Posts Tagged ‘economics’

Sustainability and some final thoughts

Saturday, August 27th, 2011

In the end, politics, economics and perhaps even environmentalism are practical matters dressed up as intellectual theory, following on from my previous blog on the theory behind sustainability.

Economics is good at analysing what happens at the point when things of value are exchanged, but is not much good at anything else.  Real economics cannot tell you how to sustain you or your family.  For example, were you have a budget of £100 to spend on your weekly shop, it cannot tell you what is the best way to spend that money on in terms of your health, or taste or what you have in your cupboards or what takes your fancy as you walk around the store.  It cannot tell you why you prefer one brand over another or why we buy olive oil from one country of origin over another, because none of us really make rational decisions based on utility, however neat a theory.  In fact, many of our decisions are decidedly irrational – for example, it is cheaper and quite easy to cook meals from scratch yet we buy, for example, fish pie or pancakes ready-made rather than make them ourselves.  A rational economist might say that we do this because we can use our labour or time more effectively elsewhere, but how many actually do redeploy that small amount of money or time rationally to optimise their wage earning potential – very few, methinks.

For me, I think the best way to think about sustainability is to think of families rather than economics, or at least money economics.  To keep a family going into the future, you first need to have children, which is rarely an economic decision, because under most cost-benefit analyses there is no rational economic justification in having children, but our desire to continue and sustain our genes into the future simply overrides and ignores any financial considerations.  Then you need to consider how you equip your children to sustain themselves in the future and the key things are to give them the capabilities to navigate their way through their own futures, with all its ups and downs, twists and turns.  So we educate them formally to enable them to open up their minds and get employment, and informally we teach them a moral code of what is good and bad and that hard work, honesty, fairness and good manners will get them pretty much anything they desire in time, or at least laziness, dishonesty, unfairness and bad manners will not get you far in life.  We might try and give them some seed capital to buy a home, but they may not get much financial support until they themselves have had a family and we can bequeath them something after death.  Finally, throughout all of this we nurture and love them as best we can.  And so it is in real life with economic sustainability, we must focus on the means of giving people the capabilities to navigate future generations through future uncertainties rather than get bogged down with numbers, which are but meaningless figures on a page or spreadsheet – one can create almost any set of numbers or scenarios that you desire to justify any position you want but to what useful end.

But while Governments, quangoes and international bodies like the World Bank or the United Nations can help with this in certain areas, they are not the best placed to act as custodians of economic sustainability.  Firstly, they have no long term perspective as their terms of office are short and their times of influence are probably even shorter.  Secondly, Governments are remarkably bad custodians of peoples’ money, even as they need that money as it is their lifeblood.  They tax and spend with impunity because they are dealing with other peoples’ money rather than their own.  Milton Friedman perhaps explained this best as he wrote in his book “Free To Choose” – “There are four ways in which you can spend money.  You can spend your own money on yourself.  When you do that, why then you really watch out what you’re doing, and you try to get the most for your money.  Then you can spend your own money on somebody else. For example, I buy a birthday present for someone.  Well, then I’m not so careful about the content of the present, but I’m very careful about the cost.  Then, I can spend somebody else’s money on myself.  And if I spend somebody else’s money on myself, then I’m sure going to have a good lunch!  Finally, I can spend somebody else’s money on somebody else. And if I spend somebody else’s money on somebody else, I’m not concerned about how much it is, and I’m not concerned about what I get.   And that’s government.  And that’s close to 40% of our national income.”

These capacities of Government to tax and spend are the root of their power and without this ability to take and then distribute with seeming largesse, Governments are nothing.  Hence, sustainability becomes another self-justification for why Governments must tax and spend, even though individuals and private collectives may be better at optimising humankind’s response to sustainability.  This takes the environment out of sustainability and it simply becomes a matter of power and control over capital.  For me, economics and environmentalism are different ways of looking at resource allocation, where money has been hugely successful at getting people to organise themselves to do things they do not want to do for a cash reward and also to exploit the natural capital resources (but note per my previous blog that money does not buy happinness or well-being beyond $10,000, while people will do charity and community projects for little or no finacial reward).  Conversely, environmentalism explains that there are limits to the natural capital available and we must all be mindful of this.  They are different, but overlap where the externalities from the economy degrade nature and where natural capital is available for exploitation.  However, they are not the same thing and do not overlap at all times.  Hence, they are different ways of looking at the world we live in, and we must be careful in merging them together.

So we must keep sustainability away from economists, Governments and politicians and per Ostrom focus on personal and community selflessness over selfishness, and look to our children and future generations rather than just the here and now.  Similarly, I would argue money is economics, and that money and sustainability do not mix.  However, I expect politicians, economists and everyone to argue that they all mix perfectly happily together, so the future will be a great and wonderful place.

On the Nature and Importance of Business Risk

Sunday, July 12th, 2009

 

One of those slightly nerdy things that has been niggling at my brain for some time now is “business risk”.  Now I don’t mean financial risk which is something that investment bankers and hedge fund managers claim to understand and to deal with, nor do I mean insurable risks which insurance and reinsurance businesses deal with.  These I would class as exogenous business risks, i.e. non-controllable business risks that need to be offloaded from the business so far as is practically possible.

 

In fact, it was by looking at the behaviour of investment bankers that started me worrying away at risk.  In 1992-1993, I was looking at buying Carnegie from PK Bank on behalf of WestLB, the German wholesale bank.  It was eventually bought by Singer & Friedlander.  When I was in Stockholm, I remember chatting with one of the option traders, who showed me his trading screen and on it there was a beautifully simple and elegant curve that showed the pricing of some option over time.  What struck me was 2 things:

 

1.       The trader didn’t actually understand option theory, but knew what his computer was telling him.

2.       What would happen if option theory was actually wrong, but that it had become correct because everyone was taught that an option is priced using the Black-Scholes model or a similar theorem.  So if everyone is told that an option is priced following this theory and all computer programs use this theory to construct their simulations of option pricing, then it becomes a truism that options can be priced using this theory.  But if the theory is simply an artificial construct, then all traders are actually doing is playing a game with a certain set of rules and they may as well construct any different set of rules or play any form of game and pit their wits against each other in a different artificial game.

 

Business theoreticians do acknowledge the importance of risk.  They make statements like “the opportunity cost of capital depends on the risk of the project”.  As an accountant and then invesment banker many aeons ago, I remember learning about Modigiliani-Miller, calculating  beta factors and WACCs (weighted average costs of capital) and using them in valuations of businesses, and working out IRRs (internal rates of return) for venture capitalists. 

 

But in the end, economists and business people simply fudge the answer.  They have created theories based on the following: (i) they assume that all businesses are big; (ii) they assume that all businesses are financed by people that hold portfolios of investments; (iii) they assume that the availability of capital is limitless subject only to pricing; (iv) they assume that all business people, investors and financiers have perfect knowledge and a total understanding of how the markets operate; and (v) they assume that all business people, investors and financiers are rational. 

 

So they simply state that the individual risk of a business does not necessarily matter, rather what matters is the risk in shares of similar businesses on the stockmarket adjusted for a further risk weighting.  Once again, have we created an artificial construct that looks good on paper and enables high financiers to trade businesses, strip out value and pass them on for theoretical values?

 

I think it’s a load of rubbish.  Most businesses have no genuine equivalents on the stockmarket, markets are irrational and capital is a limited resource for smaller businesses and because businesses are really human in their behaviour and are not financial machines.  The difference between treating the world as an animal/human system rather than a machine throws up all sorts of interesting new ways of looking at politics, economics and sociology.  So as most businesses have no actual comparators, anyone who actually deals with project risk cheats a little bit more by deciding what return they want to make. 

 

So, in other words, working out the project risk or individual business risk is too difficult, therefore we will simply state that 15% is a good annual return so we will do anything that beats that rate of return, or if I am a private equity player or hedge fund, I will look to making 30% or more on an annualised basis. 

 

But this circuituous argument misses the crux of the question “what is business risk?”.  I think business risk really does matter and cannot be theorised away.

 

Many people will simply say – so what?  Does it really matter what the risk is if you already know the return you want to make, plus the system seems to work pretty well, so why bother?

 

I think it is important to at least try and understand the empirical nature of business risk for the following 2 reasons:

 

1.      Business risk is the other side of the theoretical business equation: risk = reward, i.e. the profit you make is determined by the risks you take.  So through understanding business risk and the potential to manipulate business risk to your advantage you can improve your profitability; and

2.     Conversely by failing to understand business risk, you can make your business very vulnerable to sudden collapse.  Witness what happen in the Lloyds of London insurance market and more recently in the financial sector, where in each case there was a sudden catastrophic collapse in an industry because too much business risk (which happens to be financial as well in this case) had been taken on with little genuine understanding of what was happening.

 

It is also possible to see how some larger businesses grow by transferring their business risk onto other people.  This is especially simple to see in the classic leveraged buy-out model where the equity providers of a business transfer the financial risk in a business onto the debt providers and tax system.  The second part is even acknowledged in business theory as utilising the tax shield, i.e. you don’t pay tax on the part of the profits used to pay interest on loans, hence if you increase the level of debt in your capital structure, you reduce the underlying cost of equity for a business.  However, by reducing the level of equity in the business by stripping out all the accumulated profit reserves and minimising the cash value of ordinary share capital injected into the ownership structure, the business is much more susceptible to business and financial shocks.  So, for example, Gala has been built up by private equity businesses that have cobbled together many established businesses, however with changes in the economic climate the value of the equity invested by the private equity providers is now zero and, as they have no reserves’ buffer, they must decide whether to invest more equity or let the group go into administration.

 

Let me give an example in our business which is in the small world of spices.  We are regularly being asked by customers to provide a price for buying/selling say 500kg of organic cumin powder over 12 month period or more recently an organic dukkah mix at 60kg every month.  However, when we ask whether we can have a contract for this, there is a lot of huffing and puffing that basically comes down to the fact that customers won’t do this.  In effect, therefore, customers are asking Steenbergs to accept the sales risk of the customers’ end product as well as our stocking risks, the foreign exchange risks of the organic spices and ingredients (the forex risks have been horrific in the last 12 months).  I characterise it as trying to get a fixed forward rate or an option to buy for 12 months without paying the cost of getting that rate.     The volumes trick is another very common trick, i.e. ask for a price for 1 tonne of organic black pepper then place an order for 50kg and never come through with indicated the volumes, yet the customer still expects the same price.

 

An even stronger example of the transferance of business risk relates to Tesco.  Some farming friends of ours entered into a contractual agreement with Tesco in 2008 to grow organic potatoes.  They had never dealt with Tesco and were told by everyone that they were mad to even try as it was like grabbing the tail of a big tiger.  However, they felt that they’d got a contract in place and that you never know how it will work out unless you try.  The credit crunch ensued, organic sales fell and Tesco said that they didn’t want the potatoes; on being explained that the potatoes were growing in the ground and there was a contract in place, Tesco’s response was that if they insisted on delivering them, Tesco would simply reject the majority of the delivery and it would be wasted.  I appreciate that this story is unlikely to be provable as Tesco will have emails or a paper trail to show that the farmer willingly decided to give up the benefits of the contract.  These organic potatoes are still in the ground and are actually growing again this year, so if anyone wants loads of really nice organic potatoes I can tell you where to get some.

 

Going back to my thesis, Tesco sought to mitigate its purchasing risk by entering into a forward contract with the farmer, which is prudent, but it did more as it actually also transferred the sales risk of selling organic potatoes in its potatoes by wriggling out of its contractual obligations, which had been entered into in good faith.  In effect, it really had an option to purchase organic potatoes, however it never paid the actual cost of the benefit of entering into such an agreement. 

 

It is right and proper for Tesco and other retailers to mitigate their purchasing risks and to maintain their supply chain, but it is arguably not fair for them to offload their selling risk.  Selling product is what the supermarkets do and they have all the detailed information on sales patterns, so they should be expected to live with that risk.  If they feel that some of the sales risk should be borne by their supply chain, then supermarkets should have a reciprocal open book policy.  Supermarkets often operate open book policies whereby suppliers must show their accounts to the supermarket so the supermarkets can decide a fair profit for the supplier, so if the supplier must bear some of the selling risks they should be given all the accounting data on the sales and margins of their product lines and competitors “better to plan for future production.”  But I bet that supermarkets have never opened books to anyone!

 

I suppose in the end if suppliers are willing to trade on this basis then that’s what the market is and people like us should suffer the consequences of inequality in the marketplace.  In fact, I think it also indicates 2 opportunities: 

 

1.       You should do everything possible to set up your business in a way that transfers most if not all business risk away from you.  In other words, your business should be as close as possible to being an agency operation but you need to keep the margins at the level or higher than your peer group.  So at Steenbergs, we are now doing everything to shift our business over to this agency concept by increasing the level of outsourced activities within the business. 

2.       If you are a private investors, you need to find businesses that are set up as these agency style businesses, but that have the outside image of being a “normal” business.  While strongly branded consumer products are a classic example of this, some retailers may also have similar characteristics.

Using this concept of business, I also think that you can come up with perhaps a better definition of monopoly behaviour, even if it is harder to verify.  A particular type of business will under normal circumstances generate a particular return or operate at a particular margin.  So for example supermarkets normally have operating margins of around 2 – 3%.  There is then a range of 10-20% either way from the average return due to normal business efficiency, i.e. some businesses are simply better organised at getting the right stock to the right places at the right times, or at billing or whatever.  In the early 1990s, Sainsbury for example was simply atrocious at getting its stocking right which was simply down to bad management, so its operating margins and returns fell.  But a monopoly can shift its returns and margins significantly beyond those anticipated from normal operating, and it does this in part by shifting some its “natural business risk” onto other unconnected people within its operational chain.  In other words, simply looking at pricing is not necessarily the only characteristic of a monopoly but you should also consider how it can change the normal characteristics of its operational environment.  Some of this change will be fine, but the judgement for regulators is to ensure that this behaviour does not become predatory and so instilling greater overall risk into the business environment.