Jan

16

The GaveKal research group has an optimistic view of the forces that will affect economies across the world. This is almost the exact opposite view that Steve Roach, the Sage, the Palindrome, and the Elizabethan ghost take. Gavekal build their view on the foundation that globalization, industry de-regulation, technological processes, smaller families, the spread of the internet, low volatility as a result of more stable employment, and the emergence of the platform companies guided by trade and the invisible hand will lead to low inflation, a high profit margin, and an ebullient stock market environment. They make a written case for this in their book Our Brave New World and in two research reports, The Invisible Hand's Impressive Work and Welling @ Weeden Brave New World. I have read all these reports and I feel like one of the doubters described by Thomas Kuhn in The Structure of Scientific Revolution, although every serious student of Austrian Economics, Adam Smith, and Dimson, Marsh and Staunton should know that equity prices are incessantly going up and that Gavekal's view, opposite to that of the Abelprechfaberoachbuffesoros', will lead to great riches anyway.

Despite this, a close reading of the work shows that they build their view from many concepts and buzz words of economics, finance, and business management that are completely untested, and counterbalanced by many more incisive and useful economic theories. Their recommendations as to what to do with their work are fuzzy and are not particularly likely to lead to above average profits. 

Central to their view is that a new kind of company has emerged, which is the platform company. This kind of company consistently increases its profits by concentrating mainly on design and marketing its products. It has no need for outside capital, and it buys all its goods from companies in China and India that do the unprofitable manufacturing and inventorying, and care only about employment. But is any part of this assertion true? Are such companies more prevalent than they were before? Do they make greater returns? Are they better buys than companies in China where there are 3000 ball bearing manufacturers, and 300 automobile manufactures? Do companies that outsource manufacturing, or do service companies, make a higher return than others? Is there an increasing number of such companies and will this lead to higher or lower returns? An extensive list of linked queries and studies with ever-changing answers will determine whether this is a useful concept.

Another pillar of their argument is that we are moving toward perfect competition and perfect information where companies such as Walmart, Carrefour, Ikea, Li and Fung, and the IDS group, are the optimum investment issues and models for others to follow. This will lead to constantly decreasing prices in the bottom end of the market where the masses buy their goods, and higher prices at the top end where the rich are constantly finding it more expensive to be rich/individual. The cost of capital will remain low, prices will continue to drop, and excess capacity will develop.

I find no reason to believe that excess capacity will develop, as decision makers are very knowledgeable and they all wish to increase their wealth and opportunity. Continued above average rates of return on investment are highly transitory, subject to great competition and affected by many shifts in regimes and tastes. I doubt that Chinese manufacturers will constantly realize declining profits, and that platform companies will be able to garner these to any greater extent than the more integrated manufacturing companies that were the standard model in the older days. Such suppositions would again have to be tested. 

One of their favorite points, which many of their conclusions are based on, is a very elementary form of the quantity theory of money; mv1 + mv2 = p1t1 + p2t2 — They believe that one part of the right side of the equation increases, and that the other side will decrease.

In opposition to this belief, velocity is always changing and there is constant substitution between goods, and shifts in demand and supply. To assume knowledge of velocity or to assume its constancy is to conclude that interest rates, and competition and substitution, don't come into play. They conclude that there will be higher rates of inflation for luxury goods, an irresistible rise of real estate, declining volatility, the propriety of taking on more debt, and the chronic tendency to over-capacity. These conclusions are based on a simple model of the quantity theory, related fixed shibboleths about the rigidity of capital, and the continuation of present trends. Here's one of their typical conclusions, which I find no supporting evidence for, except for that it explains some of the movements of markets in 2003-2005.

"As the prices of financial services and luxury goods are driven persistently higher, service producing countries such as Britain, Honk Kong, or the U.S. get richer relative to countries which specialize in manufacturing … The virtual limitless supply of cheap labor and capital in China, and the chronic misallocations of capital ensures that manufactured goods continue to get cheaper." 

One of their 'buzz' subjects is the idea of Schumpeterian Growth versus Ricardian Growth . Schumpeterian Growth is driven by technology and disruption and leads to income disparities, which the lower part of the distribution will accept because of their hopes for the future. Ricardian Growth is driven by efficiency and liquidity, and investment banks have been key to providing this, thereby smoothing out our business cycles. Gavekal believe that politicians have striven too much to provide for the dark, lower side of the disruption, and that's why the U.S. has grown faster than Europe. Does such a typology have any predictive or descriptive value?

The investment conclusions that Gavekal develops in Brave New World are by far their weakest and most naive chapter. However, as they have pointed out to me in their above note, the book was dated 2005, and they constantly change the specifics of their recommendations based on changing applications of their basic principles and framework tailored to current shifts in the international competitive situation, foreign exchange and commodity market trends, and changes in monetary policy. The jury is still out on their ability to fathom the changes in monetary policy better than the next Fed watcher and I would recommend that they pay much more attention to the term structure of interest rates, especially the long term bond rate as a very accurate indicator of inflation. However, unlike the current naysayers who believe that the Fed Funds Rate is all that matters and this is totally in the control of the Fed, I agree with their focus on the old fashioned bond vigilantes as the posse that tells us what, who, and when it's good and bad.

Their first investment conclusion is that to avoid index funds, one should employ reversion to the mean strategies. The second is that one should identify momentum strategies and get in and out at the right time, and the third is that one should employ carry trade strategies by borrowing at low rates and investing at high rates, and:

"hope that the markets remain continuous. Most of the arbitrage type of hedge funds run some kind of carry trade." They conclude that macro type managers "are most likely to perceive the important changes in the investment climate." 

After a thorough immersion in GaveKal, I conclude that they suffer from the use of naive tools of economics, a view that the recent trends of the world will continue, a lack of appreciation of the forces of change and competition for rates of return, and a naiveté about how to invest. And yet, their world view, which is based on the creative and resilient power of capitalism, will lead one to far greater success over the long term than the doomsday view of the Abelprechfabers, which they counter at every turn. Hopefully, they will improve on their models, develop some more rigorous economic tools to support their work, and sharpen the practical investment conclusions that flow from their firm in the future.

James Sogi comments:

… a new kind of company has emerged, which is the platform company. This kind of company consistently increases its profits by concentrating mainly on design and marketing its products. It has no need for outside capital, and it buys all its goods from companies in China and India that do the unprofitable manufacturing and inventorying, and care only about employment. But is any part of this assertion true?

Here is an example. I bought a coffee grinder some time ago. It was a good one, and the distributor replaced the broken canister part last year. But when the main gear broke, this question arose: Is there a coffee grinder repair shop or small appliance repair anywhere in town that does not charge a minimum greater than the cost of buying a new one shipped from China at a price that does not also provide profits for the importer, the distributor, the shipper, the warehouseman and advertiser? After great debate in our house, another question arose: Does not the labor of the grinder in China or India greatly benefit from the opportunity to lift themselves out of subsistence and into the global market, and in two generations soon lead the world?

Gabriel Ivan replies:

Does not the labor of the grinder in China or India greatly benefit from the opportunity to lift themselves out of subsistence and into the global market, and in two generations soon lead the world?

They will certainly benefit (and they ought to), but in order to lead the world, one needs to builds its foundation on more than cheap labor. "The Birth of Plenty" explains the factors of wealth creation better than I can attempt to. (find the 1st chapter free here).

This goes to validate (in my opinion) this 1997 paper, and will have a huge impact on where I'll focus my investment efforts. I would test these regressions across sectors myself, but unfortunately I don't have the tools (prices database).


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