Atomic Energy

I read a very interesting – and contrarian – article in Reuters today. The article argues that it is possible – and given that those with a vested interest like Trulia and Bankrate hesitatingly agree, it is probably more likely than possible – that home ownership may be emotionally fulfilling, but it is a poor wealth creator, i.e. real estate is not a great investment.

The article led to my thinking about all investments, and whether real estate, in this respect, is unique. In thinking more deeply, I begin to wonder how any asset class can possibly have a long-term return on investment that is higher than the growth of the economy in general, other than (possibly) equities.

Here is my logic. Let us say that at one point in time, the entire stock of an asset class (e.g. real estate) is worth $1TN. Thus, the people of an economy have poured one trillion dollars into real estate. Over the next decade, the economy grows by 3% a year on average, while the stock of real estate – market value – doubles to $2TN. With a 3% average annual growth rate, compounded over 10 years, the economy has grown by 34.4% (3% annually compounded 10 times). If real estate is part of the economy, then the “natural” (relative to the economy) value of real estate should have grown to $1.34TN. The remaining $640BN must have come from somewhere else; some other asset class, or set of asset classes, must have grown, together, $640BN less than 34.4%. This should lead to arbitrage, although that is somewhat harder to do with fixed assets like real estate, and people in general seeing other assets undervalued. Over a long enough period of time, the ability of real estate to pull from, say, precious metals, should be counterbalanced by precious metals pulling from real estate. In other words, over a long enough run, real estate, and all other asset classes, should grow at no more or less than the rate of the economy, 3% per year in our example.

The more I think about it, though, the more I realize that there is only one asset class that, again over the long run, is truly an asset: equities. All other so-called assets are just stores of value. Gold, FCOJ (Trading Places?), real estate: not one single asset actually creates new value, with the exception of equities, which are investments in companies that exist to create a profit, i.e. to take $5 of inputs, create $6 of outputs, and thus create profits and new growth.

Over the very long run, smoothing out localized bubbles, it makes little sense that all of these asset classes other than equities should grow at anything beyond the rate of inflation. Quite simply, $1TN of real estate today is really worth no more than $1TN in ten years, but defined in today’s dollars, i.e. $1TN plus the rate of inflation. Every other asset class should be the same, except for equities, which are the source of all growth in GDP beyond the rate of inflation. Equities should grow at the rate of GDP growth, all other asset classes should grow at the rate of inflation.

The trademark spat between Apple and Proview of China just got really interesting, and, ironically, reminded me of Air Canada.

For those not following, Apple claims it bought the worldwide rights to the trademarked term “iPad” several years ago, but Proview claims it did not, at least in China. On that basis, Chinese officials have been seizing iPads from retail outlets in China. Further, as the above article states, Proview is now trying to get Chinese officials to block all exports of iPads. Since iPads are all manufactured in China, and Apple keeps very small inventory, this could directly shut down all iPad deliveries and have a very negative impact on Apple.

It shouldn’t surprise anyone that the Chinese government is acting in cahoots with its local companies. Many statist countries work this way – think France and airbus, Japan and the heavy industries, etc. What is surprising is the willingness to use the “nuclear option” so quickly. There is no question that this is out and out blackmail; a Chinese company is using the Chinese government to threaten the core business line of a major international technology company. Essentially, the Chinese are saying, “you need us, we own you. Without us, you are nothing, so pay the protection money, or we will strangle you.” It reminds me of the scene in Tom Clancy’s bestseller, “The Bear and the Dragon,” wherein the Politburo ministers are convinced no clothing manufacturers will ever pull out of China, since, “they need us! No one would dare leave the Middle Kingdom!”

The incident reminds me of a story with Air Canada and Tel Aviv Ben Gurion Airport in Israel back in 2000. As the Internet was booming, and Israeli startups were multiplying, Air Canada did not have enough capacity with its once-daily Toronto-Tel Aviv flights, and so wanted to add a second flight. Needless to say, Israeli carrier El Al, in bed with the airport authorities, realized the need, and decided it wanted the extra landing and gate slots. So it used the airport authorities to deny Air Canada the extra slots due to “lack of space,” to try and force customers onto El Al planes. After all, “you need us!”

Air Canada didn’t miss a beat. It went to Transport Canada, who promptly informed El Al that they were terribly sorry, but they may not have enough airspace for the El Al overflights from Tel Aviv to Los Angeles and New York – El Al’s number one market – and so they could no longer fly. Needless to say, El Al (and Israel Airport Authority) quickly relented.

The moral of the story: as they say in business, no one is irreplaceable.

Yes, in the short run, Apple absolutely needs China to get its production out to customers. It will pay up the “protection money,” whether $1MM or $1BN. But they will take the lessons to heart, and never leave themselves captive to capricious, non-rule-of-law countries again. Expect Apple to invest seriously (and convince its Japanese and Taiwanese and American partners to do the same) in diversifying its manufacturing out of China. And where Apple moves, others will follow. China has no natural, built-in, cultural or other right to own manufacturing of anything, from clothing to iPads. People go there because it makes business sense. And when it doesn’t, they will leave.

I read a fascinating article in today’s WSJ, available here, about how AOL was the first Facebook, that really understood the value of community. Unfortunately, as they became a public company, a “Taliban” of MBAs came in, focused on short term profit and their own reputations, and killed the real long term value of AOL.

In many ways, I can appreciate his perspective. Many companies have been killed by naive MBAs who think the formulae and theories they learned in business school can “save” any company, in fact all companies are just waiting to be so saved. At the same time, even when they do have value to add, they haven’t learned how to communicate with the critical producers in the company.

For those very reasons, I have always preferred MBAs with strong operating experience

before

going to B school, and schools that emphasize those with experience in their program along with a tight focus on what works in the real world and how to communicate with real people. That is one of the key reasons I went to Duke’s GEMBA program, where the minimum experience was a decade.

I believe Kornbluth’s discredit of MBAs on principle is wrong, for the very reasons that he unwittingly makes aware in the article. AOL definitely underemphasized community, a serious management mistake. But AOL also made three major mistakes, ones that creative content types would also have made, but experienced creative business types might have found.

1. Intense focus on dial up, completely missing broadband.
2. Short term revenue focus, confident that customers would continue to pay $23.95 per month for their service, when alternate revenue models were becoming available, notably the Google model of free supported by advertising, exactly the Facebook model.
3. Control. AOL loved their walled garden, but the Internet is much wider than that. People didn’t want to be walled in.

Business fail because they kill their creative people, creative edge, but also because they miss the creative business foresight to pivot with changes in the market.

In the last several years, the concept of 3D printing has shown significant promise and even actual execution. 3D printers have existed, at least according to Wikipedia, since the 1980s. However, the combination of reduced cost of printer, increased flexibility, and expanding number of materials which can be shaped using a 3D printer has brought 3D printing closer to the regular end-user.

I do not know if 3D printing will ever be a desktop experience. Unlike desktop 2D printers, which at most require 8×10, A4 or Legal sized paper and a few standard ink cartridges, 3D printers require raw materials of varied enough types to make it likely prohibitive for a home or small business user to stock them, even if the printer price itself drops to the point of being mass-market affordable.

I do, however, believe that many items which we now purchase online and have sent UPS, or purchase from our local corner store (any of those left?), Target or other big box retailer, will be purchased from a local 3D printer. Even if Amazon can buy those mugs in bulk, such that its landed cost is $5, and its shipping is as low as $1, it still has inventory costs, and shipping of the product and its raw materials to Amazon are built into that $5. Raw materials can be densely packed, usually far more so than manufactured goods, such that the $6 cost to Amazon to have it delivered to your door (plus whatever profit margin it requires), may still be more expensive than a local or regional 3D printer having the raw materials shipped and stored near you, ordering it custom online, and picking it up (or local delivery) later that day or the next day.

What I find most interesting is the macroeconomic impact. Currently, a very large number of products, both high-value/high-complexity like iPhones and Lenovo laptops, and low-value/low-complexity like mugs and stuffed animals, are manufactured in China. While China is becoming a global manufacturing centre for excellence, its primary value-add is in providing labour at a fraction of the cost of target market nations like the US, Canada, the UK and Germany. For fully or nearly fully automated manufacturing, China provides little to no value-add; indeed, there have been numerous cases of fully automated manufacturing firms choosing to stay in developed nations, rather than offshore to China, since China provides no value-add, especially when shipping times and costs and offshore management costs are taken into consideration.

The current value chain, then, looks something like this:

• Raw materials are acquired and purified, mostly in developing countries but also in fully developed ones – petroleum, bio-goods, aluminum, etc.
• Raw materials are shipped to manufacturing centres such as China
• Raw materials are turned into finished goods using relatively low-cost labour in China
• Finished goods are shipped to market countries
• Finished goods pass from importer to retailer (and some others on the way)
• Retailer sells and ships finished goods to end-consumer

Putting China in the value chain is actually quite expensive. However, the labour cost-savings (as well as regulatory overhead for running a labour plant, as Jobs told Pres. Obama in early 2011) are so enormous for labour-intensive manufacturing that they more than make up for the added steps, cost and time.

What happens if 3D printing is able to manufacture many low-complexity goods directly near end-consumers?

• Raw materials are acquired and purified, mostly in developing countries but also in fully developed ones – petroleum, bio-goods, aluminum, etc.
• Raw materials are shipped to 3D printing facilities relatively near the end-consumer
• Raw materials are turned into finished goods automatically using 3D printing
• Finished goods are sent to end-consumer

3D printing not only allows for greater customization. It may also allow significant cost and time savings in the value chain by removing China from the entire chain. China’s relatively low-cost workforce will still be necessary for high-labour manufacturing that is difficult to automate. I do not expect to see iPhones manufactured by 3D printing in my lifetime (although I may live to eat those words, and would not complain if I do so). However, China’s position as critical juncture in most manufacturing lines may be supplanted, and, given the inefficiency, probably should be.

The geopolitical and macroeconomic ramifications are something to seriously consider.