Friction needs to be managed

Friction is like transaction costs. For business economists, this is often overlooked or treated as an afterthought, yet solving the transaction-cost problem is the critical driver of most business structures. The Friction Project, by two Stanford business professors, makes an interesting observation on the impact of friction on business success. What is interesting is that sometimes it is important to reduce friction to make decisions easier. Still, there are also times when friction, slowing things down, and making decisions harder can be beneficial.

The job of a manager is to cut through friction, another way of making businesses more efficient. For example, make memos shorter. Make meetings more focused. Friction adds to the grind of impediments to increasing productivity. Look for frictions and then cut them. Friction can also be used as a tool to make it more difficult to switch or decide. Yet, frictions may mask bigger problems. 

Transaction costs often seem so abstract, so I like the descriptive word “friction” as a better way to identify impediments to getting things done.

Managing the hard things - there is help from Ben Horowitz

 

Just read The Hard Thing About Hard Things by Ben Horowitz, a management book about experiences as an entrepreneur at tech start-ups. I often pick up these books for a quick read, hoping there may be a nugget or two on how to improve as a manager. The first part was not impressive, but Horwitz then goes on to offer practical advice on numerous topics managers face. How do you hire? How do you fire? How do you promote? How do you motivate? 

These practical tips are very good and can be implemented by any manager. Are these tips easy to use? No, making hard decisions is not easy, but Ben provided a guide on how one person has addressed these issues. The usual business management book will talk about cases, but readers want specifics like how to deal with well-defined problems. This book delivers. Be direct, be truthful, and do not try to avoid the hard decisions. 

Manufacturing employment and trend

 The US has talked about a resurgence in manufacturing, but the numbers do not suggest it is happening. Where is the surge? Construction, perhaps a small uptick after being flat. Manufacturing no change in trend. The same with mining and logging. Transportation has fallen off a cliff. Utilities are also below trend. Employment is always fighting productivity. We may be doing more with less, but workers are not seeing the improvement.  

AI - all the time for business

 

You have to love some of these charts that bundle ideas that seem to be unrelated. In this case, we find that the word "AI" is used more often on earnings calss than the word "earnings". We should expect that the word earnings is fairly static on earnings calls, but the explosion of the word AI suggests that this is the what management and investors have as their main focus. For management, using the the word AI convesy what they are doing new to address issues of tehcnology and effciency. Investors want to know how firms are using new technology. The question is whether AI will actually lead to the efficiency gains that many expect.

Wet streets cause rain problem - the need for causal thinking

The "wet streets cause rain" problems, and the need for causal thinking. Reading the news causes noise in thinking about markets because newspapers can get causality wrong. If "A"  happens in the news, then that must have caused "B". Or, if I see the event "A", it is likely to result in "B", not because of past history, but just because they happen at the same time. It is vital to get the causality right before the narrative. Narrative can be easily written when you accept correlation as the driver, not causality. Causality is connected with what is probable by what may have happened in the past. 

Causality provides constraints on thinking. It can lead us to conclude that we don't know the reason for some events. It is harder to write news stories when you are forced to use reason and causality. It is harder to be an investor if you are constrained by the limits of what is possible. If you focus on causality and logic, you may have to say, "I don't know why the market moved." 

Who is responsible for the corporation?

Corporation: An enginous device for obtaining profit without individual responsibility - The Devils' Dictionary, 1911 

The Devil's dictionary is so funny because it often hits us with the truth. Who is responsible for the modern corporation? Is it the managers? It is clear that after the GFC the government was unwilling to make individuals responsible for the wide housing fraud. The shareholders provide incentives to managers but are often unwilling to discipline managers except if they do not drive earnings higher. The Jensen-Meckling view of making managers accountable as owners through stock and option grants seems to have been abused by many. Shareholder votes are hard to use as method to impose specific behavior. The question is whether the large corporate has gotten too big to be controlled by any individual with responsibility for their actions. 

NFIB survey optimism with uncertainty

Small business tell us a lot about the direction of the economy since they represent a significant portion of US employment. The optimism has shot up since the election to the levels since during the first Trump administration. This indicator can tell us something about the direction of small cap stocks. However, we have seen a large spike in small business uncertainty which will offset some of the optimism in terms of real action by firms. The uncertainty should come down as we better understand current policy. The optimism will stabilize if the promised policies are followed. 

Private versus public markets - the new blending

 

There has been a flood of funds into private equity markets under the belief that there is some special investment magic with these firms and the managers who build these portfolios. The recent data suggests that this is not the case. The rationale for private equity is simple. Buy new quality firms vetted by managers who will engage with these firms to turn them into successful investments that can then be IPO'ed as an exit strategy. Investing in a private equity portfolio will have an illiquidity premium, you will be paid for your patience and inability access your money. Some of the latest evidence provided by Macro Hive suggests that the key assumptions do not work.  

Investors are not receiving the returns expected relative to public investments which would not be troubling in the short run if you were getting your money back. Unfortunately, are seeing long holding times because there are no exits. 

Perhaps holding liquid strategies may not as some have thought. Yes, you face mark-to-market risk, but if you are unhappy with returns, you can get your money back. 

On Draghi competition thoughts - Part 6 - Productivity Differences

 

The Draghi report provides a set of policy idea that will support stronger growth and productivity, yet the problem of EU productivity is not a recent phenomenon but a problem that has existed for decades after the productivity catch-up miracle of post-WWII. This problem is well-documented in "The Lack of European Productivity Growth: Causes and Lessons for the US", "Labour productivity growth in the euro area and the United States: short and long-term developments", "Keeping Up with the US: Why Europe’s Productivity Is Falling Behind", and "Productivity growth in Europe: low, uneven and slowing". For the period of 1996-2109, US labor productivity per hour increased at 2.1% while EU productivity was only 1% per year. The cumulative effect is huge. 

There are large differences in productivity across the EU, but the overall level is still consistent with Japan and the UK. It may not be that EU is doing something wrong, it is, but that the US is doing something right. This means that there is opportunity to copy US policies but there is also a problem that the EU is not able to differentiate itself versus other parts of the world.   

One of the key differences between the US and EU is that in the EU there is less investment in new technologies and low levels of spending on R&D and R&D spending that is focused on auto manufacturing and less on new technologies. 

On Draghi competition thoughts - Part 5 - EU and US investment differences

The EIB Investment Survey for 2024 provides some interesting differences between the US and EU.  I highlight some of the survey results that caught my eye for trying to explain the difference in the economic and financial environment between the two. First, there is higher level of uncertainty in the EU associated with the Ukraine-Russia War. Second, the cost of energy is a major obstacle in the EU unlike the US. Third, the availability of finance is a much greater concern in the EU.  

What is surprising is the fragmentation of requirements and standards in the EU. It is not really a single market in the same way as the US. This generates a significant amount of costs for any business that is trying to grow and innovate in the EU. 

 

The amount of time and effort to meet regulatory requirements in some EU countries is staggering. While the number does not seem out of line for the EU versus the US, the variation is surprisingly high. 

The regulatory burden for small firms is especially high. These are the firms that are expected to be innovators and drivers of future growth. It is likely that small firms in the US have to spend more time and effort on regulatory issues relative to large firms, yet there is not the problem of dealing with intra-EU regulatory problems.

On Draghi competition thoughts - Part 4 - Growth Differentials

 

While there has been much discussion about EU competitiveness since the Draghi report was released in late September, it is important to remember that the shocks since the Great Financial Crisis. For example, we can look at the growth between the US and EU surrounding the pandemic and see the strong difference in economic behavior. 

The US saw a negative pandemic shock, but the real GDP jumped back quickly to trend. The EU also came back to trend albeit in a more muted fashion given the slow GDP prior to the pandemic. What is truly noticeable is the slow gain in productivity but again this is from a slow trend prior to the pandemic. See "An Investigation into the Economic Slowdown in the Euro Area". 

Much of the difference in growth and productivity has to do with the composition of the EU economy relative to the US. First, there is a heavier emphasis on manufacturing which has been hurt by the slowdown and impacted by higher interest rates. Second, the EU has been hurt by the strong energy shock from the spike in natural gas prices from the war between Ukraine and Russia. Third, the EU is more sensitive to trade with China. This differential may not be an innovation problem but an economic composition problem.

On Draghi competition thoughts - Part 3 - Global hubs

 

The Global Innovation Hubs Index 2024 from Nature shows four cities in the EU considered as global innovation hubs: Paris, Munich, Amsterdam and Dublin but there is strong convergence to the developed high-income hubs from Asian cities. These hubs are clustered into four development patterns, innovation economy-oriented cities, research innovation-oriented cities, combined research and innovation ecosystems, and cities of balance development.  While many hubs have held their positions longer-term, there have been significant changes with the AI revolution. 

The development or switching of rankings is associated with infrastructure development including the ability to increases global capital and labor flow. Hub cities constantly need capital and an inflow of new labor talent to maintain their edge.

Again, the EU shows consistency with their hubs, but there is an increasing global competition.

On Draghi competition thoughts - Part 2 - Global innovation

 

Global innovation country rankings from the world Intellectual Property Organization in the top 15 – Sweden, Finland, Netherlands, Germany, Denmark, and France with Ireland the only EU country that dropped out of the top 15. See WIPO Global Innovation Index 2024. The innovation rankings are stable for the high-income group but show wider dispersion and more dynamic change for lower income groups. Based on the innovation index there does not seem to be an EU innovation problem based on significant fall in country rankings. GII score is tied closely with GDP per capita; however, there are strong country performers that innovate above their income level. What is important is the output to input score which tells us something about innovation efficiency. This relative score difference is high for many EU countries. Nevertheless, the innovation pillars do show strong dispersion even for highly innovation countries. It is hard to argue that EU is failing with the innovation scorecard.

On Draghi competition thoughts - Part 1 - Higher education

I have been thinking about the Draghi report on competition in the EU. He makes a strong case for specific policy proposals. One area of focus is higher education. Our universities are where many of the innovations of the future will first be hatched, yet the EU is falling behind the rest of the world.  The US is also falling given the rankings of the top 200 universities. The big winner is China which has seen a strong increase in the number of top universities. 

We do not believe that education alone is the driver for innovation, but it provides a strong base. Education is a necessary but not a sufficient condition for innovation and innovation may not translate to competition. Enclosed is a table of data from ARTU, the aggregate ranking of top universities, that is a meta-ranking from a wider set of surveys. These top universities can also be tied to R&D spending. The EU has fewer top universities and R&D spending is less, but the real problem is the fragmentation of education in the EU. Both the US and China have integrate systems while the EU is still focused on country level education and not the EU in total.

Andy Grove's Principle of Didactic Management

Andy Grove's Principle of Didactic Management - "Ask one more question!" - from High Output Management 

I have to follow this advice for 2025 - ask one more question, be inquisitive and dig deep for added knowledge.

I was recommended this management book from a good friend, and I was very impressed by the quality of advice. There is no shortage of management books, but most keep their discussion at a high level and do not get specific with the advice. Andy Grove's book is as practical as you can get. For example, it does a good job of explaining how to run a meeting. The basic premise is that you should manage like it is a production process. It is a factory that can be broken into specific steps. I got more out of this book on how to be a better manager than almost any other in 2024. 

Forecasts - we get it wrong - a year-end reminder

At the end of the year, Wall Street makes annual predictions. Wall Street is a prediction machine. Markets are in the prediction business through expectations embedded in prices. Yet, the judgement or value in these predictions is poor. Just look at the predictions of the stock market. Surprisingly, the stock predictions are more conservative than reality.

For the bond markets, the futures prices are a poor forecast of future rates. During the QE period, markets expected rising rates that never occurred, and more recently, the markets were not able to predict the Fed rise in rates. Now, the forward prices are expecting strong declines. if the past is a predictor, don't bet on it.

 

Ray Kroc on friendly business

 

“If any of my competitors were drowning, I’d stick a hose in their mouth and turn on the water. It is ridiculous to call this an industry. This is not. This is rat eat rat, dog eat dog. I’ll kill ’em, and I’m going to kill ’em before they kill me. You’re talking about the American way — of survival of the fittest.” -Ray Kroc 

We are not saying you should follow the advice of Ray Kroc, but he may have a more insightful handle on the describing what really happens in business. We often use words like creative destruction" or pure competition without providing description of what that means. There is no question that the hedge fund world is closer to the Ray Kroc vision. With trades often being crowded and alpha being finite, there is a fight for limited excess returns.

BCG growth share matrix and investing - more dynamic betas

The BCG growth share matrix has been used in business to rationalize where to invest and what to divest within a business portfolio. The general observation is that the switching between boxes in the matrix have increased. Businesses move more quickly to drop pets and move cash from the cash cows to stars or question marks. Investments in question marks have shorter time to prove themselves.

Finance and quants should be aware of these changes because switching within the growth share matrix will change the overall risk of the firm and thus the market beta in general and within an industry. A firm that has a high cash cow share that decides to take risks in the question mark or move to the star share will see an increase in beta. Those firms that cut the pet projected will see downside risk decline. 

If these changes occur slowly, then the switch in beta will be slow; however, if there are speedier changes in the growth share matrix, the firms market beta will be more uncertain and there will be an adjustment in the cost of capital. For short-term traders, this impact will be small but for long-only longer-term investors, a changing beta that is not accounted for will have am impact on portfolio risk.

Over-precision and forecast errors - don't follow the professionals

 

In the paper, "Overprecision in the survey of professional forecasters", researchers look at one of the longest macro forecast surveys and find that these forecasters are overly precise. They have much more confidence than what would be expected by their accuracy. They may not have an optimistic bias, but they sure have a confidence bias. Follow their forecasts with skepticism especially when they say that their forecast is a no-brainer. 

With this overprecision, there is a good reason to do your own research or just follow the forecast that is embedded in prices. You don't need the professionals.

Zillow versus Case-Shiller housing index - Liking Zillow data

 

I have been studying the housing market for the last few years. We are in another housing bubble that is worse than the last one before the GFC. The great increase in money during the pandemic added fuel to the bubble fire. 

Of course, this time is different. There is less leverage, and many buyers have locked in low rate mortgages, We are currently in a world of limited supply which has not allowed prices to fall, but there is a fundamental problem looking at the housing market. What is thew right price? 

The go-to choice for tracking the housing market has been the Case-Shiller index, yet there is now a good substitute. I am really liking the Zillow index which is more comprehensive and timelier. It tracks well with the Case-Shiller index, but a review of the differences suggests that this may be a better measure. It is worth following and is available through the FRED database.