The Capital Shell Game: Liquidity & Value

A principal tenet of shareholder wealth theory is that excess returns beyond those necessary to operate the business and fund capital expenditures should be returned to the shareholders who will most optimally reinvest.  In a goods and ideas producing economy, this mechanism worked reasonably well.  Shareholders would reinvest dividends and capital gains in companies that innovated and produced high quality products at competitive prices.  This very much characterized the American economy from the end of WWII until late in the last century.

In the 80’s, a tectonic shift began to take place, however, as investment banks diversified from the traditional role of advising businesses and conventionally raising capital with securities and bank debt to create financial products and ultimately financial markets.  These products grew ever more arcane as the banks competed for the best mathematicians and physicists MIT, Harvard, Princeton and Chicago had to offer.

Eventually, these instruments became Frankenstein algorithms whose creators could not divine or control unintended consequences.  As many of the products were designed to trade outside the regulatory realm, investment banking enjoyed a shelter where the sheer velocity of trading produced billions of dollars of liquidity with no underlying value.  Even something as basic as the Dow Jones Industrial Average grew from roughly eight million shares of daily trading in 1980 to four billion today.

As long ago as 1637 in Holland when a single tulip bulb could sell for ten times the annual salary of a skilled craftsman, financial investments detached from underlying value are not sustainable.  In the global financial crisis, which began in 2007, the problem could be generalized as a lack of capital reserves to support the debt creating the illusion of liquidity.  In the simplest rendition, homeowners borrowed more than their houses were ultimately worth when the real estate market crashed.

Investment banking functioned on the same flawed principle, only in far more complex ways.  A credit default swap, for instance, is in fact insurance against the failure of a financial instrument or institution.  However, because it is arbitrarily designated a swap and not insurance, it isn’t regulated under federal law and thus is  exempt from having adequate capital reserves to back it.  Without these reserves, the investment banks were unable to withstand what in commercial banking would effectively be “a run on the bank” and so, Bear Stearns and Lehman Brothers, after a century of business, fell in a matter of days.  Others, “too big to fail”, were bailed out by the federal government.

The repeal of Glass-Steagall in 1999 was an accelerant as commercial banks became free to assume the trading and investment functions hitherto limited to merchant or investment banking.  As a result, commercial banks began shifting deposits from lending to trading.  Today, only 8% of bank deposits are lent to businesses.

Concurrently in the 80’s, a new investment entity was emerging in the form of private equity.  Much in the news now because of Mitt Romney’s tenure at Bain & Co., private equity firms do invest in companies that produce goods and services, following the postwar model but tend to do so from a short-term financial play as the typical private equity investment lasts five years or less.

In 1980, there was about $5 billion in private equity investment.  By 1995, that figure had climbed to $125 billion.  Currently, according to Bain, private equity firms have nearly one trillion dollars of uninvested capital.  In the same report, desirable private equity investments were characterized as having strong cash flow while requiring low capital expenditures and limited working capital.  Indeed, it’s an attractive low-risk investment profile but one unlikely to create jobs or new products.

Private equity doesn’t tangibly invest in products, brands or people but rather, in financial statements.  Products are inventory, brands are marketing expense and people are overhead.  The goal is to minimize these costs to increase return on assets and return on equity.  While a seemingly indisputable goal, when the investment horizon is short, the financial engineering may destroy the long-term competitive viability of the company after the investors have broken camp.  Tangible capital is often destroyed rather than created, instead merely providing liquidity to start the cycle again.

The destruction of tangible capital is by no means limited to private equity.  Publicly traded firms have similarly shifted from creating capital to creating liquidity.  Since the beginning of the credit crisis, U.S. companies have accumulated  nearly a trillion dollars in cash while capital expenditures have fallen 26%.  Granted, there is little incentive to invest when there is excess capacity at hand yet these are not all smokestack firms that have competitively lost out overseas.  Among them are Cisco with $40 billion in cash, Microsoft with just under that amount and Google with $35 billion.   In 1980, total corporate net cash flow was around $200 billion; in 2011, it was just short of $2 trillion.

Far and away, the largest use of corporate cash is for takeovers.  In 2011, global merger and acquisition activity exceeded three trillion dollars.  In some cases, synergies are created that revitalize one or both entities but more often, the consolidation results in the elimination of jobs, plants and products.  In 1980, there were 20 million manufacturing jobs in the U.S.  Today, there are 15 million.  When one considers that most of the high-tech industry has developed since 1980, our core manufacturing has probably fallen below 10 million.  Some of this decline is attributable to greater productivity and the reliability and wearability of durable goods as well as a greater proportion of income being diverted to services such as medical care by an aging population.  Nevertheless, one is more often surprised to see that a product is imprinted with ‘Made in the U.S.’

Without a change in incentives to invest in value producing capital, ten percent unemployment will be institutionalized and, correspondingly government will continue to grow to provide the income and services for the disenfranchised.  This is not an apology for lack of initiative but simply stating a fact that an uneducated and unskilled work force cannot create jobs or services.

The American education system has become biased toward high value technicians—engineers, researchers, systems analysts—who comprise but a fraction of a complete work force.  So, even where there are jobs, the jobs go unfilled for want of qualifications.  Someone in a local high-tech firm recently lamented that he had fifty open jobs but couldn’t find qualified applicants.

Even if educational reforms were instituted, the stubborn fact remains that America doesn’t make things anymore, instead having first shipped jobs offshore, then capital, then knowledge.  It remains to be seen if we can still create industries around technology to come.  If instead, we continue on the present course, productive capital will continue to decline, unemployment will continue to grow and the gap between rich and poor will come to resemble the social fabric of 18th century Europe.

Jan 31, 2012 at 2:21 PM Permalink

Getting a bit sentimental/ philosophical about our love for wine

He Said...
- Mike Willison

I've been thinking a lot lately about how very funny it is that I work in the wine industry. I mean, as a child I'm certain that, because I passionately adored Smarties, one day I would work as a Smarties technical taster and ensure stringent QC across all of the dusty pastel colors/ flavors. Incipient ambition, I felt, was going to prove to be my greatest asset. This dream was hastily dusted off, like the candy's own residue on one’s fingers, as a passing fancy by my parents. Rightly so, likely, as I then became infatuated with Twizzlers, Dr. Pepper, Dungeons & Dragons, and (finally) girls (although the D&D made the girls thing a bit unlikely). Like the bleats of a baby bird for more regurgitated grubs, my dreams would carom off of my parents' stoicism into the forgotten ether.

As I grew older my passions became a bit more fixed, with less tangential foolishness and puppy-like stick-to-itiveness, I began to realize that all of these early passion-ettes were driving me towards an inevitable explosion of real, honest to god, unbridled enthusiasm; In this case, for wine.

Just yesterday someone asked me what my favorite wine is. I realized that really don’t have an answer. I can tell you what the first wine that made me really happy (1989 Ridge Geyserville). I can tell you also that I used to pilfer wine from the gun at the bar of the country club I worked at when I was a teen ("Chablis"). I can further tell you that there are wines that I thoroughly dislike but will always try again, just to be sure (Barossa Shiraz). Maybe the most important thing that I can say is that every glass of wine I encounter is an adventure that can only be realized at that very moment. It may be kind of a lousy adventure, like going to buy stamps or returning home to see if you left the oven on, but it also just might be the most exciting, fascinating and spectacular fun you have ever had and everywhere in-between. In this case, I truly am living the dream. Love wine because of its potential for awesome, everyday, and you will be a better, more successful, more attractive person with an 18 charisma and +1 to beguile.

She Said...
- Carrie Kalscheuer

This post, in all of it's poetic excess, has sat unanswered on my desktop for months. I don't often extoll the virtues of wine to such degree (at least not until I've consumed at least a bottle of the stuff in question, and by that time my writing skills are subpar - I could never have lasted as a beat poet). But today I find myself in a similarly, albeit more concisely, reflective mood.

Why I love wine (today): wine is one of the oldest things in the history of man, yet is ever-evolving. It can be likened to politics, religion, even love in this regard– and that's a powerful thing. We will never completely 'master' wine. It will always have a shroud of mystery, even to those of us who leave work with purple hands on a daily basis. It expresses itself differently every year, in every region and with each different winemaker. It changes, grows, develops every day in-bottle. It will one day die. It's different for each taster – a uniquely personal experience. Talking about wine is a personal expression of sorts, in fact; a way to convey what each of us thinks and feels about a shared pleasure. Maybe this is why wine is considered more sophisticated by comparison to other agricultural outputs – it transcends the everyday and speaks to the greater depths of what it means to be human.

Jan 26, 2012 at 10:15 AM Permalink

Movies are important! What happens when you add wine.

He Said...
- Mike Willison

Most wine enthusiasts read or saw the tale of soggy and fragile Miles as he wended his way through California wine country with his philandering friend Jack in "Sideways." Some people even figured out that the story isn't really about wine, but rather the journey of self-discovery of one sour guy that has found himself in a bit of a rut caused by social, personal and professional ennui, with wine country as the background. Others, too, even realized that Pinot Noir, the brittle and tenuous grape variety that Miles holds so very dear (although secretly taking the silver in favor of his gold medalist Cheval Blanc, made of mostly Cabernet Franc and Merlot), is a thinly veiled metaphor for Miles or, more specifically, the way Miles views himself: a simple thing in need of just the right amount of love, sun, water, and elemental intake to produce something of incomprehensible beauty and wonder.

I then began to wonder who else we could cast in the shroud of grape variety metaphor. To wit:

Cabernet Sauvignon (Hollywood) - The character would be some obstinate tightwad that is stuck in his ways and goes into his dotage convinced that everyone else is woefully uneducated so he treats all of humanity like shoe scrapings. As he reaches his death bed, alone, wrinkled, bitter, a prune, fetid and vainglorious he has no regrets and his last thoughts are of firing his house staff before he has to pay them any overtime. Starring Jeremy Irons, Max von Sydow or Frances Fisher

Viognier (Hollywood) - A young, charismatic Frenchman unexpectedly excels at the American game of baseball and is drawn to the stadium limelight by a showy, greedy and tanned talent scout for the LA Dodgers (Chardonnay, played by Matthew McConaughey) that has wagered his career on the young star. In order to guarantee Viognier’s success, Chardy gets him hooked on HGH and the inevitable excesses that come with fame (think Jeremy Giambi or Kenny Powers) which of course lead to his muscle-bound demise. The wistful denouement has Viognier coaching in the Carolina League for the Lynchburg Hillcats of Virginia which, quite clearly, suits him perfectly. Starring Gaspard Ulliel, James Franco or Robert Redford

Zinfandel (Canal+)  - Looking for substantive meaning in his life, a wealthy Wall Street business tycoon leaves his job and his oppressive, mean-spirited and pinched-looking fiancée in search of the family and life he never knew. The film is lousy with sweeping, long, and contemplative camera shots that highlight the natural beauty and wonder of his voyage of self discovery. He visits extended family in Puglia, Italy where he falls in love with a local open-diving spear-fisherwoman that reveals to him his heart. They together travel to his family’s ancient home in Dingač, Dalmatia in Croatia where the fig trees, Zabrada Mountains and the Adriatic Sea provide a stark, open contrast to the rusting, closed-minded culture of the old bauxite miners trying to encroach on Zin's family farm (they parallel the Wall Street tycoons, of course). They will fight to preserve the family heritage, for each other, and ultimately for their souls. Starring Alexander Skarsgård, Alessandro Nivola or Colin Firth

She Said...
- Carrie Kalscheuer

While I'm all for drawing comparisons between wine and one's other interests, the movie/wine metaphor falls short for me. I don't immediately think of plot lines when I think of wine, nor characters reflected in the lifecycle of the grape. Rather than regale you all with comparisons to zombie-driven, apocalyptic-themed action films or fluffy romantic comedies (which, as anyone unfortunate enough to have watched movies with me will tell you is all I watch), I'm going to speak to the Sideways phenomenon.

Sideways, and the subsequent impact that it had upon the wine world, amazes me to no end. Yes, the character of Miles may well be a metaphor for the Pinot Noir grape itself, and that might be exactly the correlation both author and director are going for, but it actually bothers me to think so. The reason is both simple (I love Pinot, despise Miles) and complicated.

The complicated bit: when someone mentions Sideways, it is almost always in the context of Pinot Noir or Merlot, as if this is solely as far as the mentioner got in his or her research on wine and that by seeing the film, said mentioner has now become expert on all things Pinot and Merlot. The first bug on this is one you've already touched upon: that wine is merely a backdrop for the bigger story. Had that been widely recognized, I dare say I may actually enjoy this film. However, not many seem to understand this. Moreover, the dialogue, while happily accurate in certain scenes (Miles explaining how to properly taste a wine), is pretentious and egregious in others.

Possibly the worst of these last two is hidden within the "phenomenon" I alluded to earlier. There was a marked increase in Pinot sales and an almost equal decrease in Merlot sales after the release of the movie. As someone who heads up the direct sales program for a Pinot Noir-producing winery, this makes me happy. But as a wine geek, this irritates me. How could one comment in a movie tank Merlot sales? Because pretention in the wine world goes a long way, even if only delivered by a character in a movie. Miles seems an expert, yet he's really not. He's an amateur taster; a writer with ample time to drive into wine country. A better tactic is to find out for yourself what you prefer to drink, ‘cause see, the joke of the whole thing is in your first paragraph – the prized bottle in Miles' collection is exactly as you describe: Merlot blended with Cabernet Franc. So much for "I will not drink a x*%@ing Merlot!"

Jan 18, 2012 at 10:23 AM Permalink