Bullish on Automation

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Every pundit under the sun has their theories about how the “world will change” post-Corona. Personally, I have never liked airy pronouncements about how “NOW it is different.” I prefer more measured responses, like Ben Thompson of Stratchery, who has said in his articles that the responses to Corona would accelerate existing trends.

I do, however, think that one trend will reverse direction, and that has a major impact on markets: supply chains.

Many countries have been rather surprised to find that, not only do they have few manufacturers of key medical and medically related equipment, notably personal protective equipment (PPE) such as masks and gowns, but even reagents for tests, vaccines, and swabs. As such, many countries are starting to question their decades of building “efficient supply chains”, i.e. reducing cost as much as possible.

For a long time, that has meant outsourcing to China. Yes, it also included other low-cost countries, depending on the industry, Mexico, Vietnam, Philippines, but the “world’s factory floor” for a long time has been China.

When the item in question is a toy truck, it doesn’t matter all that much (except to the toy truck manufacturer). When it is masks or medical gear or computers, it does, especially in a crisis situation.

The reasons for this are simple. Your costs of building anything in business are made up of capital and labour. As we studied in business school, these balance each other. Invest more in capital (buy a tractor), and you need less labour (farm hands). Each business decides for itself how to balance these, based on its projected profit and revenues, risk tolerance, and cash on hand.

When I was at Duke Business School, we spent a week in China. During a long bus ride from Tianjin back to the hotel in Beijing, I looked around me, saw all that was going on, and asked John Coleman, my macroeconomics professor, how it can make sense to manufacture so much in China. After all, wages largely reflect productivity. The economists have models for this, but we all know it instinctively: if I am more productive for your business, i.e. make you more profit, you will pay me more. If the wages of a labourer in China are one-tenth those of a labourer in the US, would it not follow that the labourer is about one-tenth as productive? Why would I outsource my work there, especially given the additional headaches of offshore outsourcing: legal costs, transaction costs, foreign exchange risks, transportation costs, etc.?

His answer was that China has a lot of underemployed labour. In other words, supply of labour is so high, it is driving down the cost of labour below its productivity level. Thus, a labourer in China in a particular sector may be only one-fourth as productive as his or her American counterpart, especially at the time of this conversation, but the sheer number of labourers means his cost is only one-eighth or one-tenth.

Me: But eventually that goes away?

John: Yes, but that can take a long time.

Me: So… China is just a big arbitrage play?

John: Precisely.

This was true, up to a point. Even though wages eventually will catch up to productivity, a location with significant cost advantages for long enough can generate a self-reinforcing ecosystem with the supply chains around it. This in turn makes it a specialist location for these items. It no longer is a case of, “I can get labour for less then their relative productivity,” but much more, “this is the best location to manufacture these items because everything I need is right here: experienced labour in this sector, specialized tools manufacturers, repair shops for the tools, flowing supply chains for the input raw materials, etc.”

What does that have to do with post-corona?

Put yourself in the shoes of the CEO of a major manufacturer of PPE. Twenty or twenty-five years ago, you had a factory somewhere in the US, say Minnesota. Your costs go up each year, but you cannot just raise prices. You need to find a way to keep them at worst in line with inflation, at best reducing, or your competitors will eat you for lunch. There are only two ways to lower prices: reduce your profits, or lower your costs.

Obviously, reducing profits is bad for your business, and your shareholders will not take kindly to it (nor should they), so you need to find ways to reduce costs. You have several options:

  • Pay your workers less - they will leave, and if they are unionized, they will strike first and then leave. This is not good for your business.
  • Invest in capital to increase productivity - basically, automation. If more of the work performed manually today is performed via automation, the productivity and value of each worker goes up.
  • Find some place where workers cost less than their productivity.

The first option is a non-starter. The second - capital investment - seems like a great idea, but requires investing real capital and entails real risks. Some automation doesn’t work, some isn’t ready, some workers don’t want to be retrained. If only there were soem place with quality workers but low costs.

And then China joins the WTO, and trade starts to flow.

So you start to build out in China.

This strategy works great for you… until it doesn’t, twenty years later.

Many economists have written about why the last two decades of unusually low interest rates have not brought about serious inflation. I would argue that it has, but let’s not get into the macro debate, or discussion about how central banks measure inflation. One of their arguments is that the constant low-cost factory floor from China has kept the lid on inflation.

I would take that argument in a different direction.

The low-cost-versus-productivity offering from China has acted as an escape valve from competitive pressures that normally drive capital over labour. For twenty-plus years, many Western businesses have avoided the need to automate because of “cheap labour” - which really means, “cheap wages compared to their productivity” - in China.

Then came Corona. Countries, understandably, want their own ability to manufacture critical equipment. Even those countries that have their own manufacturers are discovering that the supply chain is dependent on overseas countries whose interests may diverge in times of crisis.

Let us put ourselves back in the CEO’s chair. You need to be able to manufacture those masks again, right here at home. Labour costs are much higher here, partially due to the lack of arbitrage, partially due to labour laws, but it doesn’t really matter why; you just need to do three things simultaneously:

  • manufacture masks domestically
  • keep prices low
  • keep profits high

You simply have to make your masks at home with fewer labourers than you did overseas, each one of which must be more productive than his or her counterpart overseas.

The only (palatable) way to do that is via capital, i.e. automation.

Now multiply that by multiple manufacturers in one sector, and then by many critical sectors. Then add in other sectors that may not be as essential as medical gear, but still are important - smartphones, laptops, writing implements. They all want to avoid the disruption that happened during the Corona lockdowns, but are facing the same pressures as the mask manufacturer. Once that company is able to do it, others will as well. Eventually, the cost of the automation goes down further, becomes more widespread, and, yes, even the toy truck manufacturer can bring their factories back domestically.

What is the linchpin in all of this?


This is not investment advice, and I am not a certified anything. But I read the tea leaves and have to be bullish on companies that make automation across industries better and easier.

In the last decade, automation salespeople would ask their potential customers, “don’t you want to spend $1MM to make your workers 20% more efficient?” Some would say yes, but many would say, “I could, but I might as well save 40% by shipping the work to China.” I believe this conversation will be very different in the next decade.