Thursday, October 30, 2014

Returns to capital aren't high.




Monopoly Doesn't Explain Current High Profits


















  1. Excellent post. One possibility you didn't mention that is (only) slightly more sympathetic to Krugman as an alternative or supplement to the demographic/developing world demand for future safety argument: Temporary monopolies. The argument is that technology has produced (1) a greater proportion of winner take all businesses than usual, but many of those businesses are seen as ephemeral monopolies; i.e. risky and (2) generally increased the risk of volatility from incremental investment for many conventional industries (e.g. retailing). This would lead to high apparent returns to equity but also high risk premiums pushing down equity valuations. The speed at which an entrepreneur can convert her labor into a new network that in large part steals or threatens value from existing business (Whatsapp!, Uber) does seem to have accelerated in more than one or two areas, and has started to put more risk in the teeth of supposedly staid businesses.

    Of course, more temporary monopolies and greater threat of obsolescence would actually imply higher overall returns and capital, and you argue they don't really exist. But it could well be that capital structure has corrected to reflect these risks, with the lower debt-equity ratios resulting in a barbell, with the very low returns on (lesser and more selectively placed) debt more protected from the increased competitive risk, with averaged returns on equity bearing most of the burden slash gaining most of the fruits.

    It's interesting that real returns on equity in the industries that seem least affected by an increasing pace of world change, especially financial businesses whose equilibrium competitive returns are mostly based on market-to-market asset values, have not in fact increased. On the other hand, their required returns on capital don't appear to have decreased either (in the case of financials), but there could be other reasons for that.

    1. Thanks for the input, dlr. Excellent comment. Welcome to the IW conversation! Don't be a stranger.

      I think your observation does explain some of what is going on. There is an unusual amount of survivorship bias. So, I think market values to book values are high, but market values to cash flows are pretty normal, which I think is what we would expect to see in the scenario you describe.

      Your last paragraph is interesting. I suspect, especially regarding financials, that the recent extreme volatility in the business cycle might be overwhelming other factors.