What I Learned Selling My Nintendo Stock

I’ve been giving some thought to what I have learned from my experience with investing in and subsequently selling Nintendo stock over the last 5 years.

The story begins in 2012, when I noticed that this beloved company, one whose products I was intimately familiar with growing up, was trading at a price that valued the company little beyond the enormous pile of cash on its balance sheet. This cash stockpile was the result of an enormous run of success with the company’s smash global hit game console, the Wii, and its conservative corporate practices. The Wii-era resulted in the coining of a new term amongst the company’s followers and managers, “Nintendo-like profits”, which translated into layman’s terms simply means “insane profitability.”

Investors came to expect “Nintendo-like profits” from Nintendo as a right, when the reality of looking at the company’s business in the past would’ve shown that it was a cylical business with unpredictable fads and discouraging failures. The Nintendo Entertainment System (or Famicom, as it was known outside the US) put the company on the map as a home gaming company, the Game Boy handheld gaming system proved to be revolutionary and a success and the follow-up 16-bit era console, the Super NES, was also commercially successful.

But the follow-on systems in the Game Boy line, while commercial successes, were not global phenomena like the original. And the home console business took it on the chin two generations in a row. While fondly remembered by fans, neither the Nintendo 64 nor the Gamecube saw wide install bases in the era of the Sony Playstation and Microsoft Xbox, an era that also saw the downfall of SEGA and other one-off competitors. Like clockwork, this led to critics and investors questioning the Nintendo model, which had emphasized creativity and pushing the cutting edge of technology whereas Sony and Microsoft competed on the basis of raw hardware power emulating a home PC and captured the coming-of-age “hardcore gamer” market demographic. Nintendo seemed like kid stuff, for people who weren’t serious about gaming.

Of course, that is precisely where Nintendo scored its home run with the Wii, a console aimed at casual players. I rehash all this history only to demonstrate that the company never was and likely never will be a “blue chip”, steady eddy company with a predictable earnings stream built on a permanent plateau. The nature of creative offerings (like a movie studio) and the insistence on being fresh, original and looking for new ways to play (“blue ocean strategy”) is inherently cyclical and prone to incredible volatility in earnings and expense.

Luckily, Nintendo has a super strong culture that knows and understands their own business strengths and weaknesses and engages in corporate planning accordingly. They don’t carry debt and, as mentioned before, they held on to their massive cash stockpile earned in the boom years, knowing it would be valuable to them in getting through the inevitable lean years. Most companies would go on an acquisition spree after this kind of “windfall”, not knowing what to do with it. And their mercenary management team would be looking for another big score to increase their glory before driving the company off a cliff– and rolling out the door of the vehicle and on to their next disaster before it plummets to its fiery death.

But Nintendo is served by extremely-long tenured managers and creative designers, many of whom have been with the company before it was a dedicated gaming company and was a purveyor of cheap toys and other mishmash business lines.

Additionally, Nintendo has built a powerful library of IP over the years with their character and game world properties, which they have done little to monetize in ways outside of traditional gaming through other creative licensing. And it wasn’t even until recent generations of their game systems, such as the Wii, where they even had the technology or willingness to monetize their own game library for nostalgic customers.

So, let’s review some items discussed so far:

  • Nintendo is a cyclical company prone to booms and busts in its fortunes
  • Nintendo has a strong culture, driven by its long history and dedicated creative and marketing strategy
  • Nintendo has long-tenured leadership with experience and comfort with the cyclical nature of its business
  • Nintendo has a pristine balance sheet driven by its conservative corporate culture
  • Nintendo has an extremely valuable IP library it has barely worked to exploit

Because the company has a cyclical model, it was available at an unreasonable price when I came upon it, trading for little more than the value of the cash on the balance sheet. While it is true that the cash is “phantom” because the company will need it to fund its continued R&D and marketing during off years, that didn’t make it a value trap but rather valuable– outsize success is as predictable as disappointing failure for this company, and over time value is accruing to stockholders on average.

This is a strong franchise business, one that will be worth more and more over long periods of time because of its IP-based business model. And when you’re able to buy it so cheaply, the Margin of Safety is enormous, because the company has so much positive optionality because of its strong culture, strong IP library which remains unexploited and its conservative corporate practices. There are so many things that can go right for it which are surprising and hard to predict, while there are relatively simple and certain threats or things that can go wrong which are already accounted for and factored into the price– a poorly-received system, a change in the industry that makes dedicated home consoles a less valuable offering, etc.

What I did wrong is I got scared and I got greedy. From the lows at which I purchased stock in Nintendo, the company rocketed upward over the next 4 years, in spite of the massive depreciation of the Yen (which actually caused major forex headaches, because a lot of the company’s cash has been repatriated and held as Yen), in spite of the sudden death of its beloved and talented president, Satoru Iwata, and in spite of the abysmal fortunes of the Wii U. The company followed its strategy very faithfully and began exploiting its IP in new ways, as predicted– movie studio partnerships, licensing to theme parks, strategic partnership with a mobile gaming company (DeNA) to release official Nintendo smartphone games, the opening up of the company’s game library IP to more “virtual console” sales, greater emphasis on digital product distribution at higher margins, renewed success with the 3DS handheld gaming platform, the rollout of the wildly popular Pokemon GO and most recently, the release of the greatly anticipated Nintendo Switch, which has met both critical and commercial acclaim during its first two, non-holiday sales period months on the market.

I decided to “take profits” during the Pokemon GO craze, thinking this bubbly atmosphere was not sustainable and people would soon come to their senses. I was worried about the Nintendo Switch (still code-named “NX”) being a flop. I was worried about a global recession taking the wind out of consumers’ sails and reducing discretionary income for gaming. I was worried about the lack of news about Nintendo’s “Quality of Life” division. I was noticing a big gap between Nintendo’s new valuation and its actual reported earnings, creating a multiple I wasn’t comfortable with.

I am not trying to engage in hindsight based off of recent price movements. While the company’s stock is off its most recent highs during the Pokemon GO craze, it is still “lofty” compared to where I bought it (as of this posting, the stock trades for about Y29,000 per 100 block unit, and I bought around Y9,800 per 100 block unit). What I am trying to do is evaluate a decision to sell a company that is just now hitting a predictable stride when I bought it at a price closer to it seeming like it was going out of business.

What I have learned from this experience is that when you buy something valuable cheaply, you can afford to wait. You can afford to be patient. You can afford to watch it run up, and potentially run back down again. It doesn’t matter. You make your money in buying it below what it’s worth, not selling it when it’s “too far gone.” That low cost basis becomes an absurd comp for future dividend streams, embedding a high cap rate in the initial purchase, and then you get whatever further corporate value the company generates in the meantime as a bonus.

I really regret selling Nintendo, not because the stock didn’t crash like I thought it would (it was silly for me to think I could “time” it, but that’s a separate issue), but because I had owned it so cheaply, it has done everything I expected it to and I could’ve afforded to be patient.

Review – From Third World To First: The Singapore Story

From Third World to First: The Singapore Story, 1965-2000

by Lee Kuan Yew, published 2000

Extended Introduction

This book has two parts (well, really, three, but the third part is about 20 pages and isn’t as significant as the other two parts), the first of which is about how Lee Kuan Yew describes the building of political institutions and the development of the economy of Singapore under the leadership of himself and his People’s Action Party over almost four decades, the second of which is a country-by-country exploration of Singapore’s foreign relations or what might best be called the exercise of Lee Kuan Yew’s political power abroad. I have an essay planned which will cover the first part of the book separately, focusing on the economic development of Singapore “from Third World to First” and the related political issues with specific emphasis on the myth of Singapore as an example of free market economics at work. Confusingly for some readers, I will argue both that according to Lee Kuan Yew himself Singapore was not a free market and was not intended to be one, and that despite this most of the credit for Singapore’s amazing economic development over the forty year period observed still belongs to the workings of the free market and not to intelligent central planning and wise stewardship of the economy by protectionist politicians.

Therefore, this review will only cover part of the book, but a still substantial one (pg. 225-660) and one which touches upon enough issues that will be raised in the upcoming essay that the reader should be able to get most of the story. I also plan in this review to meander quite a bit and talk about the things I found most interesting or meaningful, rather than summarizing the themes. I took extensive notes on the used copy I bought, annotating almost every other page. There’s a lot to chew on here and I probably won’t cover it all even between this review and the later essay, but might come back to it and comment on individual issues as my thoughts or interest allow. For those who are so inclined, you may wish to read some personal observations and experiences I had during a recent trip to Singapore, as well as some of the comments I made about Singapore’s history and political story, by reading the earlier posts tagged about Singapore. They may add meaningful context.

The Role of International Affairs in Little Singapore

Imagine I described to you a tiny, natural resourceless island nation situated strategically along a major shipping lane, whose historical role was one of trade entrepot and for whom fluid commercial volumes with every people and country possible were key to its economic survival. What kind of foreign policy would you imagine such a country would conduct? Do you imagine it’d have a standing army, or rely on the goodwill of other nations for its existence? What do you think it’s chief executive would spend most of his time doing and where would he most frequently be found?

According to LKY’s memoirs, though a small country dependent upon trade and commerce, Singapore nonetheless had a big role to play in international politics and was not above taking hostile stances even toward other southeast Asian nations (and even looked on approvingly at various wars in the Middle East!). Establishing a robust Singapore Armed Forces was one of the first priorities of LKY when independence was gained in 1965, reportedly to ward off threats from Malaysia and even Indonesia. And during my reading, I lost count of the number of times various chapters and paragraphs began with LKY meeting with other political and academic elites outside of Singapore.

Rather than adopting a strict foreign policy of peace and goodwill towards all nations, LKY comes across as almost bloodthirsty in his description of Singapore’s role in the Vietnam War, describing American intervention as good and necessary, claiming the Vietnamese regime deserved to be “punished”, first in a cross-border skirmish with China and then by continuing sanctions and non-normalized trade and diplomatic relations between Vietnam and Singapore even a decade after the conflict ended and even going so far as to throw his lot in with the Khmer Rouge to counterbalance the Vietnamese puppet government in Cambodia, describing the decision as one arrived at after having “no choice”! If choice doesn’t play a role in designing policy, what need have we of great leaders like LKY?

And then there is Singapore’s role as arms merchant at various times in various conflicts…

And why was it so important to LKY to get agreements with other countries to host SAF detachments for training in unusual environments? Though we are told that the SAF was created to defend tiny Singapore, the desire to train in environments alien to the tiny tropical island seem to lead logically to one place– interventionism. I doubt LKY planned to militarily dominate the globe, but surely he hoped to have his forces participate in struggles that had nothing to do with the direct defense of the island.

While many of the political tours were related to commitments imposed by being part of the British Commonwealth and its former colonial possessions, there seem to be just too many instances of LKY as a global jetsetter to excuse. Why was this man hobnobbing seemingly everywhere but Singapore?

I don’t know what the meaningful difference is between a currency board and a central bank, but assuming there is one, LKY said that Singapore did not have a central bank because,

a central bank is an easy way out for a finance minister who likes to juggle [his figures] when he has a deficit in his budget. I do not think we should put such a temptation before the finance minister in Singapore.

And yet, we witness numerous examples throughout the book, including episodes in Indonesia, Malaysia, Thailand and the Asian Financial Crisis during which Singapore attempts to “defend” the value of other countries’ exchange rates through currency intervention in Singapore. Why? What excuse could their possibly be for this behavior other than trying to be a “player” in world affairs?

But it’s not all baffling. The book has its charming moments, too, including many glimpses into how world political figures really think and what they say about their regimes and records of governance behind the scenes. Take, for instance, this phallic competition between Indonesia’s Sukarno and Lee Kuan Yew:

[Sukarno] asked, “How big is your population?” “One and a half million,” I replied. He had 100 million. “How many cars do you have?” “About 10,000,” I said. Jakarta had 50,000. I was puzzled but readily conceded that he occupied first place in Southeast Asia in terms of size.

Or, the behavior of Indian officials in the face of new golf balls:

It was a gradual slide in quality of a once elite service [Indian Civil Service], now caught up in the throes of a social and economic revolution which had reduced living standards… they could not buy good (i.e., imported) golf balls because their import was forbidden… Our high commission had advised me to bring several boxes of golf balls to distribute to the committee members of the club. It was depressing to see top brass and civil servants breaking up the packages and taking fistfuls of golf balls to stuff into their golf bags.

Indeed, golf balls were so precious that caddies would dash into any house or rough to find them. Once, at the former Bombay Royal Golf Course in 1965, I sliced my ball into a squatter area [what is a squatter area doing within driving distance of a Royal Golf Course?] and heard the loud clatter as it fell on a zinc roof. My caddie dashed off, I thought to find out who was hurt. But no– a little boy emerged with the golf ball, not to complain of injury but to bargain over the price of the ball.

We also learn of the need to be street-wise when dealing with foreign communist dictatorships looking to play a little development scam on a credulous leader:

In February 1994, I signed the Suzhou Agreement with Vice Premier Li Lanqing in Beijing, witnessed by Premier Li Peng and Prime Minister Goh… the essence of the project was to transfer our knowledge of how to plan, build and administer a comprehensive industrial, commercial and residential park that could attract high-quality foreign investors… Instead of giving SIP their full attention and cooperation as was promised, they used their association with Singapore to promote their own industrial estate, Suzhou New District (SND), undercutting SIP in land and infrastructure costs, which they controlled… It was a chastening experience… For the Suzhou authorities, a signed agreement is an expression of serious and sincere intent, but one that is not necessarily comprehensive and can be altered or reinterpreted with changing circumstances… China has an immensely complex government.

But LKY was something of a shakedown scam artist himself as Singapore was seen as a “developing” but not “developed” economy for some time. After catching some American personnel spying in Singapore,

I told the British commissioner, Lord Selkirk, that we would release these men and their stupidity would not be made public if the Americans gave a hundred million U.S. dollars to the Singapore government for economic development. They offered US$1 million, not to the Singapore government, but to the PAP [LKY’s political party]– an unbelievable insult.

He engineered something similar with Japan,

The only important business I raised with Prime Minister Hayato Ikeda was the “blood debt”, a request for compensation for their wartime atrocities… We eventually settled this “blood debt” after independence, in October 1966, for $50 million [serious money for small Singapore when the dollar was worth something!], half in grants and half in loans. I wanted to establish good relations to encourage their industrialists to invest in Singapore.

American race-baiters like Jesse Jackson and Al Sharpton couldn’t have worked a better deal with calls for reparation that would just end up in their own pockets! He even tried the same scam on different terms with the Japanese at a later date, this time playing “Godfather” over a shipping lane:

To get the Japanese to help us, for example, in investing in a petrochemical plant, we had to remind them that their ships passing through the Straits of Malacca would have problems with toll collectors if Singapore were to join the other littoral states, Indonesia and Malaysia.

“Nice open sea lane you got there, it would be a shame if something happened to it,” said in a thick, Germanic Robber Baron accent. The shakedown later continued with “soft loan” subsidies available only to developing nations:

I protested to Fukuda that his officials had spoken of Singapore not as a developing country but as an industrialized one not entitled to soft loans from Japan… We would lose our General Scheme of Preferences (GSP) [like affirmative action for international trading partners who are non-developed countries] and other advantages before we could compete on equal terms.

“Soft loans” are a form of fraud where one entity makes loans to another entity that they never intend to be repaid and usually forgive entirely. It is an outstanding source of graft, especially in corrupt political regimes where outright bribery is outlawed by the lender nation’s laws.

When he isn’t reflecting on his own actions, LKY proves to be a biting and incisive critic and a truthful observer of laws and conditions in other people’s countries. Here he is on the European Economic Community, the predecessor to the EU:

With the other commissioners, I discussed how to avoid manufacturing those products that EEC countries would find sensitive because of persistent high unemployment. I discovered to my dismay that the list was unlimited. Any member country with any influence on Brussels, feeling the slightest pain, could appeal to Brussels for protection and would invariably get it.

This brief anecdote proves three things simultaneously– (1) contrary to propaganda, the EU is a protectionist trading bloc, not a free trading society, (2) there appears to be no nation on Earth that is led by politicians who understand the benefits of free trade, even unilateral free trade and (3) not even trade-dependent Singapore is able to gain a competitive advantage by being a true free trader because it was led by a Keynesian planner-mindset politician-in-chief, LKY, who had his own worries about managing unemployment in his country to risk upsetting bureaucrats in Brussels! Now that is global political power projection for you!!

Here’s another honest and insightful observation from LKY, this time about a faux pas made by an inept American president:

When I was leaving, he gave me a green leather-bound copy of his campaign autobiography [aw gee, what a nice gift, a hastily produced, ghost-written volume of propaganda], Why Not the Best? He had already inscribed it, “To my good friend Lee Kuan Yew. Jimmy Carter.” I was flattered but surprised by my elevation to “good friend” even before he had met me. This must have been a standard practice during his election campaign.

It makes you wonder if Jimmy Cahtah even bothered to sign it himself. If you’re going to piss off a foreign leader on a cheap gesture, spare no expense!

The book is rife with such charming episodes, I could fill the blog up with them. Instead, it’s worth saying something about Lee Kuan Yew’s somewhat confusing and arbitrary arguments for polylogist legal theorizing and the explanations he gave for the success of Singapore’s economic and national development since 1965.

As a polylogist, LKY is a skeptic of the idea of simply importing “progressive” legal principles from one population to another:

the are fundamental differences between East Asian Confucian and Western liberal societies. Confucian societies believe that the individual exists in the context of the family, extended family, friends and wider society, and that the government cannot and should not take over the role of the family. Many in the West believe that the government is capable of fulfilling the obligations of the family when it fails, as with single mothers… freedom could only exist in an orderly state, not when there was contention or anarchy. In Eastern societies, the main objective is to have a well-ordered society so that everyone can enjoy freedom to the maximum [even better if they’re ruled by people like LKY!]… Democracy works where the people have that culture of accommodation and tolerance which makes a minority accept the majority’s right to have its way until the next election, and wait patiently and peacefully for its turn to become the government by persuading more voters to support its views.

And yet, he encouraged China to join as a member of the law-abiding community of nations! How can China, whose authoritarian legal system is ostensibly appropriate for the culture and values of the Chinese, join the law-abiding international community whose laws and customs are foreign and antagonistic to the culture and values of the Chinese? One potential solution is that there exist in every society a set of elite individuals who are not beholden to local political bigotry and historical traditions but can instead transcend them and tap into a more universal logic. But if they can do this for their countries at an international level, why can’t they do this at the “local” level of their domestic politics?

This seems to present some problems for the polylogist approach of LKY, although I think there’s a perfectly simple, but embarrassingly revealing, answer that has something to do with the reality of power and how and why it is exercised in any society which the thoughtful reader can probably surmise with a bit of their own consideration.

I am not a polylogist. I believe there is one, universal human logic that all mature, physically functioning adult minds can understand and employ in their own thinking and communications. That being said, I think LKY is absolutely correct that it is absurd to believe one can foist political principles that were developed over hundreds or thousands of years of combined cultural history onto a population that has never utilized them before, such as using military Keynesianism to deploy democracy in Afghanistan and Iraq, particularly when in so doing the existing political arrangements and power structures are rapidly collapsed or, worse, ignored as if they’re unimpactful.

But more importantly, I think it is naive to expect any political principle, foreign or domestic, to work miracles. For example, believing the process of revealing voter preferences through democratic elections can somehow obviate the need for working within the confines of economic scarcity. Or, to use another example, instituting a vicious socialist dictatorship which doesn’t give a damn about anyone’s preferences, and expecting it to spit out the highest standard of living in the world for its people. So, there is some truth to what LKY is saying on this subject, just not much how he said it.

And how did LKY explain Singapore’s success?

the basic principles that have helped us progress: social cohesion through sharing the benefits of progress, equal opportunities for all, and meritocracy, with the best man or woman for the job, especially as leaders in government

I’d call this a bit of self-aggrandizing delusion. When LKY says “sharing the benefits of progress”, he means that he doesn’t believe the outcomes in a market society are anything but random (he makes this claim in an early section of the book), and that the wealth should be spread around by politicians through things like government housing projects and forced savings accounts. Of course, getting to hand out welfare goodies after an election is a good strategy for winning future elections– some might call this building “social cohesion” to a particular party’s cause, such as LKY’s People’s Action Party.

Similarly, it is pure fudge to claim that you provided equal opportunities for all while running a meritocracy. A meritocracy implies an inequality of opportunity– opportunity goes to those who show merit, having performed well with other opportunities. To give everyone equality of opportunity is not just wasteful, it’s impossible. Does everyone in Singapore have an equal opportunity to be Prime Minister like LKY, or just those who control a well-oiled electoral wealth redistribution machine like the PAP? The double fudge is insisting that government leaders themselves are examples of this meritocracy. Nobody wants to lose their subsidized housing for questioning the merits of their political leaders!

That being said, I don’t think LKY played NO part in the Singapore success story. There is something to be said for a stable political regime with predictable laws and regulations over a 40+ year period, especially one which tended more toward laissez-faire than most. And clearly, looking around the neighborhood (Malaysia, Indonesia, Vietnam, Cambodia… China) Singapore could’ve had worse political management than it experienced. I just think that the credit due is negative– it’s what LKY and his team didn’t do, that made Singapore great, not what they did do. That, and what they didn’t do relative to what the more eager regimes in neighboring jurisdictions did do over the time period observed. With racial tension in Malaysia, military government in Indonesia, socialist science experiments in India, a devastating civil war in Vietnam and the Great Leap Forward and Cultural Revolution in China, you didn’t have to be all that fast to win this footrace.

By just not getting out of bed and ordering an atrocity each day, LKY virtually guaranteed the investment, development and progress would come to his tiny island nation unimpeded for decades, just like it did. But since there’s no way to run a truly controlled experiment here, there’s no way to know for sure what might’ve happened under a different set of policies, so ultimately it’s Lee Kuan Yew’s word against mine.

Review – Restrepo

I watched a NatGeo documentary last night called “Restrepo.” It’s about the conditions and objectives of a small US Army platoon in the mountainous wilderness of Afghanistan.

Very little happens in this movie over its 1.5hr runtime. There is a lot of buildup and talk about how often the base is attacked, and this is depicted several times, but overall nothing happens. I don’t know if this was an intentional part of the plot (“the futility of the Restrepo mission”) or if it’s bad editing or belies a fraud about the claims being made in the film about what it is like for these troops, but it is not entertaining. And by that I don’t mean, “Gee, I wish there were more poor, dumb soldiers getting wasted in this real life documentary” but rather, “Gee, what am I getting out of watching this film?”

That being said, this is not good propaganda for the US government’s desire to nation-build overseas. Why does the military allow journalists and documentarians to embed with their troops? Restrepo is an offshoot of a slightly larger but still insignificant base tasked with enlarging the “security bubble” in the area so that a road can be safely built connecting two hapless economic regions into one, which is supposed to bring jobs, incomes and peace and happiness to the land. Every bit of tactical maneuver in war seems really stupid when studied by itself — “50 men gave their lives for a bridge that was ultimately destroyed by the enemy anyway, why did 50 men die for a bridge?” — but the Restrepo mission seems especially stupid not because these men are fighting and dying and accidentally murdering local civilians for an unbuilt road, but because the premise behind building the road is itself very stupid. Do the local Afghans even WANT this road? If they did, why didn’t they build it before the US Army showed up?

Is military Keynesianism a viable structure for developing foreign economies? Keynesianism doesn’t seem to work to develop domestic economies. And the military, professional murderers and demolishers, don’t seem to be the right people to task with building things, let alone people’s economies. Wouldn’t it make more sense to send overwhelming military force through the area, wipe out/expel the organized Taliban elements and then let civilian diplomats and construction contractors come through and negotiate new power structures and infrastructure plans?

The Korengal Valley itself, where the drama unfolds, is truly magnificent geography. It reminds me of the valleys I hiked on the Inca Trail in Peru on my way up to Macchu Picchu. In fact, the remoteness, the terraced cultivation and the “primitive” lifestyle and social organization of the Afghans looked nearly identical to what I saw in Peru. It seems like a perfectly nice place for the locals to live and you get the insane idea watching the movie that they never asked for the US Army to invade their territory and murder their wives and children in helicopter gunship assaults, and they’re not all that thankful for their service now that they’ve shown up. Would it be unpatriotic, dare I say even treasonous, to suggest that the Afghans are getting a raw deal here and it’s hard to wonder why they wouldn’t want to overtly or covertly support the Taliban in these circumstances?

That old quip about “I’m from the government, and I’m here to help you” runs hard through the film’s narrative. We see again and again the way the local commander makes big promises and doesn’t follow through– he murders a guy’s cow and offers no agreeable compensation, he disappears a local who he suspects of being an accomplice of the Taliban and then offers the vague assurance that he’s being treated nicely and will soon return though he doesn’t, and he responds to an attack by calling in a fire mission on a neighboring village that kills and maims several women and small children. I don’t care who someone is fighting for, if I had to hold the charred body of my innocent two year old in my arms and watch a bunch of crude monkeys rifle through the smoking remains of my home looking for contraband after such an incident, I think I’d lose my shit.

And what IS the best solution to murdering someone’s cow, anyway? If you could get your higher-ups to release the $400-500 cash to pay the guy back (I think the village elders took the US Army for a ride on that request, by the way, there is no way a cow is worth half a grand in the mountains of Afghanistan) doesn’t that incentivize them to let more of their cattle wander into your concertina wire whenever they lack liquidity? And if you can’t get that cash released, aren’t you guaranteed to keep pissing off the locals while insisting you’re there to win hearts and minds?

The long and the short of it is that imperialism is a terrible idea in the first place, but the United States government isn’t even good at imperialism. It is very half-hearted and half-assed in its attempts to brutalize and control foreign peoples and spends more time apologizing and groveling about its numerous mistakes than making any meaningful progress in terms of rapine and pillage. It makes you wonder the whole time how such a pointless and ineffectual system can sustain itself, until you realize that the people who are really getting mulcted in this process are the guileless American people “back home.”

And the poor, dumb US foot soldier is the tool used to tug at those people’s heart strings while picking their pockets clean. “Thank you for your service,” indeed.

Review – Invisible Wealth

Invisible Wealth: The Hidden Story of How Markets Work

by Arnold Kling, Nick Schulz, published 2011

Recently I found myself rooting around the in archives of sites like Let A Thousand Nations Bloom and Distributed Republic and I selected a few recommended titles about the frontier of economics, politics and soft institutions (culture, legal norms, etc.) looking for answers to these questions mentioned in an earlier post:

  • Why do political borders and different legal systems seem to have such disparate impacts on economic development?
  • Which follows which, the culture/political system or the economy?
  • How sound is the idea of “competition amongst governments” and why don’t we see more countries’ policies moving toward a “developed” mean?

Invisible Wealth proved helpful in thinking more deeply about the first two questions, but it really didn’t offer any insights on the third question. The book is a mixture of introductory lessons on concepts from “Economics 2.0” intermixed with interviews from numerous academic economists who have done research in the field of the interplay between economic development and social institutions. The strongest parts of the book are the interviews with the economists. The introductory lessons suffer from too many mixed metaphors (hardware/software layer, Malthusian meadow/food court, innovation as the heart of the economy) and the insistence on delineating economic ideas as part of 1.0 or 2.0 thinking seems contrived and forced, not only because there is no existing group of economic thinkers who so identify themselves as adhering to one system of ideas or the other, but also because there is an entire school of thought, the Austrian school of economics, which recognized the importance of both 1.0 and 2.0 concepts and successfully integrated them decades ago, but which gets no spotlight aside from the consistent mentions amongst the interviews of the importance of the work of FA Hayek as an exemplar.

Briefly, Economics 1.0 is supposedly Classical Economics, which sees all economic issues in terms of the three basic inputs of land (original, unprocessed resources), labor (the effort and ingenuity of human beings interacting with those resources) and capital (the factors of production generated by mixing land and labor for future production). E1.0 is obsessed with equilibrium and static economic models, which are amenable to mathematical and statistical analysis. In contrast, Economics 2.0 acknowledges the important role of entrepreneurs in managing change and dynamism in the economy. Sadly, the authors neglect the ultra-important dimension of TIME and the role this plays in production and the coordinating activities of entrepreneurs… which is why the Austrian school again seems incredibly advanced compared to this offering and might be categorized as Economics 3.0. But even ignoring time, E2.0 is a big advance on E1.0 in acknowledging change as not only a real phenomenon of economic systems that is neglected by E1.0, but also the central element of economic development and growth. For development to take place, change must occur, and for change to occur, there must be actors with an interest and incentive in causing the change.

This shifts the analysis from studying the mineral resources or accumulated capital of a community, to studying the existence and behavior of entrepreneurs as innovators improving economic outcomes for everyone. The question begged then is, “Why do some economies have a lot of entrepreneurs, or very talented ones, while others have none or poor ones (or corrupt ones who get wealthy making people worse off)?” And for an answer to that question, one must explore the role of institutions.

With institutions, whether we’re talking E2.0 or E3.0, it’s clear that the science is still developing on which institutions are important for development, what role they play and how they can be successfully built (a significant meta-problem, because often there is feedback between a poor economy and difficulty building strong institutions and so on). There are also so many potential institutions to consider that the analysis can quickly get complicated, for example:

  • Property rights (how to define, how to enforce, what can/can’t be owned and by whom)
  • Legal norms (ie, tendency to rule a certain way in a certain type of case)
  • Legislation (ie, “the law” that will be enforced, including civil, criminal and regulatory policies)
  • “Culture” (accepted behaviors, social expectations, traditions, ideals, even aesthetics)
  • History (this is an odd one because it is so intangible and uncontrollable, but the history that each community comes from has a real effect on shaping other institutions and thus economic outcomes)
  • IQ (more on summary findings from Hive Mind below)
  • Religion
  • The family

I think this is why the interview portions of the book really shine. It is here that we get a lot of competing theories of development and which institutional factors are most important and why. They not only highlight how unsettled this part of economic or social science is, but also they provide outstanding examples of how critical each of these factors can be. And there is a clear distribution of insight and intelligence demonstrated by these interviews as well– while almost all of the interviewees have earned numerous awards and accolades, including Noble Prizes, for their economic work, several stand out as innovative giants while others seem to trade in the same, tired old statist fallacies of yore. What follows are some of the quotes I thought were most fascinating.

Robert Fogel

RF emphasized the role of technology in development, because as he says, “technological advance is the basis for all economic growth.”

One measure of economic development he suggested was looking at life expectancy. A rising life expectancy implies that people are able to produce sufficient resources to protect themselves from basic environmental and health risks. However, in looking at the historical data, there is an interesting trend in early industrial European societies by which rural populations maintained higher life expectancies than urban dwellers until around the turn of the 20th century. He blamed this on changes in technology, because

when you walked around in New York City, you were breathing pulverized horse manure, a much worse pollutant than the exhaust of automobiles

That idea grabbed me, both because it is vivid and disgusting, but also because it highlights that economic development is fraught with risk and even though the “ultimate” destination of economic development might be a less toxic technology like automobiles, the “path” along the way might include way points with more toxic technology (pathogen-laden pulverized horse manure) which is worse for health outcomes than taking your chances with subsistence-level existence in the countryside. A question I had which wasn’t explored in the discussion is why a.) city municipal services failed to keep the volumes of horse manure out of the streets as part of a sanitation program or b.) why market entrepreneurs didn’t collect and sell this “fertilizer” back to the countryside? It could be a technological problem within a technological problem.

Fogel also emphasized that the rate of technological change appears to be increasing in industrial economies:

it took four thousand years to go from the invention of the plow to figuring out how to hitch a plow up to a horse… it took 65 years to go from the first flight in a heavier-than-air machine to landing a man on the moon

Now, the example is cherry-picked and there are probably still a lot of technologies we’re using that are 10,000 years old (for example, if we ever primarily grow crops indoors, one could say “It took us 10,000 years to go from growing crops outdoors, to figuring out how to grow them indoors”, which seems like a really long time to figure out what will at that point be a best practice idea) but it still has impact.

He also mentioned the importance of economic development for the well-being of the aged:

you need to have a successful and rapidly growing economy in order for standards of living for the elderly to improve

I think this is true because the savings of the elderly need to earn an increasing return in real terms for their standard of living to improve without being forced to consume their capital, which puts a fixed timeline on their survival once they run out of capital entirely. And the only way their savings can earn a greater real return over time is if the entire economic pie is growing. It’s an interesting example of the connection between economic growth and and humane conditions.

Robert Solow

RS highlighted the complexity of the problem of solving poverty in poor countries:

Without appropriate institutional infrastructure, without the right local incentives, without complementary human capital, aid and investment will be wasted… poor countries are not only poor in capital, they are poor in the factors that make for “total factor productivity”

This is a direct application of E2.0 thinking contrasted with E1.0 thinking. The E1.0 aid crowd believes that if you just redistribute enough of the world’s wealth to the poor countries, they’ll be able to escape poverty. But RS emphasizes that they’re not just poor in terms of resources but also in terms of institutions which allow them to manage and develop resources. If this is true (and I think it is), it certainly gives one pause before hitting the “Donate to Charity”-button.

Paul Romer

PR focused on changes in technological systems and the economic impact that comes from replacing an old technology with a new one:

We didn’t get that much more light by producing hundreds of thousands of candles per person, but by switching from candles to gas

He also discussed the way technological development may improve our capacity to make further discoveries,

it may be inherent in the process of discovery that the more we learn the faster we can learn

and the impact that improvements in institutional technology have allowed us to harness those discoveries with greater efficiency:

the modern university and research system was designed not to create property rights but to lead to the rapid dispersal of new information; academics were rewarded based on the priority with which they disclosed information, so that the first person to disclose gets all the professional credit for discovering something new

[…]

what we’ve done is created better institutions over time, so that we now exploit the opportunities for discovery much more effectively than we used to

The most important insight from his interview was that growth requires change, and change creates “winners” and “losers”, and it’s easy for the losers to become a special interest group and lobby the government to arrest the change:

everyone wants growth but nobody wants change, and you’ve got to have both or you’ve got to have neither… change accompanies growth… when you have change, there will inevitably be winners and losers… we can’t let a small group of losers — either absolute losers or relative losers — stop the process of growth that will benefit most people going forward

Incidentally, this is why countries pursuing socialist policies stagnate. Socialism is a policy that preserves the status quo and tries to equalize outcomes that are created by change. Inevitably, equalizing outcomes ends up stopping the change itself and thus stagnation sets in.

Joel Mokyr

JM was actually one of my favorite interviews, so I will quote him extensively.

First, he talked about the reasons why humanity has gotten increasingly technologically advanced over time:

inventions are made when there is a minimum epistemic base… you cannot build a nuclear reactor by accident… but you can invent aspirin quite serendipitously, without having the faintest clue about how it works

[…]

We invent something, and sometimes we know a little bit about how it works, sometimes we know nothing, sometimes we know quite a bit, but in all cases, as we use it more, the epistemic base gets wider.

This technological advancement requires time, and a bit of luck, because

the only way we can think about technology is in evolutionary terms… a kind of science that makes no predictions

That’s also a really interesting idea because some economists have claimed that “science is prediction” and thus any economics which does not concern itself with empiricism and making valid predictions is not scientific. But here we have two examples (evolution, and technology) of sciences where prediction is not possible. Does that mean they are not scientific?

Later, JM goes into an explanation of the way changing technology led to economic development, and the way economic development impacted institutions and social ideas, and then the way this fed back into attempts to limit technological development and, by extension, economic development:

If you look at Europe in 1650 or 1700, what you see is a very sophisticated set of economies. They have just basically finished exploring the rest of the world, and there has been great deal of commerce and trade — joint stock companies are emerging, insurance is emerging. This is a fairly sophisticated commercial economy. The problem is, there are lots of special interests trying to get exclusionary arrangements that are good for them but bad for the economy. This is a system in which property rights are well defined and enforced, as Douglass North loves to say, but also rather distortive in the sense that you have lots of exclusionary arrangements. In other words, for the economy to function well, you don’t just need good property rights, you also need what we could call, somewhat vaguely, “economic freedoms.” You need labor mobility; you need to get rid of guilds; you need to get rid of monopolies, both local and global; you need to get rid of all kind of regulations; and above all, you need free trade. And if you don’t have that, you’re going to end up in a society that will not be able to grow.

Nowadays we have a different term for this. We call it corruption. We always say, look at countries like Russia or the Central Asian nations — these countries will never have good economies because they are corrupt. But corruption is really just a special form of what we call, in economic jargon, “rent-seeking.” I argue in my book that one of the things that happens in eighteenth-century Europe is a reaction against what we today would call rent-seeking, and that this, to a great extent, is what the Enlightenment was all about. The Enlightenment wasn’t just about freedom of religion and democracy. It wasn’t to be about democracy at all, but never mind that. It was about freedom of religion, tolerance, human rights– it was about all of those things. But it was also a reaction against mercantilism, and you find that attitude in certain people who were very important in the Enlightenment. Above all, of course, the great Adam Smith.

[…]

when you look at the few places in Europe where the Enlightenment either didn’t penetrate or was fought back by existing interests, those are exactly the countries that failed economically [Spain, Russia]

This is definitely a different take on the Enlightenment than I have come across before, but it makes a lot of sense to me and seems to do a good job of integrating economic, technological and political phenomena of the time period!

nobody has held technological leadership for a very long time… technology creates vested interests, and these vested interests have a stake in trying to stop new technologies from kicking them out in the same way that they kicked out the previous generation

That is the feedback loop mentioned earlier, and why the Enlightenment might have been a reaction against a vested interest reaction.

Cardwell’s Law: the more open the world is, the more free trade, the more ideas and people can move from one country to another, the less likely it is that technological progress will come to an end

This idea gives hope that there is a case for rational optimism assuming liberal social institutions around the world.

if you change the institutions but don’t change the culture, you’re not going to change the institutions

[…]

the degree to which we hold fast to the wisdom of earlier generations is an incredibly important element in how innovative a society is, because if you think about it, every act of invention is an act of rebellion

This suggests that “conservativism” as a social policy might lead to stunted economic development, depending upon when marks the beginning of what traditions and systems one is trying to conserve. It also highlights the problem that RS mentioned, namely, that there is complex interactivity between social institutions which enable economic growth and it’s possible that a “backwards” culture could interfere with or limit the effectiveness of “progressive” social institutions as a whole, so it’s not as simple as, say, invading a country and giving them a modern political constitution (ignoring the obviously negative social impact of a war!)

And this might seem like a throwaway quote, but I thought it was interesting:

Over most of history people have not voted their pocketbooks — Marxists included.

Thankfully! Because if they did, or do, then it will be truly hopeless to expect any kind of reform ideology to take place in the face of billions of people who could “vote their pocketbook” and keep instituting handout systems that impoverish everyone.

William Easterly

WE focused on the appropriateness of specific institutions to solving specific problems, namely, the planner-mentality to solving poverty. He looks at poverty as a circumstance created by a lack of innovation, and he identifies planning as a practice which is antithetical to innovation. Thus, planning can not solve poverty:

Planners think that the end of poverty requires a comprehensive, administrative solution. They’re trying to do something that’s a lot like central planning in the old, Soviet-style economies, in the context of poverty reduction.

[…]

It’s as if central planning has been totally, mercifully extinguished everywhere else except [in the areas with] the world’s desperate, poorest people, who can least afford such a dysfunctional solution to their problems — [areas] where it would be much better to imitate the mentality of free markets, which are all about giving financial incentives and motivating people to meet consumer needs.

[…]

corporate planning is just about scaling up a solution after you find something that works… you can’t use planning to find what works

William Lewis

WL, like JM, emphasizes the way that institutions can be used to enable and unleash innovative forces, or to restrict and restrain them. He also talks about attitudes of people in the industrialized West who are trying to create panacea solutions for people in poor countries:

Just because people are not educated does not mean that they are incapable, which is a mistake educated people in the West often make.

He points out that if the opposite were true, poverty would be a necessary part of the social landscape for much of the world for at least the next 50 years while several generations of people are being educated. But this wasn’t the pattern of development in the industrial countries before they obtained their industrial development and he doesn’t think it’s a good assumption for the remaining non-industrial countries as well.

No producer – no producer – has ever asked for more competition. So these domestic producers are really the secret enemies of globalization and they are exerting a lot of influence against it.

There’s that feedback loop! And it gives us an insight into the truth of protectionist policies, which don’t enable development but rather enable special interest groups to profit patriotically.

[Gordon] Wood showed that at the time of the Revolution, consumerism exploded in the United States. And consumerism was associated with fundamental notions of individual rights. Prior to that, at least in the feudal societies of Europe, consumption was viewed as a luxury to which only the land-owning class was entitled.

I’ve got a Gordon Wood book on my stack right now so I am excited to explore this idea further, this is another example of integrating economic and political ideas holistically and applying them to the analysis of a historical period to yield an interesting result.

And of course, the way you make a plan happen is by having a plan for production, not for consumption. There is no way you can plan or affect the individual choices that people make as individuals when they buy things, but you certainly can affect strongly what they have to buy through production planning. So this whole producer orientation was aided and abetted in modern times by the planning idea. It’s easy to see where the idea came from in feudal times– basically, the landowners and the people who owned the capital could control what happens. They were the only ones who had the ability to do anything. This whole battle for individual rights, for the political philosophies based on individual rights, and for what immediately comes from those political philosophies — namely, the idea of consumer rights — has expanded around the world to a relatively small degree.

Earlier I had mentioned [amazon text=Hive Mind&asin=0804785961]. Here are some “institutional” effects of High IQ societies, according to the author.

High IQ:

  1. Correlated with higher savings, which means more capital which raises the productivity of all labor
  2. Correlated with more cooperation, which means less corrupt government and more productive businesses
  3. Correlated with social market orientation, a form of social organization key to widespread prosperity
  4. Better at using “weakest link” team-based technology

So one challenging idea from Invisible Wealth and some of these interviews is that poor countries, in so far as they demonstrate low average IQs, as well, may have a more difficult time creating the institutional arrangements necessary to allow for sustained economic development. That has many ramifications for social policy if it’s true!

I noticed also that this idea about the importance of institutions is exactly what Hernando de Soto was discussing in his The Mystery of Capital, which I read last year. His approach was to emphasize property rights and formal versus informal economies. His argument was that poor countries tend to have major urban areas centered around the political capital where the elites in power and their cronies have the benefit of property rights enforcement and thus are able to build and accumulate capital, whereas the squatters and poor folk in the outlying communities not only have no property rights but are actively prevented from developing them or having them recognized by the formal legal system. The result is an estimate of trillions of dollars of capital “frozen” in informal structures which limit their exchangeability and thus their value, usefulness and ability to be improved or accumulated over time.

Diversity And Sameness

Walking into a small Florentine osteria like Cinghiale Bianco — there don’t appear to be any large eateries, and even after spending a whole semester in Florence and now revisiting, I still can’t figure out what the difference is between osterie, ristoranti, tratorrie and the like — I am immediately struck by the diversity and efficiency of these spaces.

In the United States at least there is a seeming obsession with uniform geometry. Every place, fancy or hole in the wall alike, is cubic and utilized in cubic form. All I have to do to clarify what I mean by this is to paint a picture for you of Cinghiale.

This little restaurant has three galleries for diners. The first is rectangular in the front and seats two rows of 4 seat tables and two rows of six seat tables. The second gallery is another rectangle behind it but attached at one of the corners and perpendicular to it. It has three tables of four and a table of two as well as a “nook” buried in the street side wall (bordering the first gallery) which seats 4 or 5. This nook has an arch and the whole thing is constructed of gloss painted brick. Above it is the third gallery, seating 2 or 3, which is accessed by a small ladder step way as if it belongs in a library bookshelf. The ladder is in the second gallery but the third gallery looks out on the first. Its claustrophobic, romantic and dangerous– a sign warns you in Italian to watch your head as you climb up because a support arch of the wall leaps out and cuts across about three feet from the top of the ladder.

I can’t even imagine how many OSHA and fire code regulations such a design would garner in the US. In Italy I’m sure this place is legally protected from ever being renovated!! The law is a singularly irrational and subjective institution wherever in the world it is crafted.

The interior of the restaurant is white washed plaster over occasionally exposed brick and dark painted timber support beams. The walls are lined with shelves covered in wine bottles and carrafe pottery. The tiny hallway segueing the first two galleries has an indent about five feet up that serves as the coat hang.

Cubic architecture should be more economical and efficient both to construct and maintain and utilize for a variety of functions, which is why I assume it is so prevalent in the US. And yet, its hard to not be charmed by the efficiency of this humanistic design in little Italy.

To a traveler, this is diversity. But the shocking truth of Italy is that all these little towns are like this. All the restaurants are ancient and cute and cozy. All the towns you ride the trains through up and down the coast are painted in a variety of dark pastel tones such as red, pink, and yellow with green window shutters. Everywhere they offer the “cucina tipica.”

Every city and village has a copy of the Garibaldi statue.

They serve the same food at every restaurant. The pasta is always good even when the meat dishes are second rate at the tourist traps. Its actually hard to find anything that isn’t Italian. Its a country that has failed by successfully and faithfully embracing mercantilist self-sufficiency, even though the osterie sometimes serve Tunisian olive oil, a blasphemy of ever there was one.

And in these ancient places nothing ever changes. It will all be here, the statues and paintings and museums and history and restaurants and hotels, next time.

Is that a good thing or a bad thing? I suppose it depends who you are and what you’re after. Its hard to imagine businesses shutting down, even in a recession — more economic thoughts in a coming post — and I’ve yet to see entire city blocks with For Lease or for Sale signs as there would be in the US. But I also don’t see how you could avoid being a 60 year old waiter one day. Or how you’d ever get to live a “modern” life of new things if you were just an average Joe. Or Jiacomo as it were.

Many of the portraits in the Uffizi, it turns out, were the likenesses of various condottieri of Florence under the Medicis. They were celebrating these military contractors who helped them crush their neighbors and enemies.

Today there are no more contractors in Italy. But the US government employs thousands. Do things ever change? Are we all that different? Which is modern, and which is not?

Notes – The Art Of Profitability

Notes from The Art of Profitability, by Adrian Slywotzky

Chapter 1, Customer Solution Profit

The Customer Solution Profit (CSP) model encapsulates the idea of understanding the customers problems and then providing them with a solution to their problems.

In the narrow sense, the CSP model captures the idea of having an intense, personal and detailed understanding of the challenges a customer faces and then providing them with a unique, custom-tailored solution that meets their needs. Such a relationship requires upfront investment of time and resources from both parties (the business and the customer) and it entails high switching costs because finding a competing business who can offer that same level of personalized service would require the loss of previous investments made in the existing relationship. This helps to create a “moat” around a CSP model business. Some examples of a narrow-CSP business would be a software solutions firm (a company producing custom back-end software that an operating company runs off of), a consultancy business, the professional relationship of a trusted lawyer or doctor, or a manufacturer of custom fabrications. The recent rise of information analytics engendered in data mining through web browsing activity also represents a form of narrow-CSP business modeling– think about the way Google can track your browsing habits to serve up targeted ads, or the way Amazon tracks your browsing and purchasing history to suggest items you may be interested in purchasing from them.

In the broad sense, the CSP model actually applies to ALL businesses. Every business seeks to create customers, and the way businesses create customers is by finding problems customers have that the business can solve. In Chapter 1, the guru David Zhao asks the protagonist, Steve, “Can you be profitable without knowing the customer?” It’s possible to think of semantic games you could play to answer this question in the positive, and surely there are some businesses which know their customers better than others, but in a general sense the answer is clearly “No.” To provide someone with a solution, you have to know them enough to know their problem.

The context of this question is partly related to Chapter 1’s exploration of the company Steve works for, Delmore, which by Steve’s judgment is a business which has seen growth in the past but seems to be stumbling and may even be heading for a downfall. Steve believes Delmore has lost its way and is not focused on serving the customer. Zhao’s question resonates even more in this regard because Delmore’s management seems more focused on administering the business rather than knowing its customers. In the present, Delmore still appears to be profitable (though much less profitable than its heyday), which seems to suggest that even a company that doesn’t know its customer can be profitable. But the implication of Zhao’s questioning is that over the long-run, Delmore will not be profitable if it can not find a way to focus on understanding its customers better.

Another idea explored in Chapter 1 is the role of company culture. Zhao talks about consulting for a company after learning the secret sauce of their competitor. He says he hand delivered the total solution to the business he was advising and they only ended up implementing part of it– they saw a pick-up in their business as a result, but it was not as dramatic as it could have been if they had implemented his ideas wholesale. Why, Steve asks, do some businesses behave this way?

To succeed in business you need to have a genuine, honest-to-goodness interest in profitability.

This suggests that differences in margin structure and net profitability for companies in the same industry could come down to the “profit culture” of the business, likely established by the original founders and permutated by succeeding hires and executives. They could have the “technology” or strategic know-how to earn a profit, but simply be disinclined to work hard enough or with a unified purpose or without the ego necessary to fully capture the opportunity available to them. This idea also introduces additional context for why much M&A activity rarely seems to bring the “synergy” promised by combining two companies into one– if they have wildly disparate cultures, getting the same performance out of the new company as was available in the two separate companies may be impossible, and cultures may clash so wildly that the overall profitability is in fact harmed by corporate unification.

The subtext to the entire chapter on Customer Solution Profit models is that to really understand the value of a business, you must look at what customer problems the business solves, and how. By studying what is unique about the customer solutions the business offers, you are able to have a better analytical window into the durability of its competitive position, the source of its profitability and profit potential, its opportunities for growth and the stability of its margin structure.

Chapter 2, Pyramid Profit

The Pyramid Profit model consists of multiple quality and price tiers for products, targeted at multiple types of customers (and customer preference), which creates two powerful dynamics for the business:

  1. Protects them from competition from market entrants below (commodity market)
  2. Creates profitable “customer migration” opportunities as loyal customers move up the steps of the pyramid (franchise market)

Why is this model so powerful?

As guru David Zhao teaches,

Your pyramid has to be more than just a collection of different products at different price points. A true pyramid is a system in which the lower-priced products are manufactured and sold with so much efficiency that it’s virtually impossible for a competitor to steal market share by underpricing you. That’s why I call the lowest tier of the pyramid the firewall. But the most important factor is the nature of your customer set. The customers themselves form a hierarchy, with different expectations and different attitudes toward price.

The competitive environment all businesses would prefer to have is that of a franchise, where their product is deemed uniquely valuable and essential such that the business can capture a franchise premium in its margin structure, a premium which is enduring and protected from competition over time by the proverbial “moat.”

Simultaneously, the competitive environment all businesses fear is that of a commodity market, where the only way to distinguish your product from someone else’s and incite the customer to buy is by offering the lowest price. It is a true race to the bottom and the turnover for businesses in commodity markets can be quite high.

As discussed in Clayton Christensen’s classic, The Innovator’s Dilemma, most innovators arrive in a market as low-cost entrants. Incumbent firms see no problem in giving the low-margin business dregs to them as they’re happy to play in the higher-margin markets upstream. The hungry commodity firms are constantly looking above them at the juicy margins available in this other market– can they apply their innovative, low-cost practices to this higher-margin space and move in for the kill? As Christensen details, so often they try and succeed.

This is the genius of the Pyramid Profit model. Incumbent firms are protected from innovative, low-cost competition by offering a low-to-no margin product that creates a competitive “firewall” at the most vulnerable place in the market, the violently dynamic commodity space. Then, they are free to play in the middle and higher margin markets without stress.

There is an additional benefit, as well. By capturing new customers even at the low-margin end of the market, the firm is able to increase customer loyalty and brand familiarity over the customer’s lifecycle. Over time. these (presumably) younger, poorer customers turn into older, richer customers following the circumstances of life.

The value of a Pyramid Profit model depends on the shape of the pyramid. A pyramid with a wide base and a narrow top is relatively inefficient and less valuable as most of the business volume is captured in the low/no-margin mass market whereas the high-margin premium market remains under-promoted. An ideal shape would resemble something more like a skyscraper tower– the same width for all tiers, all the way up, with enough segmentation via price/quality tier to progressively move customers up the pyramid at a rapid pace. The more business that is concentrated at the upper levels of the pyramid, the better the margins and the more profit the firm can earn.

The Pyramid Profit model can be found in many well known businesses, even though it is a rarer circumstance than that of the Customer Solution Profit model discussed in chapter 1. A good example is the automobile industry with its “economy” and “premium” brands (for example, Honda and Acura, or Chevy and Cadillac). Even within each brand, many manufacturers have managed to create a “pyramid” of quality, price and even features/capabilities (for example, Honda has the LX base model, EX, EX with leather and EX-L with navigation; it also has the Civic for the entry buyer, the Accord for the more sophisticated, the Odyssey for the family buyer, etc.). Another example would be the airline industry, such as Virgin Atlantic’s “Economy”, “Premium Economy” and “First Class” seating and service tiers. However, no airline seems to have created separate brands/carriers that focus on one tier of the pyramid over another, instead this segmentation always occurs per aircraft (contrast this to a “single class” carrier such as JetBlue or Southwest Airlines, though notice that even these firms have begun to offer new passenger tiers for additional money such as early boarding, extra luggage capacity, etc.)

Speaking of the auto industry again, one of the most prodigious Pyramid Profit employers has been Toyota. Toyota offers three brands in the United States: Scion, Toyota and Lexus. Scion was a brand developed specifically for the young car buyer, initially offering lower price points, simpler model choices and a “no bargaining” purchase experience that was supposed to capture a first-time buyer and put them into the “Toyota system” for the rest of their automobile-buying lives. Then, there was the mass market, multi-trimmed and multi-segmented Toyota brand, offering cars, vans, SUVs and light trucks to the everyman. And finally, there was Lexus, the flagship brand for wealthy, older, image-conscious and highly-demanding customers.

Toyota’s pyramid is awkwardly shaped, however. It’s base, Scion, is minuscule and definitely low/no-margin. The middle step is enormous and fairly profitable relative to the rest of the industry. And the top is much wider than one would expect it to be, being both relatively high-volume for a luxury market and quite profitable despite ongoing margin erosion in the industry overall. Indeed, Lexus auto dealership franchises are consistently one of the most valuable and sought-after brands in the industry alongside BMW and Audi, commanding high market multiples reflective of their premium value.

The key to a successful and highly profitable pyramid is twofold. First, you must be lucky enough to operate in a market that is conducive to segmentation of customers (especially self-segmentation). Second, you must know your customers well– the Customer Solution Profit at work again! The better you understand your customers and their specific needs, the better you will be able to create custom quality and pricing tiers in your pyramid that will meet their subjective needs.

Chapter 3, Multi-Component Profit

The central idea to the Multi-Component Profit is “same product, several businesses,” in contrast to the Pyramid Profit which targets distinct customer sets with distinct product offerings (differentiated in terms of quality and price). The example given in the book is Coca-Cola, which may be offered at several prices in several different venues ranging from a 6-pack at a gas station to a 2-liter bottle at the grocery store to a glass at a restaurant. The price per unit is different in each case,  meaning variable margin structure, but the customer is captured nonetheless at each consumption opportunity.

While each of these margin structures and business opportunities combine to average out to one margin for the controlling firm, Coca-Cola, each product represents a unique business opportunity from the standpoint of marketing and advertising, competitive dynamics and ultimately, profitability. And this is where the secret of the Multi-Component Profit lies– just as an entire economy can benefit from the division of labor by breaking large tasks into smaller ones that individuals can specialize in, an individual firm can benefit from identifying ways to segment its large business into several smaller, distinct components, managing each one uniquely.

How is this possible? If the price of a firm’s good is set at one price regardless of the volume, and marketed in a uniform way, the firm can miss opportunities to sell their product to a.) people who don’t see value in marketing not aimed at their needs and tastes and b.) people who would be willing to buy the product at a different price and in different quantities than how it is normally offered. By catering to these preferences as distinct markets, the business is able to offer optimum combinations of price and quantity that meet each markets needs better, thus increasing total volume and profit.

Another example of a Multi-Component Profit model at work would be a software operating system company, such as Microsoft, which has different business units for Business/Enterprise, Government/Education and Retail and Wholesale channels. Each user buys a different amount of software licenses and pays a different price for them. This would also be a principle at work in a computer manufacturer’s business, such as Dell (same business lines), or a networking component company like Cisco.

Would an oil producer qualify, such as Exxon Mobil? An oil producer actually produces a number of slightly differentiated products depending on source and quality of the oil sold (West Texas Intermediate, Brent, etc.) which would seem to put it more into a Pyramid Profit model, though even that relationship is tenuous because oil is a nearly ideal commodity product in the sense that it is hard to create a “firewall” product as well as to move customers up a pyramid structure, especially with the fact that oil tends to trade at a uniform price across world markets no matter where it is produced (if it is of the same type). An oil firm probably does not give significant discounts to “different customers” based on quantity ordered, either.

Similarly, an oil refiner would seem to be a Multi-Component Profit model with its different kinds of refined products marketed in different ways (kerosene for lamps, or kerosene for jet engines) but again, these markets are so commoditized and regularized across world markets that it is hard to imagine these businesses creating separate marketing and pricing initiatives for differing customer demand, instead just dumping their product into various wholesale markets that then re-sell the products to end users (though perhaps these businesses are in the Multi-Component Profit model).

Over time if I think of other examples, which there undoubtedly are, I’ll post them but for now I will close out these notes with this summary from the book’s protagonist:

Different parts of a business can have wildly different profitability. The customer behaves very differently on different purchase occasions. Different degrees of price sensitivity.

The value of this lesson, as the book’s guru says, is that constant innovation is a key ingredient to maintaining and growing the profitability of any business, and one way to innovate is to find ways to break your existing business into smaller and smaller components which can be separately managed with unique marketing, growth and profit trajectories.

Chapter 4, Switchboard Profit

The Switchboard Profit model combines three essential elements to generate outstanding profit:

  1. Packaging; the provision of necessary component resources for a task in one place/package that can be hired together instead of separately
  2. Monopolization; control of a critical resource that all users need to hire
  3. Market share; control of a critical mass of the total market (approximately 15-20% minimum in practice) which gives the perception of dominance and incentivizes economic actors to utilize the switchboard firm, thereby creating a multiplicative network effect that enhances the value of the switchboard with every additional increase in market share

Those are the essential ingredients. The way they work together to create outstanding profit opportunities is like so: limiting competition and reducing transaction costs. Those are the primary principles at work. By putting together various resources which would normally be hired separately (and thus, would be exchanged each in their own competitive markets), the Switchboard Profit model brings these resources under one roof where they can be hired together (packaging), where they can be hired no place else (monopolization) and where other similar resources, typically skilled labor, are thus attracted to because they see the probability of being hired at advantageous rates themselves to be much higher by participating in the network effect of the Switchboard Profit model firm (market share).

The result is a constrained supply which can negotiate for a higher total hire price. It is valuable for those hiring the products of the Switchboard Profit model firm to pay this higher price because they save on search costs and they also face the alternative option of hiring lower quality substitutes. The more that the resources in question come under the control of the Switchboard Profit model firm, the greater profit the firm can generate from being the central hub for hiring the resource out.

One company that sounds like a Switchboard Profit model on its face is Amazon, a logistics giant that aggregates numerous consumer goods in one place. This satisfies the packaging criteria, and it almost satisfies the market share criteria as suppliers of goods want to participate in Amazon’s marketplace because it can increase their market exposure and thus the chance that the product will be purchased. But Amazon does not maintain anything close to a monopoly on these goods because they’re widely available “commodities” rather than unique or limited supply products carried only by Amazon.

The example given in the book was the Hollywood talent agency of Michael Ovitz. Ovitz combined top star power with “total production resources” (writers, actors, directors, etc., all in one place) and he commanded a large share of the market such that additional writers, actors, directors, etc., had a strong incentive to join his firm and thus increase his profitability as his market share grew. An obvious additional example would be any other large, dominant talent agency such as for sports stars, musicians or other celebrities who each represent unique products that can be easily “controlled” and “constrained” by one firm.

The network effect seems to be a key aspect to the profitability of the Switchboard Profit model. Google’s dominance in search means it is largely the central hub by which people conduct their internet searches, meaning a person buying ad space in the Google network is getting a better package deal than other search network ad buyers.

A television network might also qualify as a Switchboard Profit model: if you have the best shows on TV and a large market share with all the kinds of shows in one place that people might want to watch, advertisers will be more attracted to you and so will TV show producers and so, too, will TV viewers. And the more people who utilize your TV network, the more valuable it is to everyone involved.

Other examples might include a health insurance network which includes top medical professionals under the insurance plan; a legal association with the best legal minds in a market in one place; or even a top university or research institution known to have the brightest minds.

Something interesting about the Switchboard Profit model is that most of these businesses seem to revolve around human resources, rather than non-human resources (commodities which are common or rare alike).

Chapter 5, Time Profit

Many of guru David Zhao’s profit models come with simple illustrations which capture the essential ingredient of the profit model. The image of the Time Profit model is an X-Y axis with “$/unit” on the Y-axis and “time” on the X-axis. Plotted across this chart is one line, which runs from the top left corner toward the bottom right corner at a 45-degree angle reading “Price”, and another line below that labeled “Cost” at a more mild angle, eventually intersecting with the “Price” line near the right side of the chart and then overtaking it.

The concept is simple: Time Profit is generated by being the first to market a new product or service because over time imitators will compete and eventually drive price toward cost. Time, therefore, is of the essence.

In TAOP, Zhao and Steve discuss Time Profit models in the context of firms without special legal protections (such as patents or copyrights) on their works which serve to shield them from competition. However, whether such legal protections are permanent or limited in duration, the Time Profit model principle is the same– only by being first to market would you even be afforded such legal protections in the first place, so there is an incentive to be first else you finish last.

Zhao and Steve discuss the Time Profit model within the context of an investment bank constantly innovating with new financial products. But this model could also easily apply to pharmaceutical and software development companies (which enjoy legal protections on their products), as well as a tech product manufacturer, such as a smartphone manufacturer, whose core product features are likely not subject to legal protections. Here, the Time Profit model is essential as the first firm to get a product to market with a valuable innovation that creates a consumer craze can capture a premium for their products while competing firms figure out how to duplicate this technology and make it standard in their follow-up product offerings. These “second place” firms are doomed to earn commodity returns on their products, only the first-mover gets to enjoy a profit premium.

Like the Customer Solution Profit model, the Time Profit model is more than just a specific business model, it is something of an essential feature to the competitive conditions of any firm in any industry facing innovative development which, practically speaking, is all firms in all industries. Whether a new product, a new service or a new internal or customer-facing process, all businesses seek to adopt one another’s best practices to save costs and increase profitability. The first firm to innovate something that is eventually imitable by others gets a profit advantage during the period of time between innovation and imitation by others. Time Profit models can be thought of as temporary competitive advantages due to periodic innovation.

As David Zhao teaches, a key component of the Time Profit model that is often overlooked is the role diligence in the innovative process plays:

Tedium is the single greatest challenge for a business that’s built on innovation

The first act of innovation is thinking, the arriving at of a brilliant new idea. The second act, and far more important, is the doing, the translation of an innovative idea into an innovative product, service or process. This part requires the same rigmarole of standard business practice: making phone calls, sending emails, training people, holding meetings, crunching numbers, keeping people on task and pulling in the same direction, etc.

Innovating, idea-making, is sexy and fun. But turning innovative ideas into real profit is often boring, common and time-consuming. The people and firms that are able to apply energy and determination to this part of the process are the ones who can most consistently capture the Time Profit. As innovator Paul Cook says, “What separates the winners and losers in innovation is who can master the drudgery.”

Ancillary Notes

Chapter 5 had a few other points worth mentioning, some of which were connected to carryover discussions from earlier chapters.

The first point concerns the power of critical numerical thinking. When working through a number problem, Zhao advises,

Getting the order of magnitude right is what matters, not the details

This is similar to Buffett and Munger’s “approximately right versus precisely wrong” dictum. Zhao also talks about using the numbers to ask and answer critical questions; the numbers of business (assumptions, projections, actual results, etc.) can tell us a story, but we have to be curious about the numbers. It’s not enough to wonder, “Why are the numbers what they are?” we have to be able to put forth some effort to attempt to answer such questions ourselves. As Zhao says,

Being able to take the measure of the world is one of the most crucial skills we can develop

The second point, which is arrived at in a discussion of business innovation, is the “paradox” Zhao observes in the semiconductor industry, which is that the firms involved “copy each other’s chips, but not each other’s business models.” It is the business model which is responsible for mastering the Time Profit concept and other models discussed in TAOP– why don’t more managements focus on copying successful business models rather than imitating successful products and services?

It brings to mind a question for potential investors, too. Which businesses could see their value dramatically improved by focusing the company’s efforts on copying the leading business model in the industry rather than engaging in the rat race of perpetual product innovation/imitation?

The final point has to do with the nature of learning. Steve the student asks Zhao for a copy of his notes from a previous meeting. Steve wants to see how Zhao solved a problem they both worked on. Zhao suggests,

you’ve got to learn how to solve these problems in your own way

the idea being that true knowledge means being able to solve a problem in your own way, not by imitating somebody else. This is why some firms are innovators while the rest are imitators. Innovators are capable of solving problems their own way; imitators just copy the innovator’s solution. But it’s a lesson that’s important to the budding business analyst, as well. How will you solve problems when there is no guru there to teach you? You have to find your own path and do your own thinking.

Until you can do that, though, as Steve says, copying a few “Picassos” to practice a known master technique can be helpful.