An implication of the BABA IPO

After the Alibaba IPO, the market is on average expecting that Yahoo's CEO Marissa Mayer is going to destroy $11 billion dollars in shareholder value. That's how much the operating company of Yahoo is valued at when stripped of its cash, Alibaba and Yahoo Japan holdings.  

This is actually a little harsh. There are some tax issues which would lower the $11 billion number slightly. On top of this - Alibaba is currently very hard for an arbitrager to short. Once it becomes easier to borrow Alibaba stock it is likely that the implicit negative valuation of the core Yahoo business will shrink.

Investors are guessing that a significant portion of proceeds from Yahoo's Alibaba stake are going to go towards value destroying acquisitions that boost the importance of the CEO at the expense of shareholders. When Facebook bought Instagram, they made a good decision to buy a nascent competitor who understood the mobile space. When Yahoo bought Tumblr for $1.1 billion, Mayer spent $750 million of that cost on intangible assets in an attempt to try make Yahoo relevant/cool, with the side effect that the person running Yahoo would also be more relevant*. 

Mayer can prove the doubters wrong in one of two ways. The easiest way is to find a tax advantageous way to return money and shares to the shareholders. The harder way is to make acquisitions like the market expects, but to buy companies that will actually generate earnings for the core operating company.

Mayer taking the hard approach is the most likely, but she has committed to returning at least 50% of the proceeds of the Alibaba IPO to Yahoo shareholders. Given that this payback, it is really hard to destroy as much value as the market is currently pricing in . They are probably paying too much attention to Yahoo's past acquisitions of GeoCities and Broadcast.com. 

And given how cheaply Yahoo is currently trading, this entire discussion could be moot. Yahoo itself could be bought before we have a chance to find out what Mayer would have done with its influx of money.


*It's important to note that Tumblr's value has gone up if value is measured on a basis of how many users the service has, but it has disappointed the market in that it has been harder than expected to generate revenue from these users.

Assorted Links

1. One of the scariest things for a start up in the valley today is the prospect of a down round. Interestingly enough, Facebook had one in 2009. Their value was over $10 billion and it was in the midst of a financial crisis, but it's still interesting to note that it happened.

2. Peter Thiel did an AMA. I for one have always thought that capitalism was the private ownership of the means of production. But the insight that the best investments are outside of commodified industries almost sounds like the best businesses are those with a moat or long lasting competitive advantage. This theme has helped other investors compound significant amounts of capital for a long time.

3. Positive news on the US patent front. But there is a long way to go.

4. The concept of time optimization, engaging in activities at unusual time to get better use out of underutilized resources, is severely undervalued in most people's everyday life. This advice from Tyler Cowen about eating early in the evening before restaurants get sloppy is interesting. It's best for those who either do not need to eat with others or who have enough status to convince others to eat with them at an unconventional time.

Revolving Door Politics Needs a Systemic Solution

Eric Cantor, the former House Majority Leader who recently lost his primary, demonstrates a major hole in the current campaign finance reform agenda via his recent actions.

Long accused of being too friendly to Wall Street, Cantor is now being paid very well to work for a boutique investment bank. His contract includes a relatively common provision in which leaving to go back to work in politics is essentially encouraged:

Unvested initial RSUs and unvested incentive RSUs will be forfeited if Group LP terminates Mr. Cantor for cause or if Mr. Cantor terminates his employment other than (i) for good reason or (ii) after the second anniversary of the grant date, to take a full-time elected or appointed position in federal government, state government, or a national political party.

So not only are they monetizing his connections now, but they are paying him millions of dollars and assuming that he will go back into politics after two years. This is a very common practice. Rahm Emanuel also decided to monetize his political connections after his time with the Clinton White House. Then in late 2008 he was part of an incoming Obama team, part of whose job was to determine whether or not the bail out of the financial system should retain the status quo in which too big to fail banks could make the equivalent of "Heads I win, tails you lose" bets. It's hard to imagine that a group of people who know that multimillion dollar jobs are easily available from the companies whose fates are in their hands will be able to remain unbiased. 

More egregiously, Raj Date worked as deputy director of the Consumer Financial Protection Bureau where he helped create regulations that drove banks out of an area of the mortgage business and then started a financial company to take advantage of the hole in the market he helped create. Less ambitious regulators might not create business opportunities for themselves quite so directly, but the incentives and opportunities for them to do this are there.

Ideas like the PAC to end all PACs would reform the financing of elections, letting congressmen study legislation more closely if they didn't have to spend as much time fundraising. But this does nothing about where their big pay days come from after leaving office. Even under a revised system, any officials and elected representatives can still choose to spend a significant portion of their time thinking about how they can help the very same people they are soliciting political donations from today. The practice doesn't have to be obvious, they don't even need to get jobs directly from the influentials they help. If the officials/politicians are owed favors they can call in favors while working for their new employer and everything will look above board.

It's difficult to quantify the potential positive impact of campaign finance reform compared to closing the revolving door between business and government, but on a relative basis solutions for the revolving door problem deserves much more attention.

Right now the revolving door is only brought up during partisan high profile nominations (when the partisans will bring up anything that makes a nominee look bad) or when those appointed officials are perceived to be misbehaving (like with Tom Wheeler and the FCC's and net neutrality rules).  And so the US still lacks broad systemic rules to stop those who create or enforce legislation and regulation from immediately getting high profile jobs in the private sector where they can monetize their owed favors and connections. Unless the officials are making decisions directly related to government contracts it doesn't matter where they work. And activists don't seem to be putting actionable solutions on the table - outing the people involved in revolving door politics or trying to block a few nominations seems to be as far as most groups will go.

Partially this is because there is less incentive for people in power on either side of the aisle to bring further attention to a practice that helps themselves or at least helps their friends and colleagues. Finance reform has a natural constuency among legislators - those who aren't as good at raising money and those who dislike the process of raising money can support it or at least be lukewarm about the idea. On top of this, those on the left don't favor revolving door storylines that paint government officials in a negative light when the problem of attracting good people to government work and getting voters to back additional progressive policies is a higher priority. 

And the op-ed writers pushing for campaign finance reform have an extra selfish incentive to do so - if generic rich people have a harder time making their voice heard then the ones in control of the media, such as the writers who have a column every Sunday, will have more impact.  They don't have the same incentive to talk about system wide solutions to revolving door politics. Pushing for policies that would hurt the economic wellbeing of legislators and officials could cause them to lose the access that makes their job significantly easier. 

Like campaign finance reform, the solution to the revolving door issue can get messy and complicated once implementation is considered.  France imposes a three year waiting period between working for the government and working in the private sector. This seems biased towards keeping poor people out of politics, but some version of this rule with exceptions carved out for unrelated jobs such as medical practice or teaching would be an improvement on the status quo. Singapore's solution of paying officials very well, just not quite as well as their private sector counterparts, works well in the context of their political system. Mandatory transparency from former officials in their business dealings after leaving office would also improve the situation.

When it comes to getting money out of politics, it's time to admit that the revolving door is a significant problem that requires a systemic solution.

Unassociated Links

1. The Flynn effect has yet to have a significant impact in Liberia.

Exhibit A: The looting of an Ebola quarantine center and the stealing of, among other things, bloody sheets.

Incidentally, the next time we see an article on how average white political science major can't possible do much good over there - remember how irrational and uneducated members of these developing countries can be.

2. Brad DeLong on long run market returns and the cyclically adjusted PE. There are a lot of reasons to be skeptical of the Shiller's CAPE as it applies to predicting future long run equity market returns - it's a relatively unhelpful metric that gets far too much airtime.

3. An example of how not to run a police officer camera program - the SDPD refuses to release camera footage when it matters.

"San Diego police effectively lock any relevant videos in a vault and throw away the public's key. The footage their officers record will never show up on YouTube and go viral. Nor will it help fill in the gaps when a major crime leaves lots of unanswered questions. Crime victims or their families may never get to see and hear what the devices recorded."

It's not just a question of getting police to wear cameras, the policy also has to promote transparency.

Some Thoughts on Ferguson and Police Transparency

We don't know what happened when Michael Brown was killed, but the way the Ferguson police department is acting makes them hard to trust. Washingtonpost reporters have been arrested in two cities this year: Tehran, Iran and Ferguson, MO.  It is likely that the non-police witness's version of the story is true. an unarmed black teen was killed with his hands up by a white police officer. The way the Ferguson police department is refusing to even name the officer is reminiscent of the way police departments around the country often respond to investigations - by protecting their own. And the records indicate that Ferguson police are racially biased - the percent of whites found with contraband that are arrested is just 15% compared to the almost 50% for blacks (Presumably not all of these arrests are related to the contraband found, but it's a way to control for how police treat members of the groups who have committed some type of crime).

Rand Paul's op ed on the excessive militarization of police is dead on. It's interesting that he is walking the fine line and taking what can be construed as an anti-law and order stance because he is one of the front runners for the GOP nomination. 

It's probably because he is aiming to win the nomination that he didn't go farther: Active duty police officers need to be automatically recording everything they do. With recordings, incidents such as those happening in Ferguson can be quickly resolved one way or another. When tested in Rialto, California, recording reduced both complaints filed against police officers and the incidents where use of force was required. There will still be cases where police officers use excessive force in murky situations but by and large transparancy via recorded police and citizen interactions should protect the innocent parties, see more guilty parties punished and cause better behavior all around.

The main obstacle for making officers record everything is the political reaction to how such policies impact the status of police officers. The word of a police officer is generally trusted more than the word of a suspect. Telling officers "We are going to make you record every interaction" sounds less like "We are protecting you from false allegations" and more like "Officers, we know you often risk you life as you protect citizens but we don't quite trust you." The way many police officers currently respond to citizens legally filming on duty police is telling - many officers would prefer to remain in control of situations without anyone looking over their shoulder. And the options on the table aren't just "Recording or no recording" - there is also the option of letting police officers record when it protects the officer and not record when it might incriminate themselves. 

Even if recording was always on there is still the issue of structuring the system so the police are unable to delete incriminating evidence. There is also the problem of whether or not pervassive recording might have unintended negative side effects when recording technology is combined with facial recognition and prosecutorial discretion. 

Despite its potential flaws, the upside of preventing police misconduct (murder/manslaughter, for instance) and the potential riots that follow are likely bigger than the downsides. The idea that interactions between police and citizens needs to be recorded as a matter of course needs to be a bigger part of the discussion after these types of events.

Assorted Links

1. Advice to Hillary for 2016 from an anti-interventionist: Please just lie to us? Apologies for the pseudo partisan snark, but if anti-war candidates from Woodrow Wilson to Barack Obama can't seem to keep our country out of war it seems odd to think that pressuring a known element to modify their rhetoric will have any real impact.

2. College admissions and sports - 20% of admissions at Ivy's and small liberal arts colleges are recruited atheletes. And it isn't just the big sports, Harvard has 39 intercollegiate teams. Are esoteric sports that are rare outside of wealthy school districts the easiest ways for colleges to discriminate in favor of wealthy and/or legacy admissions?  This is probably why preferential admission for college athletics lacks many of the critics that are directed at affirmative action. While the plight of the college football players who aren't ready for college might get some notice, the rich, relatively athletic but otherwise average student who gets into their Ivy of choice because of lacrosse or crew isn't given a second thought.

3. This defense of large US braodband companies by the Mercatus Institute is interesting because it challenges the current zeitgeist, but it misses the point on quite a few marks. First, they add in media taxes that EU citizens are paying anyway for owning television and radio and use this to erroneously suggest that this makes US broadband costs equivalent to rates of other developed countries. More generally, arguing for an institutional structure that encourages and rewards investment is correct, but most of these companies are also holding local monopolies which need to be addressed.

4.  Sometimes, low investor confidence is an opportunity that needs to be taken advantage of rather than a problem that needs to be solved. Kinder Morgan's gigantic M&A transaction shows how connected businessmen can capitalize on control of their companies when faced with doubters. The Kinder Morgan Energy Partners LP was trading at a discount to peers after it looked like the bulk of its future gains would go to the general partner and not the limited partners of the MLP.  This made the economics of the general partner KMI buying out the LPs favorable to everyone relative to the status quo. 

Correlation and Causation and Inequality

In a takedown of the recent S&P study on inequality and growth (HT: MR), John Cochrane gives us the following quip that I wanted to share/save:

Well, that's what forecasting is about. "The weather forecaster causes rain" is a model that forecasts well. Until you try to kidnap the forecaster and make a sunny day.

It sounds like the plot of a very fun movie.

With regards to the S&P report on inequality, worries about inequality impacting aggregate demand shouldn't be too worrisome. Aggregate demand is a cyclical issue that can be managed by monetary policy when needed. 

However, the hypothesis that relatively bad education outcomes are driving both low growth and higher inequality than in the past is more worrisome. The modern education system is ill suited to the needs of many people and those at the bottom of the ladder are increasingly forced to compete on a global basis when they enter the workforce (Or rather, they are forced into local service jobs because of potential global competition). Combined with assortive mating, the children of those with poor education may continue to have poor education and low productivity themselves - thus lowering future economic growth.

It should be pointed out that inequality is not the causal drver of growth in this analysis, education and globalization are the main driving factors. And while this is related to inequality, worrying about the education gap is different from worrying about whether or not the growing wealth of the 1% will impact future economic growth.

Here is a thesis of how inequality of the 1% and growth might be related (particuarly in more corrupt developing countries): High levels of inequality are sometimes a symptom of excessive rent seeking. This rent seeking is damaging to long term economic growth. In these cases redistribution may not improve growth outcomes unless the rent seeking behavior is itself taxed. Since the most successful rent seekers are generally people with significant political influence, it's very unlikely that they'd lose the battle. But it could still be one worth having. 

Piketty and Expected Return

One of my favorite blogs came out of hibernation to comment on Piketty (Warning, it's pretty overtly political), and it reminded me that I still haven't contributed.

A lot of ink has been spilled the question of whether or not the return on capital after will be above the growth rate for significant periods of time.  The merits of the arguments generally fall on the side of r > g in perpetuity being nonsense. Either labor prices have to eventually rise (on a global basis they are doing just that) or the return on capital needs to fall.

How can the return on capital fall? Two ways come to mind.

1. Earnings stop growing. This can happen when effective taxes go up more than prices rise to compensate for the increase. This would also occur if unit labor costs started increasing more quickly than the prices of goods sold and profit margins fall. Already, the sales growth of the S&P 500 has been below the economic growth rate of the economy for the past few years - and this is noteable because the S&P also has exposure to faster growing emerging market economies. 

2. The expected return of assets fall. 

#2 has been interesting - because it is what has been happening over the past few years and yet analysts have if anything gotten more worried about wealth inequality. That's because in order for the expected future returns to capital to fall, prices today need to go up. A company with an earnings to enterprise value of 10% has a much higher expected future return than a very similar company with the ratio at 2.5%. But if the company is earning one million dollars a year in cash, it would have to move from a $10 million dollar valuation to a $40 million dollar valuation in order to reduce the expected return on capital. 

Analysts looking at the 16.0% total return to the S&P 500 in 2012 and 32.4% returns in 2013 will plug those numbers into models which uses past returns to predict future returns for various asset classes. After the recent bull market, they might assume that the future return on capital will be even higher than it was in the past. But over this time period, the price to earnings ratio rose from 14.87 to 18.15. In other words, the average earnings yield of all of the companies fell from 6.7% to 5.5%. Instead of concluding that the expected rate of return on capital is higher, analysts should be assuming that future returns will be lower.

The same principles apply to other asset classes, but in many cases interest rates are already below the nominal growth rate of the economy. Equities are one of the few places where the earnings yield is above the growth rate. So if we find ourselves watching the stock market go up over the next few years, it actually means Piketty is more likely to be empircally wrong than right in his r > g prediction on a forward looking basis..

Market Commentary from the Fed

In 1996, Alan Greenspan didn’t mean to say the markets were suffering from irrational exuberance, he just implied it when discussing whether or not central bankers should worry about the stability of asset prices:

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?

Source: Bloomberg

After mentioning how concerned the Federal Reserve must be with asset price stability, Greenspan presided over one of the largest asset bubbles in modern history over the next three years.  Almost 18 years later when the S&P 500 is again making new highs, Janet Yellen has waded into the market commentary space with the Federal Reserve’s recent Monetary Policy Report. The valuation of a smaller class of equities is questioned:

Some broad equity price indexes have increased to all-time highs in nominal terms since the end of 2013. However, valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities. Nevertheless, valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year. Moreover, implied volatility for the overall S&P 500 index, as calculated from option prices, has declined in recent months to low levels last recorded in the mid-1990s and mid-2000s, reflecting improved market sentiment and, perhaps, the influence of “reach for yield” behavior by some investors.

(Emphasis added)

On a price to book basis, it does look like valuations are stretched in biotech companies.

Source: Bloomberg

The value of biotech companies, and social media companies for that matter, come from intangibles that aren’t measured in book value and are yet to be captured in earnings.  What the high valuation tells us is that investors think the expected value of these companies is higher relative to its tangible book value than it has been in the past. That may be because the drugs the new companies are working are particularly promising, or because investors have decided to value the lottery-like payout of biotech stocks at higher prices. But either way, investors can’t be said to be “reaching for yield” in these sectors because it’s exactly the wrong place to look for yield – yield only comes after sales and earnings exist.

The beta of the Nasdaq Biotech index to the market is 1.2, which implies that biotech stock valuations are being moved by factors other than whether or not their drug trials are going well. Part of the explanation may be that in a high liquidity environment the market will value lottery tickets more highly.  A higher proportion of companies with no earnings have been going IPO since the 1999 tech bubble.  And the companies with no earnings will on average have bigger IPO day pops than companies with earnings. It’s almost as if there is something about real earnings that makes investors look more skeptically at a company.

Source: Initial Public Offerings: Updated Statistics, Jay R. Ritter

The Federal Reserve report also mentions low interest rates, and compares them to the mid 90’s and mid 2000’s. Data for implied volatility doesn’t go back much farther than the 90’s, but we can look at the historic volatility as a proxy.

Source: Bloomberg, Author's Calculations

The other time periods that volatility was low were good economic times, the early 50’s and mid 60’s. So while regulators might be worried about the formation of eventual imbalances, it’s much more likely for low volatility time periods to lead to future periods of low volatility and high growth. The next Minsky moment in the US economy is a long way off.

Unassorted Links

1. Keith Rabois has been raising money for a company that is likely to eventually be a REIT that will be easily funded thanks to its Silicon Valley halo.

2. Some of the odder parts of Transformers explained. (HT: Vasu) One of the interesting side effects of the rise of the Chinese consumer is cameos by pop stars and famous atheletes in blockbuster movies that are totally unknown to US consumers.

3. A Harvard professor demonstrates that social scientists suffer from significant cognitive biases when their status is called into question by others who fail to replicate experiments meant to prove subtle effects such as various priming scenarios. (HT: MR) The belief that most sociological theories tested in the lab are as true and unrefutable as the existence of black swans leads to silly attempts to defend them from criticism. One point that is worth thinking about is how to fully align the incentives of those who replicate studies with truth seeking behavior - if studies are only replicated when there is an axe to grind then there will be false negatives. But the proper answer to this problem should involve raising the status of those who replicate published studies rather than denigrating them. Pre-registering experimental methods (as the author suggests) - and publishing the results regardless of the outcome - would also help.

4.Tim Harford points out that low volatility is pretty consistent with good economic times. Before low volatility leads to high volatility and disruption, it leads to more low volatility growth.