Links for Thought -- April 6, 2012

Disruptive Innovation: Can Health Care Learn from Other Industries? (HealthAffairs.org) -- This is a great conversation with Clayton Christensen on the impact that disruptive innovation can have on the health care industry.  Christensen gave us THE essential mental model for understanding innovation, and it's important to understand how this model will impact health care over the coming years.  One of my biggest critiques over the health care cost concern is that the entire conversation assumes the past growth rate will continue forward in perpetuity.  Meanwhile, right now there are rapid deflationary innovations sweeping through the industry that I think will not just mitigate, but realistically will drive down the cost of medical treatment over time.  In order to understand this, one needs to know the distinction between something that is merely an innovation, and something that is a DISRUPTIVE innovation.

Important Read on Franchise Investing and Investing "Gurus" (CS Investing) -- Important read is definitely the best way to describe this post.  Here CS Investing gives us a look at what a competitive moat is and what the concept means.  Plus we get a great glimpse into how some of the most prominent investment gurus, including Warren Buffett, analyze moats when making their own investments.

Keynes: One Mean Money Manager (Wall Street Journal) -- Jason Zweig takes a look at the investment track record John Maynard Keynes and wow was it fantastic.  Despite Keynes being a macroeconomist, his successes in investment were primarily driven on the micro level, combined with an understanding of the behavioral element to investing.  This closely aligns with the value investing school of thought on markets, that alpha is possible with scrupulous fundamental analysis.  

Climate Change Isn't Liberal or Conservative: It's Reality (Boing Boing) -- In all seriousness, the title of this article should go without saying.  I first learned that climate change was real when the family swimming pool, which had frozen every summer as a child for me to play hockey on, just stopped freezing enough to skate on.  This started happening in the late 1990s, but now things have been taken to a whole new level.  I am increasingly frustrated and sickened by the "questions" raised over this very real issue.

Cutting A Star Out of the Picture (Wall Street Journal) -- Speaking of my childhood days playing hockey, this article is about the Islanders severing ties to Pat LaFontaine.  I grew up a rabid Isles fan, and even bigger Pat LaFontaine fan.  Pat is one of the all-time great Islanders and a model citizen.  Charles Wang once again demonstrates why he is a despicable person.  While we're on the topic of Pat LaFontaine, go check out his Companions in Courage website to learn about (and perhaps contribute to) some of his charitable initiatives.

Commodities Supercycle or Bursting Bubble? (Pragmatic Capitalism) -- This has been my question of the week, and led to today's post on our country's subsidy for commodity speculation.  It's an important question, because the answer has serious implications for the global economy.  Give this a read to help prepare for a conversation on this blog in the coming months as to whether the commodities bull is a monetary policy phenomenon or an emerging market growth story (or a little bit of both).  

I typically conclude this weekly links post with a nature picture, but for a second week in a row I will depart with a twist.  Here is Van Morrison with The Band performing Caravan at The Last Waltz, rock out for the long weekend, and happy holidays to all:

Why Subsidize Speculation in Commodities?

If you follow me on Twitter @ElliotTurn, you know that commodities have been a big point of interest of late.  I’ve been spending some time trying to distill whether the driver of the commodities bull market for the last decade has been US monetary policy or China’s rapid acceleration in growth.  The answer to that question has significant implications for several different types of investments today, and is really just an interesting and important point in understanding today’s macroeconomy.  But today, with commodities a hot-topic and tax day quickly approaching, I want to take a glimpse at commodities through a different lens entirely.  With oil prices rising quickly in the face of our largest build in crude oil inventories since 2008, there are obvious questions being raised about the impact of speculation in commodity markets (see here for a good look at the question).  After all, how can something go up in the face of an overabundance of supply?  Rather than try to answer the question of how much of a premium in commodity prices is driven by speculation, to this too, I want to take a different angle altogether.

Whether one agrees or disagrees with speculation being a factor in commodity markets, I think we can all agree that such activity should not be subsidizes no matter what.  Yet, that is exactly what our tax code does—it incentivizes speculation in commodities over speculation in any other market.  Even more, speculation in commodities is a great way to guarantee a lower tax rate than the general income tax, when compared to any other profession in America.  There is a hot debate over carried interest, yet this loophole is at least as egregious. 

Broadly speaking, we are in a state of heightened global macroeconomic volatility, and that alone does yield way to increased volatility in demand and pricing for resources; however, that does not explain some of the radical swings in commodities ranging from oil to palladium to gold in recent times.  Since the 2003 Bush Tax Cuts, long-term capital gains are taxed at a 15% rate, while short-term capital gains are taxed as general income, at a 35% rate.  These capital gains apply to most forms of investment income; however, they do not apply on gains in futures contracts–the principle way in which commodities are traded.  Futures contracts, as prescribed by Section 1256 of the tax code, are taxed with a blended rate of long and short-term gains: 60% long-term capital gains and 40% short-term.  The blended rate results in an effective tax rate of 23% on income derived from futures/commodity trading (check out this site for more information on trading taxes).

In essence, the tax code promotes short-term speculation in commodities markets, and it does so in several ways.  People who are speculating in commodity future markets are inherently short-run, and care far more about the discount on the short term capital gains tax rate than they do the increased cost of long-term commodity ownership.  Whereas a short-term equity speculator is taxed at the general income rate, a commodities/futures speculator is taxed at 23%.  The consequences of this are two-fold: first, there is an economic incentive for speculators to ply their craft in commodities markets as opposed to equity markets, and second, speculators desire volatility in the short-run in order to maximize their capacity to make money, such that there is a serious misalignment of incentives between speculative market participants and the purpose of commodity markets. 

The goal of commodity futures markets is to provide a venue through which buyers and sellers of raw materials can share some of the risks in price fluctuations and both can secure some sort of certainty for longer-term budgetary purposes.  Fundamental commodity market particpants are not necessarily trying to make money on each transaction, but rather their aim is to gain security in price on both sides of the equation in order to more efficiently plan and manage their business.  Because this is the existential purpose of commodity markets, it should be noted that volatility poses dangerous risks to the players who need smooth functioning in these markets most. 

Meanwhile, short-term transactions that result in realized gains in commodity markets are not done with the intention ever taking or giving delivery of the underlying goods themselves.  Rather, these transactions are done for the purpose of realizing a gain off of changes in price.  These transactions require inefficiencies between supplier and buyer PLUS volatility in order to generate a profit.  In seeking volatility, such transactions promote yet further volatility.  Because of this fact, volatility and market dislocations lead directly to more opportunities for speculative gains.  Pushing such actors into commodity markets creates a situation where volatility becomes a self-fulfilling prophecy for the benefit of a significant portion of market participants, but a detriment to society at large. 

Speculative traders do play an important role in that they provide liquidity for the true suppliers and consumers of commodities; however, there is no reason for the government to provide a direct subsidy in inducing speculators to prefer commodity rather than any other market.  And there’s really no reason that speculators who engage in these markets for a living should pay a lower tax rate than any other hard working American.

Since markets like these are zero-sum, where one actor must inherently make money at the expense of another, there is unquestionably at least some coefficient of a speculative cost in the price of commodities.  No one these days is seriously concerned about a lack of liquidity in commodity markets, if anything we as a society acknowledge the abundance of this liquidity between the proliferation of commodity-based ETFs.  While we can’t necessarily weed out all speculation from these markets, we can realign the incentive structure to be symmetrical with every other profession in our country.  This is a question to which both Democrats and Republicans should be able to find some common ground.

Links for Thought -- March 30, 2012

A Template for Understanding: How the Economic Machine Works... (Bridgewater) -- This is a MUST READ, and I mean that to the fullest. Ray Dalio and Bridgewater lay out a more complete, robust and accurate assessment for how an economy works than anything we see in the financial presses.  Plus the write-up is concise and written in layman's terms so that anyone and everyone can extract real value.  Reading this report should be a prerequisite for ANY candidate who runs for office, maybe then our economic rhetoric would be a bit more complex, but way more rational? One can dream!

Google Cloud: Coming Soon to Robots Near You (Seeking Alpha) -- To date, the robotics story has primarily been hardware driven, based on innovation in mimicking human movements and/or actions based on necessity. Now the rapid advance in software is adding a whole new dimension and setting the stage for the dawn of widespread adoption of robotics. While on the topic, check out this awesome video of a robot that can jump over 30 feet if need be! 

World's Changed Man, World's Changed-China Edition (Financial Times) -- This is from earlier in March, but still just as relevant.  Throughout the month, each market downtick was more a reflection of concerns over China than Europe.  That's quite the change from this past summer.  What are the consequences?  Well one might be the end of the big commodity bull that's lasted over a decade.  Can the commodity bull persist if China slows?  Does this bode as a positive, or a negative for the US?  These have been the questions that I spent the majority of my attention on this past week.  I should have some charts and analysis within the next two weeks.

Insane in the Membrane (Outside Magazine via Readability) -- This is a fascinating long read on the history of Gore-Tex and the state of the waterproof, breathable fabric market.  There is an intense battle being waged for market dominance that includes some interesting twists and turns.

How the Natural Gas Craze Will Impact Clean Energy (GigaOM) -- This is an issue I have spent quite a bit of time contemplating myself.  Is natural gas a transitory or enduring shift in terms of efficiency, cost and environmental cleanliness?  If so, what are the consequences for clean energy on each of those variables as well?  We seem to be at a big inflection point in the adoption of both.  Is this an "either or" proposition, or can both succeed?  There are way more questions than answers right now, and in these answers lies considerable opportunity.

Why Minsky Matters (EconoMonitor) -- In my book, Minsky is the most important economist today.  Yet, there's a bit of a debate going no amongst the new age Keynesians as to how exactly Minsky is relevant.  Here is L. Wrandall Wray's analysis as to why Minsky is so damn important.  It's slightly wonky, but a must read for anyone interested in macroeconomics.

Praise is Fleeting, but Brickbats We Recall (NY Times) -- Really fascinating psychological analysis of how the mind processes negatives in contrast to positives.  We tend to recall negatives more frequently and with more clarity and this has to do with how the brain works.  Understanding psychology generally speaking is very important in improving as an investor.

I usually close with one of my nature pictures, but today I will leave you all with this awesome video presentation taking advantage of the power of the iPad:

 

Do You Believe in Evolution? (S&P 500 Edition)

With equity markets breaking out to multi-year highs, amidst a persistent spate of negativity, there are all kinds of stories designed to scare people into thinking there is something sinister behind the rally.  Some argue that without Apple, the S&P 500 would be going nowhere, some argue that profit margins are too high and must regress, while others argue that the cyclically adjusted P/E  (CAPE) remains elevated and inconsistent with a longer-term bottom).  All of these arguments have some merit, but none of them measure a key point: today’s S&P 500 is not yesterday’s S&P 500. 

What do I mean by this?  Well quite simply, there is some serious Darwinism going on in the indices, with the outcome being that survival of the fittest has a strong upward bias.  Since the market peaked in October of 2007, exactly 100 companies have been added, and 100 removed from the S&P, with the vast majority of the change having happened during the 2008-09 collapse.  I don’t have the long-term data, but I would surmise a guess that this was the period of the highest turnover in our most prominent benchmark index EVER.  If anyone has the data necessary to confirm this, I would greatly appreciate it.  Regardless, I think it’s safe to say that at the very least, over these last few years we have witnessed one of the largest shakeups in the constituent holdings of the S&P since the Index’s inception.

This is consequential for many reasons.  One particularly important reason, and the inspiration behind my digging into the numbers is the fact that while reading numerous comparisons of the S&P 500 pre and post-2007, not a single analysis I have seen has mentioned or attempted to dig into the composition of the index.  Meanwhile every day I read something that tries to assert Apple is skewing the index.  After looking at the data, it’s become clear that while Apple is a large force, the turnover in the constituent holdings has had a much bigger impact.  Just from the turnover alone, the S&P has been tilted away from financials and old sluggish companies with little to no growth, towards technology and innovative, young companies with rapid expansion.

Out of the 100 companies removed from the S&P 500, 20 were financials that either went bust, were bought out while in distress, or their market caps shrunk so much they were no longer relevant.  Another 7 companies either went bankrupt, or were near bankrupt due to their exposure to the debt crisis, or the rapid disruption of their business model during the crash. 

Here’s a selective list of some notable removals from the S&P 500 since October, 2007 (this list is not comprehensive, but rather just some notable departures):

  • Circuit Cities
  • Ambac Financial Group
  • Countrywide Financial Corp.
  • Federal Home Loan Mortgage Corp (aka Freddie Mac)
  • Federal National Mortgage Association (aka Fannie Mae)
  • Lehman Brothers
  • Washington Mutual
  • Merrill Lynch
  • General Motors
  • CIT Group
  • MBIA
  • KB Home
  • RadioShack
  • Eastman Kodak
  • The New York Times

Some Notable Additions (again, not a comprehensive list):

  • Intuitive Surgical
  • MasterCard
  • Salesforce.com
  • Life Technologies
  • Red Hat
  • Priceline.com
  • Visa
  • Ross Stores
  • Urban Outfitters
  • Berkshire Hathaway
  • TripAdvisor
  • Chipotle
  • Blackrock
  • F5 Networks
  • Netflix

Note how the list of removals is populated with many very old companies, with a heavy concentration of financials and other legacy US businesses that have either gone, are near, or were on the brink of bankruptcy.  Meanwhile, the list of newcomers includes many of the hottest “new” economy companies that are core components of today’s thriving digital age.  Berkshire Hathaway stands out like a sore thumb on the list of newbies, as the company entered the S&P 500 upon completion of its acquisition of Burlington Northern and splitting the “B” shares.  Berkshire “replaced” BNI in the index, thus finally bringing one of America’s largest, most profitable businesses into the composite that is designed to represent American business.  This is a big change, as Berkshire is now one of index’ 10 largest holdings.

This all has a meaningful impact on the intrinsic metrics of the S&P, including earnings, growth, and most importantly, performance.  Priceline is the best performer on the list of newcomers, and it alone is up 779% since the market bottomed in March of 2009.  That is pretty remarkable compared to Lehman Brothers, which only this month “emerged” from bankruptcy as a nearly worthless entity for equity holders.    

Not that these facts alone mean the market should be moving higher, but it is very important to contextualize what we mean when we say “the S&P 500 is making new multi-year highs” and conduct any analysis that relies on index-wide metrics.  Had these changes not transpired, one can reasonably guess that the S&P 500 would be closer to 1,000 than 1,400 today.  And that is a good thing!  Evolution is a powerful, natural force that drives things forward and helps to overcome yesterday’s vulnerabilities.  It is progress, hence it is a more valuable total index.

Links for Thought -- March 23, 2012

It's Friday again, that means it's time for more links for thought!

Jonah Lehrer and the New Science of Creativity (Why We Reason) -- If you read one article from this post, this should probably be it.  It's points are so widely applicable and relevant to everyone.  The post takes is a book review on Jonah Lehrer's new book called Imagine: How Creativity Works and takes look at the creative science behind Bob Dylan plugging.

Please Stop Apologizing (NY Times) -- Bill Maher tells everyone to chill out and stop apologizing. He also proposes that we "make this Sunday the National Day of No Outrage. One day a year when you will not find some tiny thing someone did or said and pretend you can barely continue functioning until they apologize."  Great points from Maher about how hyper-sensitivity has been taken way too far in general, and has simply become a distraction from the real, important questions in life.

The Man Who Broke Atlantic City (The Atlantic) -- Awesome article on Don Johnson, the man who won $6 million playing blackjack in just one night, and over $15 million in a short time.  There are many lessons to take from this article, particularly from an investment perspective.  Any investor should do as Johnson did, and seek to stack the odds in your favor, while those same investors should never do what the casino did in desperately seeking a way to make a buck.  

5 Things that Surprised Me About A Career on Wall Street (Ritholtz) -- As a lawyer turned investor, this really struck a chord with me.  Barry Ritholtz too comes from the same background, and he takes a stab here at some of the real shocks of entering the investment world.  Point #1 in particular should hit EVERYONE on Wall Street real hard, because it is just so damn true: "Surprisingly few people rolled up their sleeves and thought deeply about why things in market are the way the are."

A Stock is a Business (Oddball Stocks) -- This is something I say and will continue to say often, "a stock is a business."  It is not a line on a chart, it is not a spreadsheet of ratios, it is a real, vibrant business.  Oddball Stocks takes a good look here at why that's an important point and how it impacts investment analysis.