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Friday, January 7, 2011

How to Making Money

Business cycles and the essence of long-run economic growth are distinct issues. Preventing recessions is not the key to growth, as these are regrettable but unavoidable companions to an economy directed by a capital allocation process that is susceptible to systematic failure. Preventing the last failure is pretty irrelevant, because the next systematic failure will be different. Last I checked, only the US government is offering low-down payment loans, and no one offers no-documentation loans, so our government is not really helping here. As for creating growth via something new, if centralized governments could do that, the Soviet Union would still be around.

That decentralized, self-interested, people can collectively make such large errors seems irrational or corrupt to many, but they should remember that growing economies require people to be making things better, which means, new ways of doing things. New ideas are often wrong. Economics has gone onto intellectual cul-de-sacs many times (socialism, Keynesian macro models, input-output models, Hilbert spaces in finance, Arbitrage Pricing Theory, Kalman-filter macroeconomic models, etc.). Other scientific disciplines have their own mistakes, and political mistakes--stupid wars--are also common. These are rarely conspiracies, but rather, smart people making mistakes because the ideas that are true, important, and new, are really hard to discern, and tempting ones are alluring when lots of other seemingly successful people are doing it.

My Batesian Mimicry Theory posits that recessions happen because certain activities become full of mimics, entrepreneurs without any real alpha who got money from investors looking in their rear-view window of what worked and focusing on correlated but insufficient statistics. For example, people assumed a nationally diversified housing prices would not fall significantly in nominal terms, because they had not for generations; people assumed anything related to the internet would make them rich in the internet bubble, conglomerates would be robust to recession in 1970, that the 'nifty fifty' top US companies had Galbraithian power to withstand recessions in 1973, that cotton prices would not fall in 1837, etc.

As in ecological niches, there is no stable equilibrium with when mimics arise to gain the advantages of those with a real, unique and costly, comparative advantage. Every so often there are too many mimic Viceroy butterflies, not enough real poisonous Monarch ones, and a massive cataclysm occurs as predators ignore the unpleasant after-effects and start chomping on all of them. The Viceroy population grows until this devastating event occurs, a species recession. Next time, it won't happen in butterflies, but rather, among frogs or snakes. They key is, some ecological niche is always heading towards its own Mayan collapse (distinct from the 2012 Mayan apocolypse).

The key to wealth creation is doing less with more--destroying jobs at the micro level and creating jobs at the macro level by reallocating capital and labor to more valuable pursuits. The computer got rid of things from typesetters, secretaries, to engineers working with slide-rules, but these people didn't stay unemployed, they did something else, making the economic pie bigger. This is antithetical to government and unions who think creating a permanent 'job' creates productivity--stability at the micro level and stagnation at the macro level. Wealth is created by having decentralized decision-makers focused on simple goal of making money, which means, they oversee transactions where revenues collected are greater than expenses paid. If externalities are properly priced (I know, most liberal think this never happens), this implies value is created. The continual improvements in method (ie, productivity, wealth creation) merely maintain profits in a competitive environment; to do nothing would see their profits eaten away by competitors would could easily copy what they did and just undercut their prices.

The key to this is having managers who keep their workers focused. A good example is a story I heard second-hand about a football player for Minnesota Vikings in the 1970s. Coach Bud Grant called this marginal player into a meeting, and said, 'Here's what I need you to do...'. The player, an articulate fellow quite confident in himself, interrupted with an explanation of why he wasn't doing better and suggestions about how to correct it, mainly focused what others were doing wrong. Grant cut him off: 'You don't understand. This isn't a negotiation. Do what I'm telling you, and you have a role here. Otherwise, you don't.' Hierarchies only work well when people have clearly defined goals, and managers who manage their direct reports singlemindedly.

Private firms can do this much more quickly and often than government, and are rewarded with investment and retained earnings to the degree they do it well. When the government wants to do something, like build a light-rail system, it instead satisfies all its stakeholders who have no financial downside, only veto power, and so the cost/benefit calculus is almost irrelevant. The probability that benefits will outweigh costs when not prioritized is negligible, as highlighted by the fact that companies have to work very hard to make this positive when all those other considerations are ignored.

Thus, Minneapolis's light rail, at the cost of $1.1B for 12 miles of track, takes me longer to go downtown than a car because it stops 19 times at places no one wants to go because these 'hubs' were then sold as development opportunities, and an unusual number of ex-city councilmen are part owners of coffee shops and stores near these stops. Ridership does not even cover their marginal costs. It could have worked if they had an express train that went non-stop from end to end, but doesn't because it was not designed with the goal of making money, only the hope.

Good companies like Facebook, Apple and Google, have this sense of really understanding their users. Lots of simple things that making going to their sites and getting what you want. Their inferior competitors are relatively ugly, cluttered, and clunky. These generally weren't genius ideas like the ideas needed to create the first transistor, or Cantor's diagonal argument, in that there competitors had similar raw competence in these field, but it did take people looking to do things better than others, and decisive people who could empathize with their customers created really great things.

Robin Hanson had a neat article about the Myth of Creativity, where he criticizes Richard Florida's vision of bohemian lead productivity:

This is a Star Wars vision of innovation: "Feel the force, Luke; let go of your conscious self and act on instinct." And it is just as much a fantasy as that celluloid serial. Innovation is no more about releasing your inner bohemian than it is about holding hands, singing Kumbaya, and believing in innovation.

In truth, we don't need more suggestion boxes or more street mimes to fill people with a spirit of creativity. We instead need to better manage the flood of ideas we already have and to reward managers for actually executing them.

Sure, it's good to punish fraudsters, and be wary of the stupid ideas that were passed off as brilliant in the prior cycle (eg, Angelo Mozilo winning the American Banker's Lifetime Achievement Award in 2006, celebrated by politicians on the right and left, prized by Fannie Mae, and Harvard, is now an example of the 'unregulated predatory private sector'). But this is like learning not to put one's hand on a hot stove--good to know, but old news to most. Our priority at the top level should be to get out of the way, and so government should focus on its essential but limited perennial tasks as opposed to creating some new engine of growth. Leave that for the millions of people making sure millions of small changes are constantly made to daily procedures. Such changes do not require vision from politicians, subsidies, or tax breaks, but are rather the natural by product of people trying to make a buck. It's the standard Hayek/Friedman view of macroeconomics, and it's still the best description of how the complex adaptive system of our economy works.

Even the long fawning UK press is now saying what any startup who has tangled with the music industry has said all along: Spotify will not be able to launch its free any-song-you-want-to-hear-the-second-you-want-to-hear-it service in the US. The Telegraph is reporting that at the last minute the labels demanded too much upfront cash, killing a hard negotiated potential deal.

This is sad, but not a surprise. Despite all the reasons consumers would love it and labels should be empowering a rival for iTunes, the labels are in defensive mode and have never been rational when it comes to these things. My issues with how Spotify has handled this aside, I actually didn’t want to be right on this one. It’s a sad day for users.

But this will be the interesting thing to watch: Does Spotify just roll these we’re-definitely-launching-in-the-US assurances forward to 2011, the way the company has the last two years or does it pivot, and focus on building a profitable site for Europe and other less guarded pockets of the emerging world? In the Telegraph link above an unnamed source says the year of brutal negotiations has forced Spotify to “stop and think about whether it can afford the move to the US and indeed whether it is worth it,” while the article quotes a Spotify spokesman as saying the negotiations are “on-going.” Oh, Spotify.

Here’s my advice: Pivot. Spotify has spent two years, and undoubtedly plenty of money and focus, fighting what was always a Don Quixote like battle to make the US labels listen to reason. This is the same industry who sued their users. It was a valiant effort, but it didn’t work. We can argue why they should back Spotify all day long, but the last two years has proven that they are just not going to listen without Spotify having to make some major concessions.

I think Spotify should walk instead of making those concessions. No matter how hot of a startup you are, money and time are exhaustible commodities. Spotify should start directing them at challenges elsewhere until there is enough of a sea-change in the US music market that labels see reason. Giving into the labels’ demands isn’t the answer. Instead, Spotify should retreat, build in other countries, perfect its model, get to profitability, and then come back to this market when the labels are weaker and Spotify is stronger, boldly proving cynics like me flat wrong. Use your international headquarters as an advantage, not a liability.

Spotify board member Klaus Hommels told me in an interview late last year that he believed Spotify may be the venture industry’s last-ditch effort to build an online music company. (Other than Pandora, of course, the online music company with nine-lives that finally won the right to exist.) He told the labels in negotiations that if they opted instead to drain Spotify’s venture cash and leave it for dead the way they have to so many others, they may never get another hot upstart to back. And that would resign them to an Apple dominated world.

He may be right. So why not play the long game, instead of the short one?

(Note: Don’t worry, I’ve put two dollars in the TechCrunch Pivot/Swear Jar.)

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Thursday, January 6, 2011

Making Money Without

Banks increased fees for initial share sales by 62 percent to 5.63 percent
from the lowest level on record, even as the amount that U.S.
companies raised from IPOs decreased by almost half to $16.4 billion
this year, according to Bloomberg data. While the biggest surge
in stocks since the Great Depression revived the IPO market and helped
enrich bankers, almost 40 percent of offerings sold by underwriters in
the second half of 2009 have left buyers with losses, the data show.

… Crunch the numbers: at a $50
billion valuation, with Goldman in the box seat as lead banker to an
IPO and at the rates quoted in 2009, then it could pocket $2.8 billion
gross in fees. And that’s on top of whatever it creams off the $1.5
billion fund it is creating as part of the deal that sees it currently
investing $450 million. Assuming an IPO in the next 12 months then by
my reckoning, Goldman’s ‘investment’ nets a 6x return.

If Goldman is successful (and
remember that the Special Purpose Vehicle covering the $1.5 billion has
to get past the SEC first but honestly – do they care?) then what
happens to the Twitter’s of this world? Does its investors start
clamoring for an exit? You bet.

That can only spell one thing: bubble times are here again.

Ya Damn skippy, sailor. Howlett hit it right on the head. What type
of revenues, profits and growth justify a $50 billion valuation for a
very young, private company with sparse net cash flows? The type that
are marketed by those who are doing God’s work! now, let’s build on Mr.
Howlett’s and Dignan’s ideas the BoomBustBlog way. We shall begin with
the $1.5 billion dollar fund that Mr. Howlett alleges GS is creating
around the Facebook cash injection. Yesterday’s BoomBustBlog rticle, Facebook Becomes One Of The Most Highly Valued Media Companies In The World Thanks To Goldman, & Its Still Private!
clearly detailed why and how many of these private equity and client
funds routinely gut investors (we’re talking up to 92% in losses!) while
Goldman (and other GPs) still walk away with profits (see Even With Clawbacks, the House Always Wins in Private Equity Funds). I have posted the model that illustrates this bank wins, investor loses phenomenon as a live spreadsheet online for all paying BoomBustBlog subscribers
to use at will. It’s quite the comprehensive model and allows for the
user to run a myriad of their own assumptions using any inputs they
please. As subscribers will see, it is nearly impossible for Goldman to
lose money on their Facebook private fund, no matter how badly Facebook
shares perform. Please beware that is unlocked and fairly complex, so
please do not make any formulae changes to it for it corrupts the
experience for other users. Here is an excerpt for those who do
subscribe to our research and services, YET!

Even with the fund taking 45%+ losses and the LP (limited partners,
ex. Goldman’s clients) losing every last single dime, Goldman easily
pulls a 33% return. God forbid Facebook share actually do well,
Goldman’s numbers look… Well… Damn near illegal! Almost as if they can
pump up a price without any fundamental justification or public
disclosure of financials and still sell it retail to the public. Of
course, such a thing could and would never occur – not with the every
vigilant SEC to take our backs. Excuse me while a cough a up a lung from
laughter…

You see, this is the dirty little secret of private equity funds.
They are not in the business of investing money for client’s maximum
risk adjusted return. They are in the business of collecting fees. Those
poor innocent (or not so, particularly when they are investing their
clients monies, hence are in the same business) souls that actually
believe as the commenter above quoted “Wow!!! If Goldman is putting their money in this, it must be serious!”simply
the lamb being led to the private equity/IPO slaughterhouse. You see,
there is no loss to GS – no matter how high they bid up the valuation
nor how hard it comes crashing down. This gives them the incentive to
shoot for the sky with the private equity deal, because when the IPO
breaks, its bonuses bigger than nearly any have ever seen. Facebook
makes and excellent marketing story as well. Boy Wunderkind CEO, a
product nearly everyone uses and loves, and a mysterious dearth of
business model to give it a mystical effect. Don’t forget the
involvement of the “cream of the crop” of Wall Street banks, whose
bankers, traders and analysts are all so much smarter than us guys from
Brooklyn. Add this up, and you get “Wow!!! If Goldman is putting their money in this, it must be serious!”.

I will continue this in a few hours via my next article that
illustrates an actual Facebook offering, complete with valuations –
which should be a doozy, Wait until we get to add up all of those
Goldman fees – Facebook investors win or lose. Just to be clear, this is
not hate for Goldman, but elucidation and clarification regarding
exactly what business Goldman, et. al. are actually in and how they are
able to generate the profits that they do. Many think that Goldman is
the best and brightest on the Street. Those guys went to the same
schools, studied under the same teachers, graduated and employed using
the same strategies trading the same products as everybody else. Get
over the mysticism marketing bullshit and you just have a politically
connect, very well marketed investment bank that was just bailed out by
the government. The same as every major IB in this country. I have no
hate (nor love, for that matter) for Goldman but I am about setting the
record straight. If you really think Goldman is really that good at
anything outside of raking profits off the back of their clients, I
suggest you take a long, strong look at their track record versus mine - Did Reggie Middleton, a Blogger at BoomBustBlog, Best Wall Streets Best of the Best?

Click here to subscribe to BoomBustBlog.

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The Middle East’s largest online auction and buying site has decided auctions are so last decade.

From the beginning of 2011 sellers won’t get the option to sell their products in an auction. It’s fixed price, or none at all.

The decision comes as a shock to many as Souq.com, which opened its doors to the public in 2005 and has since launched in 5 countries in the region, has always been portrayed as the eBay of the Middle East. At least in terms of online auctions, not anymore.

“We (and most of our sellers) want to offer the best online shopping experience to users in the region, and this is one step along the way to support this goal.” said CEO and Founder of Souq.com Ronaldo Mouchawar in an email about the recent shift.

This change, as most in life, will have its supporters and detractors. The good thing is, it looks like a only slim minority might end up annoyed.

To illustrate the above, lets say you’re a painter and you work from home during your spare time. I’m one of those who believe art has no price, but since it’s good to have paint to create priceless masterpieces, putting the occasional price tag on your work isn’t entirely evil. The only problem with that is how do you put a price tag on art in the first place? Van Gough considered giving money for art is as important as being an artist yourself. That’s where auctions come in strong.

By putting up a painting to sell through an auction, the seller allows the highest bidder to give her as much it takes to win the auction, or otherwise ask to ‘Buy Now’ according to a price the seller sets. Will this shift be good for those who realistically don’t know how much their work is worth? I would say no.

On the flip-side regional retail stores tend to invest large amounts of money to put their products online on their own, and usually fail miserably. Many factors come into play, but the most obvious are a large user base and an easy to use website to buy from.

This encouraged Souq.com to build a platform for merchants and retail stores to offer their products on Souq through fixed prices (almost all the time), and through Souq Stores which are customizable online outlets for retailers such as UAE’s
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