Cycles, amplification and greed

Posted: 05 Jul 2007 00:44
Registered User Currently Offline	Posts: 16 Join Date: Feb 2007
It is difficult for us these days to imagine a world any different from what we know. Capitalism, the market economy or relatively freedom to do business in the economic world, as we know it, as a system has only existed for a shade longer than 230 years. True over that time it has had varied forms and guises but (to reference the movie “The Matrix”) the construct; the basic programming for market mechanisms is modern. It evolved as a system best equipped to solve the problems of society – to weed out inefficient capital allocation. Capitalism is however not perfect and theorists have to contend with and attempt to solve one if it’s most notable, inherent flaws: business cycles. Cycles composed of ups and downs are a symptom of excess and overshoot, typified by high highs and low lows. Instead of reaching a mean, momentum results in overrun, followed eventually by back tracking and later momentum in the opposite direction. Within functioning markets are the means to create snowballs, either wittingly or otherwise. These snowballs are a disproportionate outcome to an event – an amplified event. Amplification is like leverage in that a small amount of effort produces a large amount of influence. Where financial leverage may be used to reap positive gains, the capitalism is a double-edged sword. It may work devastatingly in the opposite direction. We know this as a bubble. Business cycles produce the other drawback: concentration of wealth. During a rising tide all are doing well. But not all prosperity is the same. Some are doing better than others. When downturn comes, those doing less well find themselves moving below a threshold and having to sell assets to pay off loans. Those who were doing a little better, even whilst feeling the pinch, are still above the threshold. They still have healthy credit ratings and are able to snap up those assets in the fire sale. Over time this asset accumulation occurs and benefits the same people at each downturn. Thus wealth is gradually concentrated more and more. No one would dispute that an ordinary motor car is a complicated machine, full of teeny-tiny parts and electrical wires all over the show. It’s a complex system just like the world economy. Any system is dependant on all of its essential components to function. But within a bubble economy i.e. the motor car traveling at 150 miles per hour, it’s even more dependant on these critical parts – the faster you travel the more important the contribution from all the components for the sake of safety. Even the contribution from the most ordinary of components (say a small bolt with its nut) holding the suspension system to the chassis. On the grand scale of the whole car, it would seem insignificant, but failure thereof means that the rest of the system cannot function or fails catastrophically even if all the other parts are in peak condition. A small event, large consequences! For an integrated world economy so dependant on oil, an itty-bitty hurricane can take out just one itty-bitty oil refinery and the shock waves reverberate across the world. The cost of the refinery: a few hundred million dollars; the hurricane, a stock standard natural event occupying a fraction of the earth’s surface; but the effects are a few trillion dollars in insurance claims, oil price shocks, inflation, etc. A small event, large consequences! For a well oiled (pun intended) business enterprise, you certainly have a few key members of the staff who make a completely unique contribution to the business. They may possess specialized knowledge or have 30 years of experience working for that company. The power bestowed on this specialist (and we all know at least one of them in our lives) creates an undue level of risk. The risk that being hit by a bus or simply being poached by a competitor, may just throw the business into dire turmoil even to the point of sinking it. A small event, large consequences! When evaluating an investment, the analysis has to include what amplification the business would be susceptible to. This lends itself to all favored investment philosophies i.e. growth, fundamental, top-down, bottom-up, value, etc. Would the company benefit from other’s misfortune during a downturn or have to sell its own assets to service debt obligations. Assets which are currently retaining customers and producing your dividends. Personally I would like to be a partner, with the likes of Warren Buffett, who are beneficiaries from the concentration of wealth. These business owners perhaps benefit from amplified events but do not rely on them for prosperity. Business owners who don’t just pitch up for work and run a business, but who live their business. They continually think about the environment, the business, the risks and the customers – even down to the smallest bolts and nuts holding the suspension assembly together. They’re my kind of owners. Scarborough

Posted: 05 Jul 2007 11:21
Registered User Currently Offline	Posts: 51 Join Date: Nov 2006
Very cool post, looking forward to reading more!

Posted: 05 Jul 2007 23:49 Last Edited By: Scarborough
Registered User Currently Offline	Posts: 16 Join Date: Feb 2007
Thank you Ethan