Chapter 2
An Approach to Economics—Bottoms Up
Economics is sometimes described as a social science that focuses on decisions about the allocation of limited resources. This definition is broad and acknowledges that economics may not always only involve commercial decisions. It could study the decision process of someone with a limited amount of time that has to allocate between going to a party or to the gym. This book takes the approach that finance and the study of investments are subsets of economics. Finance focuses on investments, assets, liabilities, uncertainty and risk over time and is sometimes defined as the science of managing money and funding activities.
The economic philosophy that influences this book is that all economics starts with the choices that individuals make.4 Individuals have different needs and wants, and this leads to different priorities. The hierarchy of needs will change from person to person and will even change for the same individual over time. These priorities may not always be purely driven by financial considerations. It is easy to forget about nonfinancial factors when considering economic and investment problems, but they often play a major role in the outcome of investments. This is especially important in the face of the large millennial population boom and changing demographics, which may lead to a large portion of the population having very different priorities than prior generations, this will cause them to value assets differently.
Many theories assume that all decisions are made on sound economic principles to maximize profits and that everyone will act as an “economic man.” This is clearly not true. There is a myriad of motivations for people’s actions. Individuals have limited resources and they apply these resources to meet their needs and wants where they can get the most satisfaction for them or in other words where they get the best “utility.” An individual’s decisions are based on the amount of utility they think they will get out of each decision. However, that utility is not always based on making more money. Simply put people are looking for the most “bang for their buck” but each person may define their “bang” differently. We have all seen instances where the pursuit of a nonfinancial goal leads to decisions that may not be considered the most financially sound. Think of some of the financial decisions that are made in pursuit of a physical relationship. These decisions may not maximize a person’s financial situation, given what they might spend on their hair, clothes, and dinner. However, it is clearly an economic decision because they are choosing to apply a limited resource (time and money) toward a goal that they believe they will get the most utility out of at that time (even if that utility might be fleeting).
Macroeconomic data is just an amalgamation of people’s decisions. Gathering of large amounts of economic data is destined to have flaws in the process and most macroeconomic data is flawed in some ways, if a large group of people are pursuing careers or starting businesses that are not included in the traditional counting methodologies, the economic numbers will get even more distorted from reality than usual. This is more likely to happen when an economy is seeing constant innovation. There are large swaths of the economy that get lost in these big numbers and are not properly represented in the averages. Sometimes the individuals or companies that are not acting in line with the averages are the more exciting part of the economy. Think about a sports analogy, in the 2016–17 Spanish soccer league on the championship team, Real Madrid, among goal scorers the average was six goals for the season. However, Cristiano Ronaldo scored 25.5 His goal total was not near the average and he certainly brought a bit more excitement to the team than the average player, but the “average” figure did not capture this.
The concept of marginal utility is important in understanding demand and asset prices. Marginal utility is based on the changes in the benefit that a person gets from getting more units of an item. For example, the “utility,” or benefit, that someone gets from buying the first three tires for a car may be less than what they get for the fourth tire, the difference between the value of tire three and tire four is the marginal utility. Similarly, their marginal utility for the first four tires for their car is probably much greater than for the sixth tire. Analysis of marginal utility can be applied to business decisions such as product pricing or a decision of where to reinvest in a business. This is what drives an amusement park to offer lower prices during slack seasons and this is also the tool that a company might use to decide if it could make more money by adding another manufacturing shift or hiring more sales people.
Institutions and structure are critical to an economy. The financial and legal institutions that are in place and through which people must make their economic decisions (e.g., stock markets, legal systems) can make a big difference in how well an economy operates and how well it can adapt to changes. From an investment point of view, the laws and institutions that are in place to control markets must have a high level of consistency, clarity and fairness. Rules-based economies help people to have greater confidence, which creates less uncertainty, and usually attracts diverse streams of capital. To operate properly, markets need rules of law and fairness. The institutions that control markets are so important because markets are a critical part of any economy. Markets are any place where transactions occur. Information from markets can help tell you what the value of your home is or can tell a distributor which products are in demand. Markets are the way individuals express what they want and do not want. This does not mean that markets are always right about asset values over time, but when a transaction happens, and an item is bought and sold, that price is the value of the item at that moment, even if the value changes a second later. The price where something transacts in the market is a signal given at a precise price point in time.
Security market systems provide some of the most important sources of data, they are the purest and most real time data points you can use to make investment decisions. Markets often react first and lead the economy, but markets also give off lots of noise and false signals. Markets are not always right about the ultimate value of assets, but they can not be ignored. Many securities markets respond to corporate news and this data is usually released more rapidly than economic news. Corporate news releases are valuable data to monitor. For example, if during one month half of the companies that report earnings state that they are not hiring anyone for the foreseeable future, markets can react and they do not need to wait for the employment numbers to come out. Monitoring corporate data can give you great insight into the broader economy, especially if you group some of the individual corporate data into segments and track trends.
The markets give important signals about trends in items like valuations and interest rates. However, the value of this data can change over time or be distorted. For example, there are fewer public companies now than in many prior periods; the impact of stock market signals, therefore, may be based on much narrower information than in the past. Additionally, index driven buying and momentum driven algorithmic trading may increasingly be distorting valuations of public stocks relative to the value that an actual buyer of a company might be willing to pay.
Markets are important because value is subjective. No matter what asset you are looking at, if it is a guitar, real estate or a stock, the valuation is not based on what it cost to make or where the seller wants to sell it. The valuation of an asset is what someone is willing to pay for the asset. A person telling you what an item cost to make should not make you want to pay more. When it comes to valuations on things like stocks and bonds, many people use similar methodologies to determine what they will pay, but their assumptions and the nuances in their methods will cause differentiation in the final price each person will want to pay. No set of data will always work because the economy is dynamic not static. There is no single best economic and investment theory that can be applied universally and have it always work. Economic data that might drive investment decisions in one place or time, does not necessarily work in other places or times. This means that economic theories that work well for a small agrarian society do not necessarily work well for a modern industrialized economy. Similarly, the data points that are correlated with increased asset valuations in an industrialized economy do not necessarily translate well if that economy transitions into one that is service and technology-oriented.
No economic or business concept is timeless or ubiquitous. A key economic concept is that there is constant creation and destruction in healthy economies. There are an endless number of examples of how great successful ideas eventually run their course. The big box retailer Toys ‘R’ Us was once an innovative disruptive force in retailing and the toy industry. Charles P. Lazarus was the pioneer in retailing that founded Toys ‘R’ Us. He had come back home from being a cryptographer in World War II and saw service men coming home and marrying. He assumed this trend would lead to a baby boom and an increase in demand for baby furniture quickly opening a store specializing in it. He soon realized parents usually bought only one set of baby furniture but many toys. In 1957 he opened the first Toys ‘R’ Us store in Rockville, Maryland. It was a pioneering firm offering a huge number of products and as it expanded it began to crush the local toy stores. It was an innovator in the use of computer inventory tracking and pricing systems. Video games and the sale of toys on the internet rapidly changed the dynamics in the industry. After several tough years and a buyout, the price at which Toys ‘R’ Us debt was trading at in the market signaled they were in trouble and many years after Mr. Lazarus had left the company, it filed for bankruptcy in 2017. In March of 2018 reorganization seemed unlikely and a liquidation of the entire company was being proposed, Mr. Lazarus passed away the same week.6,7
These types of failures due to industry transformations are lessons and at some firms they are not ignored. Mark Shenkman, a pioneer in the leveraged finance market and founder and chief executive officer of Shenkman Capital, holds a morning meeting each day with his investment team. At these meetings, Mr. Shenkman shares his views and opinions on the credit markets, interest rates, and the economy, and his comments are frequently peppered with history lessons. Shortly after Mr. Lazarus passed away, Mr. Shenkman related, how as a young analyst at an equity firm in Boston, he was impressed with Toys ‘R’ Us innovative marketing. He also commented that Mr. Lazarus was a driving force in the retailing industry. However, Mr. Shenkman ended his remarks by pointing out that no concept or business model can prevail forever, because every idea or business must adapt, change, or die.
No investment or economic model works forever. The economy is ultimately driven by individuals. Individuals do not act like mathematical formulas, they change. All economic data starts from the bottom up, and the data may change each time a decision is made.