Feature Stories | Jun 20 2006
By Greg Peel
GaveKal Research is an independent economic research house and consultancy created in 1999 in the US by Charles Gave and partners. GaveKal has a reputation for "original thinking". The following feature series is drawn from a GaveKal publication of 2005 entitled: Our Brave New World. This is Part VI.
There is a raging debate at present between the bulls and the bears as to whether financial markets are experiencing a healthy correction in an upward trend or the bursting of bubbles that ushers in a downward trend. One of the bears strongest arguments is that current asset valuations are way out of step (much higher) than historical averages. Bulls favour the notion of a secular shift in pricing.
The platform model takes the bears to task and suggests that things are different this time.
The price/earnings ratios of S&P500 companies are still above historical averages despite a bear market between 2000-2003 and an impressive growth in profits in recent years. The bear would say there must eventually be a reversion to the mean. The platform company model suggests the mean is the past, and the present is different.
Consider two iconic US companies: Caterpillar, which specialises in earth-moving and construction equipment, and Proctor & Gamble, which provides a good deal of the household goods available in supermarkets (both companies are also prevalent in Australia).
Caterpillar’s business is highly cyclical, being at the mercy of mining and construction cycles. Consider the resources super cycle we are in now compared to a few years ago when no one would even look at mining companies. Proctor & Gamble’s business is non-cyclical, as no matter what the prevailing climate – boom or depression – people still need household items.
If over the long term both companies showed similar growth in earnings, Proctor & Gamble should trade at a premium to Caterpillar for the simple reason that non-cyclical earnings are less volatile and more predictable, providing investor comfort.
The economies of Western countries under a platform model are now far less volatile than they have been in earlier times. Economic growth is less volatile, corporate profits are less volatile, financial markets are less volatile (see Brave New World Part III). Thus it follows that there should be a premium placed on stock valuation – we have taken a step away from the mean.
Platform companies outsource the cyclical part of their procedures, and thus offer high, stable returns on invested capital. This makes them popular with shareholders. The twist is that platform companies actually don’t need a lot of capital.
Consider one of the world’s most successful companies – IKEA. The ubiquitous Swedish provider of flat-pack furnishings has never sought equity by issuing a share, nor borrowed by issuing a bond. It has only ever funded itself on cashflow. Yet anyone who’s ever visited, for example, what I call The Colossus at Rhodes in Sydney’s west – IKEA’s warehouse/retail outlet – on a weekend can only marvel at what one Swede has achieved.
(It may have helped that the guy is reputedly so tight he will only catch public transport and fly economy and still lives in the same small flat. Folklore? Not sure.)
IKEA never needed capital to take over the world because it started with a handful of furniture designers in an office in Sweden and outsourced everything else from the start.
So if platform companies don’t actually need capital, yet they provide high and stable returns, what is the obvious response? Share prices go through the roof.
Today we live in a world with a large pool of disposal capital, but companies don’t want it. Two ramifications follow from this. Firstly, company executives pay themselves ridiculous compensation packages that would have been criminal only a few years ago, but this doesn’t stop share prices going up. (Australians would be familiar with this concept).
Secondly, with nowhere to allocate capital companies begin to return capital to shareholders in the form of buybacks and special distributions. (Ditto).
A third ramification is that this creates even more excess capital (executives with too much money, shareholders with returned investments) which still has to go somewhere, so it goes back into stock markets (which are now at historically high levels), or bond markets (yields are at historically low levels) or real estate (high) or hedge funds (growing exponentially). Hedge funds then farm their investors’ money into stocks and bonds, and other asset classes such as commodities. So here we are.
Money also flows into emerging markets, such as the BRICs (Brazil, Russia, India, China) as that is where the capital is actually needed. However, investment in emerging markets is fraught with danger (because that’s where all the Western volatility has been transferred to) thus being a place for only the most risk-thirsty, and besides, financial markets in emerging countries are not yet sufficiently developed to deal with the efficient allocation of capital.
Emerging countries are renowned for the cyclicality of their markets, with extremes of boom and bust. Note that while the Chinese economy is all boom, boom, boom, the Chinese stock market is still one of the scariest rollercoasters ever created. Hence those looking for stable returns will tend to favour mature economies, and hence markets in those economies deserve to be revalued to levels which are above historical means.
The exponential growth of hedge funds is testament to the search for capital returns in a stable economy. In 1998, one of the world’s largest hedge funds – Long Term Capital Management – was brought down by gambling in Russian sovereign debt. Russia defaulted, and LTCM nearly brought down the entire Western financial system, but for the intervention of the Fed. Hedge funds became tainted as high-risk dangers that should be banned.
But they weren’t, and now hedge funds represent a huge and growing slice of the investment world. There are no longer a handful of large, over-capitalised funds, but rather a plethora of smaller outfits that dart in and out of markets. At any one time there can be hedge funds that are long this and short that, and others which are short this and long that, providing a wealth of trading liquidity in all financial markets. They don’t provide the capital, they just make markets more efficient.
The rise of hedge funds is a response to the excess liquidity within today’s global economy and a response for the need to direct excess capital into some financial instrument or market that will generate a positive and healthy return in a stable and mature financial market setting. The money must go somewhere.
While the Western world goes on becoming wealthier new problems emerge within the political landscape. Firstly, the power base of traditional left-wing parties has been undermined by the reduction in levels of blue collar workers in the West, as these roles have been outsourced to emerging markets. With fewer members, trade unions become less potent. This has happened in the US and it is presently a very big issue in Australia. This reorganisation of labour globally also has ramifications that could threaten the existence of the Welfare State.
The Western world might be becoming richer but the emerging world is becoming richer too as new entrepreneurs come to the fore. It then makes sense for the new wealthy to transfer funds out of their own volatile markets into the safer return markets of the West, into the likes of stocks and bonds, and even real estate. In the case of real estate, the new wealthy want to experience all the good times the Western world can offer.
Asset prices in the Western world must thus always remain slightly overvalued. The capital account of Western countries will be positive if financial markets are well developed. The current account, which is the opposite side to the capital account will thus always be in deficit, and massively so.
This capital flow pushes up the value of Western currencies, particularly as the new savers of Asia, Latin America or Eastern Europe replace gold with dollars as their new standard. A high currency and low cost of capital in Western countries means that the production side of any business becomes highly competitive and very low margin. Best to revert to a platform company model and send the production offshore.
While platform companies are making lots of money by only maintaining design and sales areas onshore, they subsequently end up paying a lot of tax. What is the solution to this problem?
Did you know that on any given day, the biggest foreign net buyer or seller of US treasuries is the Caribbean Islands?
As we all know, Caribbean countries are not the world’s largest investors. The hedge funds domiciled there, however, are. The efficient capital of the world used to be domiciled in the big investment banks of New York, London, Frankfurt and Tokyo, but now it sits in the world’s tropical tax havens. And don’t executives just love being given the excuse to visit "head office" occasionally. Some have set themselves up there for good.
And it is not just the preserve of hedge funds. Large companies are now also domiciled in tax havens. One of the world’s biggest video game designers, Electronic Arts, is incorporated in the Caymans.
As the world moves towards a platform company model, tax receipts in countries that do not adjust to the model will collapse. Income taxes will also become increasingly more voluntary as platform company employees can choose to domicile themselves elsewhere. It happened with rock stars, it happened with sports stars, why wouldn’t it happen with financial stars?
When this occurs, governments will be forced to derive tax income from other sources such as property and consumption taxes. (Australia, again, is a perfect example. Take New South Wales: despite increased wealth in Australia’s most populous state, the state is broke and is heavily reliant on the likes of land tax and poker machine tax. The Commonwealth relies on GST).
The likely outcome is a downsizing of government in Western countries to a more efficient level. Without sufficient taxes, the Welfare State is under grave threat.
In the First Wave world (from the first civilisations to the Industrial Revolution), governments provided subjects with basic regalian functions – army, judges, police. In the Second Wave (Industrial Revolution to now) governments also provide income redistribution into education, and welfare – pensions, unemployment benefit, healthcare.
In the Third Wave (that which we are entering) governments will struggle to maintain such services. They will need to compete with each other to attract global platform companies by providing the best services at the lowest possible price. This means the most efficient regalian functions. The city-states of Hong Kong and Singapore are two examples of this reality in practise.
Will other countries go bankrupt?
Coming up: Brave New World wraps up with an analysis of how one should invest one’s money in a platform company world.
The ideas and examples put forward in this series are the work of Gave, Kaletsky & Gave: Our Brave New World, self-published, 2005. The writer has added observations as well.