The Center Should Not Hold

The title of Brandon’s previous post “The Center Can Not Hold” is ripped from the end of the famous TS Elliot poem The Wasteland.

Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world.…

The poem was written in the immediate aftermath of WWI when Europe was rendered a bloody mess as the various socio economic institutions and political alliances that had held Europe together since the fall of Napoleon were ripped apart.

Brandon uses the phrase to describe what he sees as happening to the poker world. Poker had experienced a renaissance of sorts ever since Chris Moneymaker won the WSOP in 2003. Moneymaker was an unknown who had learned to play poker by playing online. His success spurred the popularity of online poker websites. These websites not only helped pull in new players but helped as Brandon describes it pull the game away from the shadowy underworld that had previously operated it. In the new corporate world of poker, everyone from college kids to major Hollywood actors could play and they could do so in games kept far away from shadows. Now with the fall of some of these poker sites, this new world is being torn asunder and looks to be reverting to the old.

This development is unequivocally bad for professional poker players and Brandon is right for thinking so. If the games become harder to access then new money, dumb money will not access it and you are left staring at a bunch of wolves. However, what is bad for the pros; is good for the larger world. If there was a world that needed to be destroyed by the forces of otherworldly chaos summed up in The Wasteland, the world of poker was it.

On the surface, I should have no problem with poker. It is a zero sum game – for every winner there is a loser and vice versa. However, this is a deceptive monkier. Regardless of whether you win or lose, poker does subtract one thing and that is time. It subtracts time from people who are very talented who could be participating in positive sum games. The problem with poker over this past decade is that too much dumb money came in and too much intelligence arrived to capture that dumb money.

When guys who win the Hoopes prize for mathematics are giving up careers in mathematics to focus on poker, the world is a poorer place. And this is precisely what has been happening over the last several years. Poker went from being a fun hobby for the legions of smart people who play it to being their actual day job that they could do from home through online poker sites. They turned away from engineering, from teaching, from law and they spent their days trying to win $10,000 pots on Full Tilt while sipping coffee in their underwear. You couldn’t blame them either. The decision to play poker full time was by far the more rational economic choice and made many of them multi millionaires. 

It is hard to look at poker and not draw parallels to the world of high finance. While finance arguably has greater social usefulness then poker, much of the activity in finance over the last decade – the high frequency trading funds, the engineering of esoteric mortgage products – had very little to negative societal value. Like poker, finance drained away some of the most intelligent people in society and the world was left a worse place.

Now both industries are under regulatory attack from the government and for different reasons. The charges that are being levied though have nothing to do the most serious crime that these industries committed, the crime of being too beautiful and alluring to too many of the best and the brightest. The government can’t arrest these industries for being too beautiful so the government is doing the next best thing by trying to throw acid on their faces. Whether it works or not to detract interest remains to be seen. …

Buying Shampoo from China

This past week, the WSJ reported that the CEO of alibaba.com, a business to business platform that primarily helps Chinese manufacturers connect with Western buyers, was forced to resign after it was discovered that more than 2,300 sellers registered on the site committed fraud, sometimes with the help of Alibaba’s sales staff. As shocking as this might be, it is hard to pretend like this is a new kind of news story. Corruption in Chinese manufacturing is something we hear about all too often and it is something we have come to expect. We willingly tolerate it in order to have access to the largest manufacturing base ever created.

Even though every day we consume dozens of products that were made in China, we have little collective idea of how those products are made and how they get to us. If you are like me and you are curious about what really is happening behind the scenes of the world’s greatest economic miracle, then I highly recommend that you read Poorly Made in China.

 

Poorly Made in China is a detailed true story account of an American consultant’s trial and tribulations in the Middle Kingdom. Paul, the protagonist and author of the book, is tasked with managing a partnership between an import/export businessman in the United States who is sourcing shampoo bottles from a start-up Chinese manufacturer. The book takes you through the evolution of the relationship and in so doing reveals all sorts of hidden truths about the world of Chinese manufacturing and Chinese business practices in general.

So how do things play out? Well the relationship between the two – Bernie, the American export/import guy whom Paul is representing and Sister, the Chinese woman who owns the shampoo producing plant, begins wonderfully – at least from the American point of view. Bernie and Paul at the outset are able to negotiate ridiculously low manufacturing prices for the product. At the price they agree to, Sister has no operating margins. At the end of the negotiations Sister feigns like she has been defeated by the power and bluster of the Americans. However, the battle and intrigue has actually just begun.

Sister will get her profits in due time and she is patient at first. The business partnership begins slowly and over time it starts to run reasonably well. However, just as Bernie’s dependence on Sister grows, she begins to employ various tricks. She starts by changing the terms of the deal after orders are placed. She claims that “price go up” for various inputs and therefore she must charge different prices to her wholesaler. When she is called out on it by Paul, she protests and feigns like she has been insulted and lost face. So Paul has to relent and concedes on some of the prices.

When she has pumped all she can from rearranging prices she begins the “quality fade.” She changes the specification of products so that cheaper lower quality inputs are used that can save her money and increase margins further. The shampoo product becomes less shampoo and more like a dangerous mixture of toxins. That continues until she is caught and again she feigns insult and claims loss of face and is able to extract more concessions as a result. She uses tactic after tactic which in most normal operating circumstances in Western countries would be considered incredibly illegal. However this is not a Western country. Time and again, the tactics work and she wins out.

This circus continues until at the end it is clear that Sister has thoroughly won the war. She gets enough revenue from her partnership with Bernie that she can expand the plant and start other lines of businesses and so she no longer needs Bernie. No longer in the position of power Bernie is told by her what to do rather than the other way around.

……..

What is worrisome about the saga of Bernie / Sister is that it is by no means unusual. Many American companies like Bernie were suckered into China by incredibly generous terms. The Chinese government will help finance projects, the Chinese will work for nothing and they will be guaranteed all sorts of end markets in China.  Like Bernie, their greed blinds them into thinking that these generous terms are permanent.

They quickly learn differently. They find that Chinese government financing becomes contingent on sharing sensitive intellectual property with a Chinese JV. They find that the Chinese supplier may work for free at first but will quickly change the terms of the contract at the first sign of supplier dependence.  Finally those end markets they thought they had access to in China never materialize as the Chinese government ensures through various restrictions that those markets end up in the hands of domestic players. Before the Western company knows it, their cost structure has vastly increased, their IP has been pillaged from them and they are competing with a million Chinese companies that now know exactly how to make their product because they shared that expertise with them. They like Bernie come home after 10 years more or less empty handed.

American companies and the American public in general are just waking up to the fact that our economic relationship with China…

The Fall of Airline Pilots And Rise of Hedge Fund Managers

There is a great scene in the Steven Spielberg movie Catch Me if You Can where Leonardo DiCaprio playing the young Frank Abiginale has his “Aha” moment. Frank’s parents have just gotten divorced and he has run away from home seeking a life on his own in NYC. He is down on his luck and is feeling sorry for himself when he sees an Eastern Airline pilot get out of a cab accompanied by several beautiful stewardesses.

Frank is stopped dead in his tracks at the sight of this pilot. The pilot and his bevy of women swoosh past Frank and head to the classy hotel where they are staying. There the pilot is given a big welcome by the manager before heading up to his room. On his way up, he signs autographs for wide eyed youngsters and advises them to stay in school.  After watching all this, Frank decides that he too must become an airline pilot.

Catch Me If You Can is set in the early 1960s which is the only reason why anything in this scene makes sense. It is absurd nowadays to imagine an eight year old asking a commercial airline pilot for his autograph. Nor could one imagine the stewardesses accompanying that pilot being young attractive women and not dumpy and grumpy middle aged ones. Being an airline pilot was once a very prestigious, high paying job with loads of glamour. Now it is quite the opposite.

In his testimony before Congress in 2009, Captain Sully, the hero of the Hudson River landing, brought to light the tough working conditions faced by many modern commercial airline pilots. Over the past eight years the pay scale for most pilots has dropped by 30 to 40 percent on average. The starting pay for a pilot at a major is somewhere around $30,000 annually and it takes several years of seniority before you even begin to crack six figures and that is assuming that your airline does not go bankrupt.  It is even worse for regional airlines where pilots are sometimes making only $14,000 to $24000  a year.

There are all sorts of reasons cited as to why pilots have been squeezed – deregulation, rising fuel prices, the cyclical nature of the industry. An important reason perhaps the most important one is supply. The requirements for becoming an airline pilot have lessened over the years. It used to require well over a thousand flight hours. Now new regional hires only need 300-500 hours. Before military experience was a given. Now less than 50% of all pilots have it. Somewhere along the line, airlines decided that having super experienced pilots was not as important as having a super plentiful pool of less experienced pilots who were willing to take a cut in wages. With supply up and demand volatile, the fortunes of the airline pilot profession went south.

While the salaries of airline pilots have tanked over the years, the salaries of hedge fund managers have skyrocketed. If there was a ever a profession that was on the cutting edge of pay and prestige the last ten years – the hedge fund PM was it. Hedge fund PMs made millions and sometimes tens of millions, hundreds of millions and in a few cases billions of dollars a year for a time. They have gone from being completely anonymous guys laboring behind Bloomberg terminals to business celebrities.

The real question though is how will this industry look 20 years from now?  Lots of people are entering this industry or trying to at least. Everyone including the hedgefunds themselves get how grossly over compensated they are. That said they deliver returns. Even after this whole crisis you have not seen the collapse of 2 and 20, the industry standard performance fees. Many hedgefund managers are still raking in hundreds of million of dollars a year in salaries.

Now, I have no way to know whether this will continue or not. However, I can say that in order for it not to contiue, the barrier to entry to becoming a hedgefund manager will have to be lowered. That is the gate keepers of money will have to decide that they would rather go with the less experienced fund managers with no track record who is going to charge a significantly lower fee structure then the experienced fund manager charging a bundle. However, it is hard to imagine that happening given the potential reputational risk in getting a judgement call like that wrong. It is also hard to imagine people still getting 2 and 20 for generating easy alpha.

However, the battle develops, I can tell you one thing. The second the 8 year old on the street know what a hedge fund manager does and wants to be one is the second you should begin shorting the long term financial and prestige prospects of hedge fund managers. …

Why OpenTable is a Short

I have been told that you shouldn’t short high valuations. Short broken business models instead. A lot of guys have been shorting high valuation stocks like NetFlix and Amazon.com. They have gotten crushed as these businesses go from strength to strength. Now the market is afraid of anything that has a model that might be similar. However, not all these web 2.0 business models will work out. Some of the stocks that are being mistaken as the next NetFlix will come crashing down. Remember once upon a time we all thought that AOL was going to take over the internet. However things do change. Anyways, a great example of a good short right now in this space of overvalued Web 2.0 companies is OpenTable.

Click here and open the PDF to get the full pitch -    Open Table …

Why Libya Right Now Is a Dow at 6,500 Type Moment for the American Foreign Policy Establishment

 

Every once in a while a pitch comes along that looks like the sweetest, juiciest, fattest pitch you are ever going to see. That is what you wait for. — Warren Buffett

In watching the US pensiveness and inaction regarding Libya, I couldn’t help but think of the above Warren Buffet quote. Here we have a moment that is absolutely perfect for US intervention, the fattest pitch US policy makers could have ever hoped to receive, an opportunity to put the failures of Iraq and Afghanistan on the backburner for a while and both do good by ending mass civilian killings and also helping secure oil supplies. Yet we can’t swing. We simply don’t have the capital and wherewithal to do so.

As Warren Buffet and other value investors well understand, you don’t always need to act. In fact it is better be patient and wait until the moments when the course of events throws up an opportunity where the reward is maximal and the risk is minimal. If you act before those moments then you run the risk that when those moments arrive you are not ready. Many of us experienced what that feels like in the spring of 2009. We knew that markets were at a low and it was a great time to buy but we just didn’t have the capital to do so having wasted it on moments where the risk/reward was less obviously skewed.

Libya right now is in many ways a Dow at 6,500 type moment. The rewards for acting far outweigh the risks. However, like many investors in 2009 our capital and attention is too tied up in disastrous investments in this case Iraq and Afghanistan for us to make a move.

So what are the rewards exactly? Well for one, we could get oil flowing again. Libya is the largest oil producer in Africa and the troubles there have caused oil prices to spike above $100. Killing this oil price rise would be worth hundreds of billions of dollars to our domestic economy. Furthermore, we can show the world that our military is still capable of doing good. The Libyans unequivocally want Gaddafi out. He is killing civilians and destabilizing the region so his neighbors want him out as well. America would win this PR battle very easily and see its international reputation which has been battered by the wars in Afghanistan and Iraq rise as a result.

So what are the risks then? Well the obvious risk is the loss in military life and the potential of a protracted expensive conflict. However, a quick glance at the facts would reveal that to be unlikely. First of all, Libya is a very small nation population wise – 6 million versus the 35 million in Iraq. Secondly, the part that is supporting Gaddafi is an even smaller fraction of that 6 million and is centered entirely in Tripoli. If we secure Tripoli, we secure the nation. This likely would not take very long as those soldiers who still are loyal to Gaddafi would immediately become unloyal the second America showed up. Their loyalty to Gaddafi runs no deeper than the money he gives them.

At the moment though, no such military action looks to be forthcoming. America like myself and others in spring of 2009 is passing up on an opportunity to make a move at just the most opportune moment. …