Dr. John Rutledge “Tuesday Lunch Series” 2-14-12 from CGU School of Politics & Economics on Vimeo.
I did a spot on CNBC Squawk Box this morning to discuss the impact of the recent unrest in China. Much of the news surrounds stories about migrant worker protests. As I wrote yesterday, the drivers for the protests making the news is not ideology–it is practical life issues like pay, jobs, work practices, discrimination, and corrupt local government officials. Wen Jiabao recently said that corrupt officials is China’s greatest crisis. Last year more than 146,000 corrupt officials were arrested in China; 97% of them were at the county, city, or village level.
Our discussion this morning turned on the impact on the US. The biggest US risk is supply chain interruptions, much like the Japanese earthquake. Just under half the manufacturing capacity in the world is in China. Much of it is in southern China, especially Guangdong, where the factories are operated by migrant workers from Sichuan, Hunan, and Xinjiang. Recent job losses in Guangdong caused by “hollowing out,” (businesses moving to cheaper locations in Vietnam and other Asian countries) are a real problem. Migrant workers are often the only source of income for their families in poor villages in western provinces. Rising food prices has also put the squeeze on migrant worker incomes, even though the incomes are rising at 10% per year.
All this is interesting, but what I care about are the people. It is easy to lump groups of people together and call them “migrant workers” if you have never met them. Not so easy when you know their names.
I thought I would just take a minute to inject a little humanity into the story by posting a few pictures of the kids I work with in the migrant worker schools in China. For several years, my partner Fred and I have organized teams of university students to work in primary schools in poor villages, often migrant worker schools. We have done projects in Tibet, Yunnan, northern China, and tried to do one in North Korea that failed to happen. In each case, we supply the students with books and materials to build libraries and kitchens, plant gardens, pay student fees, and give the children pencils and paper. The students spend a month or more in the schools teaching and working with the children.
Here are a few pictures from one of our recent projects in a migrant worker school in northern China.
The photo above is our team for a migrant worker school project. Fred (white t-shirt just in front of me) is my partner in all the projects we do. Ethan (black Rutledge capital shirt in front of me) was team leader for this project. The other team members are students at China Agriculture University.
Below are a few of the children, including an unforgettable kindergarten student showing me her very beautiful graduation dress.
This is a migrant worker school classroom. The classrooms have no doors and no heat in the winter–the students weal heavy coats in class to stay warm.
Finally, the picture below is a very special one for me. We were able to arrange for 15 of the students graduating from the migrant worker school to go to the official public school nearby, which will allow them to later go to university. They needed clothes, school supplies, and the like to fir into the new school. This is a picture we took on their first day of class. I keep this photo on my desk.
I hope you get to meet some of these wonderful children one day for yourself.
JR
When people asked Leonardo da Vinci the secret of his creative and inventing genius, he replied “Saper Vedere,” to know how to see. Our objective is to help people see the link between government policy, capital formation, and growth, then help them see strategies for growing their businesses, increasing the value of their investments, and improving their economic lives.
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Expand All: How We Think
Thirty years of traveling the world have convinced me that growth is the answer. Economic growth is the only reliable engine for lifting people out of poverty and improving their lives. Access to capital, along with the people’s focused productive energies, are the principal drivers of growth.
Capital comes in many forms; modern equipment, efficient factories, new technologies, high-speed communications networks, and improved education. All represent the stored energy of previous generations of investors, innovators, entrepreneurs, and workers. All make workers more productive, increase output, and provide the resources for people to achieve their economic, personal, and social goals. Incentives for creating capital and for the productive use of energy are the keys to increased growth.
As a young economist I taught graduate and undergraduate students in macroeconomics, monetary theory, international trade and finance, and econometrics. Like other academics, I taught students how to build and manipulate all the textbook models of economic behavior. I did so for three reasons. The models were mathematically elegant, which made them both beautiful and easy to teach. Publishing journal articles about them was the key to advancement in the profession. And, having never set foot in the real world, it was all I knew how to do. Later I ventured into the real world where I learned the models were not always up to the task of helping policy makers, business managers, and investors understand change. While keeping my healthy respect for the limitations of economic models, my colleagues and I developed a framework of our own to guide our thinking. That framework-which is, of course, a permanent work in progress—underlies all of our work.
The first pillar of our thinking is also the simplest: Stuff Matters. No macroeconomic analysis is complete without accounting for people’s multi-trillion dollar holdings of Stuff. Stuff describes the items on our balance sheets, including tangible assets (land, office buildings, collectibles, used cars, and other claims on future services), financial assets (stocks, bonds, bank accounts, and other claims on future cash flow), and all forms of liabilities (credit card debt, mortgages, and the obligation to service and repay the national debt).
Analyzing the income statement alone, i.e., GDP and its components, is just not good enough. That’s because there is so much stuff out there. This year US GDP will be just over $11 trillion, compared with total assets (not including more than 700 million acres of government-owned land) worth more than $120 trillion at market value.
Stuff matters because the values of the individual items on our balance sheets determine our net worth, and our solvency, collateralize our obligations, and influence our behavior. Those values are set in markets based on the relative risks and after-tax returns of different assets and liabilities. Government policies that result in abrupt changes in relative risks and returns induce massive responses from private investors. These responses are the most important channels of economic and financial change.
In the late 1970′s, for example, rising inflation added an artificial capital gains component to the return on tangible assets, while rising income tax rates artificially depressed the after-tax returns on financial assets. The resulting shift of investor demands drove a boom in hard asset prices and destroyed three-quarters of the real value of the stock market.
As a second example, the 1981 Reagan policies of falling inflation and falling tax rates reversed this shift by boosting financial asset returns relative to returns on tangible assets. This led to a decade of restructuring in US industry, and to an eighteen year bull market in bonds and stocks which triggered a huge wave of investing in the 1990′s.
As a third example, the 1996 Telecom Act artificially subsidized the returns of some communications companies–cable operators and CLECs (Competitive Local Exchange Carriers, such as MCI and AT&T)-at the expense of the regional Bell operating companies. The resulting wedge driven between their respective returns on capital led to massive overinvestment in the former, and to a multi- trillion dollar loss of market value for the latter, and contributed to both the stock market bubble of the late 1990′s and the severe recession since then.
Shift happens internationally too. The opening of China to foreign investors has exposed the gap between Chinese returns and ours. The result has been a massive flow of capital out of the US , the EU, and Japan and into China , millions of unemployed manufacturing workers, and growing trade tensions.
Our valuation approach is simple. Investors own securities for one reason-to get paid. Stocks and bonds are simply claims on the future cash flow generated by the underlying assets. The present value of those future free cash flow streams is the Intrinsic Value of the securities.
Intrinsic Value estimates will only be as good as the estimates of the value drivers for the underlying business–sales, price, cost, margins, tax rates, capital requirements, and cost of capital-behind the calculations. These value drivers are strongly influenced by government policies.
From time to time the interactions of buyers and sellers in the asset markets result in market prices which we find to be significantly above or below the Intrinsic Value of the securities. That’s when stocks or bonds are over-valued or under-valued. Investors who consistently buy securities when they are undervalued, and/or sell securities when they are over-valued, will earn a higher-than-market return.
For a more detailed discussion, see Tracking Value.
Intrinsic Risk
Risk does not mean volatility; risk means losing your money. That happens when a business fails to deliver the operating performance embodied in the price an investor paid to acquire it. We call this Intrinsic Risk, and we measure it by explicitly estimating the probability the Value Drivers that underlie a market price fail to deliver the implied free cash flow stream.
In physics, when two objects are brought into contact heat flows from the hotter to the colder object until the temperatures are equal, after which point there is no further change. This is known as the Second Law of Thermodynamics the most inviolable law in science.
Thermodynamics explains the weather, where temperature and pressure differentials cause storms. They explain chemical reactions, which are thermodynamic cooling processes. And they explain economics, where price, wage, or return differentials lead to the arbitrage behavior that moves prices and changes the allocation of resources. Our Shift Happens methodology is nothing more than a restatement of the Second Law of Thermodynamics in the language of economics and portfolio analysis.
Thermodynamics deals with systems, not with particles. Recent work demonstrating the formal equivalence of far-from-equilibrium physics and irreversible (entropy producing) thermodynamic processes has led to a fuller understanding of the situations in which systems fail to adjust smoothly to change. These situations of system failure (blackouts) help us understand recessions, depressions, currency collapse, credit-market failure, and other discontinuous events in economics. Ironically, Irving Fisher, Knut Wicksell, and John Maynard Keynes studied these topics a century ago.
For a more detailed discussion, see Supply-Side Thermodynamics
Major economic change is almost always the result of a change in government policy that drives a wedge between the after-tax return on one type of asset relative to others. This leads to a SHIFT in asset demands as investors attempt to rebalance their portfolios to take advantage of the return differential. The rebalancing drives asset price changes, and ultimately shows up in the creation or destruction of assets.
Formally, these asset market disturbances are identical to the temperature and pressure differentials that drive the storm systems on a weather map. It is worth remembering that economic shifts, and the risks and opportunities they represent, are always transitory.
The principal of arbitrage lies at the heart of economic analysis. Indeed, it may be the only positive statement that economics has to make. It is, however, immensely powerful. Arbitrage, in turn, stands on the strong shoulders of thermodynamics, the most robust area in all of physics
Thermodynamics says simply that temperature differentials cannot persist over time between objects in physical communication. The end result is thermal equilibrium–the state in which there is no further tendency for temperature to change. Thermal equilibrium is the physicist’s definition of death.
Almost all activity in life reflects the physical manifestations of thermodynamic processes. It is why the chemical reactions occur in our cells. It is why sunlight leads to photosynthesis. It is why volcanoes erupt and tectonic plates shift to make earthquakes. And it is why weather systems form.
In fact, weather systems are the best and simplest metaphor for economic change. We all know what happens when high and low pressure systems try to occupy the same space–thunder, lightning, tornadoes, and hurricanes.
I think of global investing as an exercise in meteorology. My job is to identify the thermodynamic events–usually changes in tax rates, government spending, regulatory policies, or monetary policy$mdash;that lead to localized temperature or pressure differentials which set up the arbitrage situations we use to make money.
A change in zoning laws that alters cash flows, for example, creates a return differential that forces a change in the value of a piece of land. A tax law change that impacts after-tax returns leads to a return differential that forces a change in the value of a piece of capital equipment. A change in monetary policy that increases inflation increases the returns on tangible assets relative to securities, forcing a change in stock and bond prices. All can be viewed as weather systems moving across the weather map of the global economy.
I also like the weather map metaphor because it reminds me of two important facts. First, extraordinary investments, like weather systems, are transitory phenomena. Even the best investments don’t generate excepitonal returns forever.
Second, investing, like meteorology and thermodynamics, is not an exact science. It can help you to identify the storm systems that are going to make things happen. And it can tell you what things will look like when the storm has passed and thermal equilibrium has been once again restored. But it tells you very little about what happens in between.
There is no exact science that describes the disequilibrium states which occur while change is taking place either in physics or economics. This is important because all of the real money is made and lost during the disequilibrium adjustment—nobody makes or loses money in equilibrium. That’s why faith in the end result and the liquidity to withstand the turbulence and chaos along the way are so important.
The global weather map gives me a hat rack to give structure to the thousands of factoids that fill the news every day so I can boil it all down to a manageable number of themes to watch closely.
The way to make money investing is to identify a storm system that is powerful enough and likely to be long-lasting enough to serve as an energy source for revaluing a portfolio. Then you move capital into position to take advantage of the implied prices changes.
For the past twenty years the weather map has been obscured by one huge storm system, a stationary El niño front, as the world went through convulsions learning to live without inflation. Although we are still cleaning up the wreckage, that storm is over now. In its place we have a large number of localized weather systems as individual countries attempt to compete for the capital they need to grow.
This environment favors hedge fund investors over long-only investors who can no longer ride falling interest and rising valuations. And it favors investors who can break camp quickly to take advantage of change over the battleships we built for the long bull market. Investors will have to be quicker, have a bigger canvas, and be willing to take both long and short positions to benefit from these conditions.
