Seeing Past the Noise, Economic Volatility

March 30th, 2009

February 24th Salon, a Summary

Though not a rare experience in my career, Jim’s* case stands out as representative of the conflict between what I call the business model and economic theory. It is a story of an expansion, a doubling in productive capacity, which followed a dozen years of profitable operations that had increased the capital base 8 times over. The business model won. The business lost.

The noise surrounding this case was loud, as usual. What I mean is that Jim, my client, was surrounded by people who were enthusiastic to double the firm in size. They were employees, family, and lenders–also as usual. Economic times were good: stable growth was apparent everywhere.

In a previous entry I had critiqued the business model as a means of making major decisions. Stated simply, that model is based on profitability, facts, and proof. This seems rational enough, and used properly, has its merits. But it leaves important questions unasked, let alone answered, and is a recipe for disaster.

Economic theory begins with these basic theories:

  • Price and value never match.
  • When price exceeds value, it is a time to sell or at least not buy. Value is calculated (a funny word because value is subjective) by measuring return on assets.
  • When value exceeds prices, it is time to buy or at least not to sell. Another way to say this is sell high, buy low. In practice, in times of high excitement, we have a strong tendency to do the opposite.
  • Prices are greatly affected by credit supply, its cost and availability. Government is the major manager of credit supply. The effect on credit, and hence asset prices? Predictably disastrous.

The apparent relevance of this theory depends on our view of the future. Much of the time the future turns out just like the present. The relationship between price and value one day is pretty much true the next day. But sometimes it changes.

Jim’s expansion was forecasted to show higher, much higher, profit than before. That number had everyone’s attention, and was all the argument they needed. What they didn’t want to see was the return on assets. This was much lower than historic performance, the performance that increased wealth eight times in the preceding dozen years. It predicted dangers. It is always just a matter of time before the price/value pendulum swings back, and ruins all sorts of calculations, especially those that are limited to nominal profits.

I don’t like winning arguments this way: everyone loses. As return on assets made clear to me, when the price/value relationship shifted, the return on assets on the entire business plummeted, and the promise of higher profits dried up.

I had not been clear … enough. The case was so difficult that it was instrumental in my taking 3 years to review, research, and write Oddballs and Misfits: the entrepreneur’s war with himself and corporatism.

For Jim to combat the business model meant he had to disagree with everybody. He had to stick to his own opinion about the future and not be guided by everyone else’s view. As an oddball entrepreneur, it was how he did things up to this point.

Jim knew that by personality if everybody took one side I would take the opposite. Maybe it is a personality trait. In my defense, it is also how I find the chink in the armor–either my client’s, before an adversary finds it, or in my client’s adversary’s, so he can exploit it.

Perhaps Jim heard my personality and not my argument from economic theory. Prices were greater than value at this time. They had been for sometime. Inevitably, the inequality would reverse and that added to the ordinary challenges of a major expansion were too much to overcome.

Today, the inequality is on the other side of the pendulum’s arc. Value is becoming higher than price. The opportunity is great, and resistance to seizing it will be high.

* For obvious reasons, not his real name


Next salon will be Thursday, April 23, 4.30 p.m.

Subject: Economic Volatility: part 5, “Only Action Matters”

This is the final of the series.