinking and Applying Minsky

Hyman Minsky developed a framework for understanding how debt impacts the behavior of the financial system, causing periods of stability to alternate with periods of instability. Stability inevitably leads to instability. Minsky identified three types of financing: Hedge financing, speculative financing, and ponzi financing.  It seems some people only remember Minsky every so often when there is a financial crisis, but the framework is useful in all seasons.

Hedge Financing

An asset generates enough cash flow to fulfill all contractual payment obligations. For example, a conservatively leveraged rental property that generates enough rent to pay down the entire mortgage over time, regardless of the change in quoted property prices. Or a company that issues some bonds, then pays them back using cash flow from the business Generally hedge financing units have a lot of equity down. Even a market crash, will not cause an investor to suffer permanent capital impairment if they only use hedge financing. The equity holder who uses hedge financing will never depend on the capital markets.

Speculative Financing

An asset generates enough cash flow to fulfill all debt payments, but not the full principal amount. In this case debt must be rolled over, or the asset must be sold, in order to pay back the full amount. For example, a rental property financed with some sort of balloon payment structure that generates enough cash flow to pay off mortgage payments up until the balloon payment at the end. When the balloon payment comes due, the investor must roll over the debt or sell the asset. An investor ttat uses speculative financing is dependent on capital markets. If there is a delay or a problem in refinancing, they could lose their investment.

Ponzi Financing

This is basically “greater fool” investing. Ponzi financing means there is so much leverage n an asset, that the investment must be refinanced, or sold at a higher price quickly, otherwise the entire investment is lost. Sometimes property purchases will be financed with shorter term bridge loan. If the bridge loan can’t be refinanced with longer term mortgage, the investor is out of luck. Towards the end of the market cycle, many companies will be issuing bank loans or bonds that can only be repaid by refinancing. If their unable to refinance, they go bankrupt.
Use of ponzi financing means the investor is highly dependent on capital markets. The slightest disruption in capital markets or change in interest rates/inflation results in a large capital loss.

Junk bonds are not inherently bad. A higher interest rate can in many cases compensate for greater risk, especially across a portfolio of non correlated investments. Howeve, duringthe junk bond era, many companies

Similarly securitization is not inherently bad. It can allow capital to flow more effeiciently. But often banks would end up aggressively securitizing, with the need to sell the loans they made quickly. But if they weren’t able to resell they couldn’t hold the loans. This happened to Nomura during the Asian financial crisis, as vividly told in this Ethan Penner interview. 

Ponzi in this case is not illegal activity, just extremely risky. Of course those investors who finance their activities ponzi style often end up feeling the need to commit illegal acts. The Minsky Kindleberger model is useful here.

The cycle repeats

During a recession is very difficult to get any debt financing that is not “hedge financing”. Lenders are scarred from the last cycle, and there is a paucity of available risk capital. But a price rise, and investors get more comfortable, more and more financing becomes ponzi units In fact. Lenders may lower their standards and become more accepting of ponzi units.
Throughout the market cycle, more and more financing is ponzi units. Eventually there is no greater fool to sell to. When many ponzi units are forced to sell at once, it eventually leads to a collapse in values. This is how stability inevitably leads to stability. The cycle repeats.

How to apply this?

To protect my capital, I look try to mainly expose myself to hedge financing, with a small amount of speculative financing. I position my portfolio so that I don’t need to refinance anything or sell anything in a rush. When I invest in leveraged companies with speculative or ponzi financing, I make it small position(always in some sort of limited liability structure), and generally won’t average down much if at all. Additionally, when I notice an increase in ponzi financing in the markets, I become more cautious.

Leverage, like liquor , must be consumed carefully if at all.

 

See also:

Minsky and the Junk Bond Era

is credit really the smart money?

Disequilibrium Analysis