Thursday, December 16, 2010

Effectual Charity

I was thinking the other day about how I would structure a charity if I were to build one.

I've long believed that charities, just like companies, work best when they have a coherent vision of one thing they wish to accomplish. By trying to accomplish many different things piecemeal, you end up inefficient, weak and non-impactful. (This is not to say that flexibility is not important - if you come across another concept that is a better way for your organization to proceed than you initially thought, that's great... but even if you alter the vision, you should still have one vision that everyone is working towards).

This is an opinion, of course, but I base the rest of this post on it.

I was thinking about what a really effective way to promote medical research would be. I have always preferred charities involved in medical research because the impact-per-dollar if you do it right can stretch far beyond just the direct recipient of each dollar you spend. In other words, you're investing in goods that otherwise receive too little investment because of positive externalities. Safety net charities are certainly admirable, but the opportunity cost of my dollars is such that I prefer scientific research.

This got me to thinking: What would happen if you created a pharmaceutical or medical devices company, structured entirely for profit, with the only stipulation being that 75% of all profit must be spent on R&D, and some percentage of R&D spending (20%? 50%?) must be basic research? You'd probably want to ban M&A in most cases, as well, because then you're buying something that others have already discovered - you want the spending to go to NEW treatments.

In all other respects, the company would operate as a for-profit - advertising, market development, salaries, pricing, etc. If your goal was to make an impact on medical progress, wouldn't this be the best way to divert as much money as possible to furthering medicine?

You don't want all profit going into R&D because then nobody has an incentive to grow the business. You need the basic research stipulation because basic research is the most underfunded area and also the most economically unprofitable.

Wouldn't this structure direct the most possible money to further medical research? Your initial dollars largely go to research (to have a pharma or medtech company, you need a product), and followup dollars go to research, too. That's a way to really further medical technology.

Anyone interested?

Rich vs Poor Relative Marginal Consumption under Deleveraging

A number of people have made the argument that the tax cut isn't really as stimulatory as it could be because rich people save too much of their income, so they shouldn't get the tax cut.

The problem with this argument is that we're currently in a period of deleveraging, and marginal savings rate is what matters when you have a tax cut.

Peter Poorman may make little money; say, $25,000 a year (We'll ignore the substantial aid programs that exist that would boost his salary substantially - like, double). He's in debt. He's trying to pay it off, slowly, after incurring it over the last few years. His savings rate has risen from negative 2% to positive 3%, and he's adjusted his lifestyle to fit the 4.9% budget reduction (spending 102% of his income to spending 97% of his income means a 4.9% reduction in his budget).

Rodney Richman may make more money - say, $250,000 a year, and have no debt. He's able to save 20% of his income!

Clearly, Rodney's savings rate is much higher than Peter's; the economy would be better off if Rodney would spend like Peter.

The problem, of course, is that this is an average effect, and a tax cut happens on the margin.

If you gave Peter an extra $100, some of the money is going to go to alleviating the budget reduction, but, importantly, he's ALREADY SET A GOAL OF REDUCING HIS DEBT BURDEN. It's quite plausible that he'd use $25 to alleviate the budget reduction, and $75 to hit the debt that he knows he needs to get.

Rodney's behavior's a little more challenging, but not much more so. Rodney is not likely to exhibit the behavior "Save 0% up to $200,000 and 100% after that!" His savings on the margin will be higher than his average - as should always be the case for everyone, regardless of income level - but it's actually quite likely that he ends up saving 50% and spending 50%, just like Peter.

50/50 and 25/75 are arbitrary numbers; I don't know what the real ones are. But based on the psychology of debt consumption and an understanding of marginal utility of income, it is very likely that on the margin, tax cuts for the rich are more economically stimulatory than tax cuts for the poor IN AN ENVIRONMENT OF DELEVERAGING. The conventional (read: "during leveraging") wisdom about savings for rich vs poor gets thrown out the window when you're in an environment where the poor are deleveraging.

Think Carefully: Government Role in Regulating Relationships

This case - the Columbia political science professor who has been carrying on a three year (physical) relationship with his now-24 year old daughter - brings up a number of very interesting areas, some of which have been touched on somewhat elsewhere.

The first question is the simpler one - why is it that he is being charged, but she isn't? I understand that in most cases, the party perceived as the "victim" is not charged, but the law isn't supposed to be based on perception of victimhood, it's supposed to be based on actual victimhood. A 21 year old girl is old enough to know what she's doing. There is no evidence of coercion or "abuse of a position power", and even if there was, then incest isn't the right charge - rape or blackmail is. The fact that they're charging him and not her is very disconcerting. Part of it is because he's older, part of it is because he's the man, but from any principle of equity, you need to charge both or neither.

It strikes me that the correct action may actually be "neither", in this case. I'm in no way condoning incest, and even the idea of making an argument in defense of the professor and his daughter makes me somewhat uncomfortable, because they're clearly screw-ups, and it's a really gross story. However, being a gross screw-up is not in-and-of-itself criminal.

The question becomes what the proper government role is in regulating consensual relationships, and the implications are far-reaching.

There are a number of choices you have to think about when formulating this policy. Does the government have any moral right at all to tell consenting adults what they can do? If it does, what is the basis for deciding what is appropriate?

To list some of the issues on which you have to be consistent:
Gay Marriage
Consensual Incest
Consensual Polygamy

If you believe the government shouldn't regulate what consenting adults can do, then you implicitly need to permit all of the above. Bestiality is one possible exception, depending on how you feel about animal rights, but people do much worse things to animals than bestiality; it seems silly to ban bestiality with a cow if you can cruelly slaughter it as a calf, for example. Adultery is actually the next easiest thing to combat - marriage is a contract not to be unfaithful and in being unfaithful, you should be open to civil lawsuits for violation of contract. This is the only camp I can feel comfortable placing myself; even if I find incest or bestiality, in particular, to be distasteful, moral consistency and tolerance of others' independent choices (with no direct impact on others) require this viewpoint.

If you do believe the government should regulate what consenting adults can do, you need to have a basis, because "it makes me uncomfortable" is not a valid reason for banning consenting adults from activity that hurts nobody else, and "Christianity says so" isn't a valid reason in a secular government.

One popular argument is reproductive - relationships are meant to be reproductive, so anything that isn't reproductive isn't legitimate. Of course, this doesn't provide any valid reason to ban polygamy, and many conventional heterosexual relationships are not reproductive. With the advent of birth control, sex and children are no longer necessarily attached. Banning the above requires banning birth control, as well. I don't see anyone other than the Catholic Church making that argument, and the Catholic Church does so a) based on religion and b) in opposition to polygamy as well. So I'm not sure there's a consistent argument there.

Another is "family-based" - Some things are destructive to the "family ideal" and thus shouldn't be permitted. This, too, doesn't pass scrutiny. It's hard to argue against anything on the basis of family if there is no family involved. You don't see people clamoring for the position "gay relationships are acceptable but they can't have kids" (if they believe that children of gay parents are worse adjusted than straight parents, which I do not.). Similarly, bestiality has nothing to do with a family ideal. This would argue against adultery, incest and polygamy, but not the others. People don't seem to be on a crusade to send adulterers to jail, so this seems like a difficult thing to pin as the principal driving force. Drinking and smoking while pregnant is not illegal, and that is far more detrimental to children than any of the above things (other than incest).

Power relationships is a common argument - polygamy, bestiality and incest and such rely on relationships between one person who is more powerful than everybody else. Setting aside the "bargaining power" element of polygamy - maybe one man is the implicit "boss" of multiple wives, but each woman, being in greater demand, has much more bargaining power than each man does - how does gay marriage qualify? For that matter, incest between consenting adults doesn't really qualify, either - by the time you're 18, the law holds you responsible enough to do most things, and 21 pretty much knocks off the rest of the things you're legally allowed to do. Why should incest be different?

Counter-evolution is a final example I can think of - some things are negative from an evolutionary perspective - but that seems to apply strictly to incest, because the others do not create evolutionarily weak offspring, nor do they prevent a party from (if they wish) creating evolutionarily strong offspring.

Maybe there's something else I'm missing, but I can't think of a basis by which the government can regulate those behaviors in the manner they currently do (adultery ok, gay marriage highly conflicted depending on the state, the others prohibited) in a manner consistent with its own role in regulating relationships and other areas.

Some of those clearly make me uncomfortable (incest and bestiality are, in my opinion, genuinely disgusting), but uncomfortable isn't a basis for law. The only conclusion I can come to is that the prosecution of this professor and the legally-justified prosecution of his daughter is an unjust role for the government to be playing.

Monday, December 6, 2010

Wikileaks Defenders, explain this

I've mentioned a couple times before that I think WikiLeaks' "full disclosure" ideology is irresponsible and puts American lives at risk, and that pragmatism is important when dealing with this stuff. Wikileaks' defenders call it "journalism" and simply assert that transparency is always good.

I'd like to posit that the following is an example of why this is completely false:
"WikiLeaks has published a secret U.S. diplomatic cable listing locations abroad that the U.S. considers vital to its national security, prompting criticism that the website is inviting terrorist attacks on American interests."

can someone give me ONE good reason why this type of transparency helps people? Except for maybe Iran, North Korea and Al Qaeda, who benefits from this?

I'd also like to point out that (at least according to my went-to-Medill-and-is-an-actual-journalist cousin) a cornerstone of journalistic ethics is that you don't publish things that threaten national security.

Friday, November 12, 2010

US-Sino Currency Rap Battle

The US-Sino Currency Rap Battle. Horrifically offensive accents but even so, it's kind of amazing...

Monday, November 8, 2010

Growth Matters when talking about Deficit

I've seen people post this:
Be skeptical when people say we had a structural surplus under Clinton. We had a surplus based on some very, very optimistic projections about what the internet was going to do to the economy. Bush made it worse with the wars (no denying it - not sure the tax cuts were as bad as everyone makes them out to be, but the wars certainly were) just saying the idea that we had a structural permanent surplus in 2000 was a little fanciful. People are really bad at understanding cycles - whenever people say ANYTHING about the "2000s under Bush", they have to realize they're starting with the biggest bubble we've ever had and ending with one of the two or three worst recessions we've ever had. If I drew you a graph of cycles and the bottom in 10 years matched the top of 06, it'd potentially mean we're doing really well depending on how cyclical we are.

More generally , deficits only matter in the context of growth - a 2% deficit is a big deal with 0% growth and it's minor with 5% growth. You don't have to believe that the Republicans are fiscally responsible from a spending perspective if you believe they're more pro growth. A low-tax driven deficit is better than a high-spending driven deficit because low taxes recover part of the losses through growth (and from an overall economy perspective are a positive) whereas high-spending doesn't, really. It's amazing how many economic and distributional things don't matter when you grow because the problems just take care of themselves. This is great in theory, but when you find out things like "the estate tax is a massive growth killer" or "high income taxes and high poverty transfer payments kill growth", that's where the rubber really meets the road. Growth isn't usually free.


Wednesday, November 3, 2010

Fundamentally breaking down Healthcare's Role in the Economy

I'm really interested in healthcare's role in economic growth moving
forward. I think this is a discussion not enough people question.

Most people think that curbing healthcare costs is an important part
of maintaining long-term economic growth. I'll revisit this thesis,
but for now, let's assume it's true.

The complication is that this is a levels vs changes argument. US
healthcare costs are higher per capita than you'd expect given GDP per
capita, due to a number of structural issues with health insurance and
hospitals and the fact that we subsidize innovation for the rest of
the world - these are all important things, and they all affect the
LEVEL of US healthcare spending as a percentage of GDP.

However, if you told us that the level of US healthcare spending as a
percentage of GDP would remain constant, it would not be nearly so
concerning. The part everyone worries about is if healthcare costs
explode upwards. If you spend 5000 dollars a year on healthcare,
growing at 10% year, but you can eliminate 20% of the costs, you may
only spend 4000 a year next year, but youre going to be spending 4400
(or 4500, depending on whether the growth parts slow down or not) next
year, and 4840 or 4950 the year after that, etc. It's still going to
keep growing for a long time. You've delayed the economic problem for
a few years but certainly you haven't fixed it.

This means that if you're focusing on healthcare as a long term
economic driver, your policies need to directly affect GROWTH. To an
extent, the Obama administration superficially understands this (they
talk about "bending the cost curve") but no parts of their policy
really do. Instead, most of it focuses on LEVELS. The social justice
stuff - preexisting conditions, dropped coverage, etc - is all level
based. They'll either increase or decrease costs, but they're not
touching the growth rate. (I'll note that although people argue about
whether they'll drive the levels up or down, I find many of these
arguments disingenuous - they will pretty clearly drive the levels UP,
because we're treating more things, and emergency room efficiency and
all that is somewhat secondary, but the driving the levels up in the
name of treating more people is not necessarily a negative thing.
People just don't like the idea that they propose a tradeoff, so
supporters argue it'll drive costs down)

All the "inefficiencies" stuff also explains a LEVEL - the increased
cost of paperwork from dealing with insurance companies, the
malpractice suits, the various "too many procedures" and "badly
incentivized" and "badly organized hospital" arguments - all aim at
the LEVEL (either as a dollar amount or, more typically, as a
percentage of overall spending). These explain why the US spends more
per capita. Some of these are very valid targets for change - some of
it is, in fact, waste (and some of it is foreign freeriding, which
should also end). But while all of them are important (that money can
be spent elsewhere, we care about people being healthy, we care about
incentivizing doctors to want to be doctors and to do a good job),
none of them affect the "long term economic outlook" the way they have
been disingenuously claimed as doing.

Healthcare GROWTH is a different animal - it's fundamentally an
innovational thing. The levels are different, but every country's
healthcare costs seem to be growing at the same rate - other countries
perhaps lagged slightly, because we get innovations first, but
generally speaking, growth has been a world constant. Doctors don't
increase the rate of procedures they do - they just do too many by the
same % every year. Other than innovation, it's hard to come up with
good answers to why healthcare costs are growing - arguably, it's a
factor of fewer and fewer doctors for more and more people, but for
that to be true somebody has to pocket the surplus - and insurance
companies aren't that profitable (certainly no more than they used to
be), doctors are paid significantly less in real terms than they used
to be, and hospitals are in worse shape than they used to be. Unless
there's a secret dollar sink somewhere, the supply/demand argument
isn't a great one either (though letting supply grow faster is a way
to offset other growth factors - like innovation).

Thus, you can't argue that you're saving the future economy with a
healthcare bill if you're not addressing innovation.

Of course, the problem is that you don't WANT to curtail innovation.
Dying is cheap, cures are expensive, and I'm willing to pay a LOT more
to not die. From one perspective, as the economy grows, we should be
devoting a greater and greater percentage to medical care - buying a
third tv just gives me my marginal utility from a third TV for the
life of the TV, whereas buying an extra day of my life gives me one
day's worth of marginal utility from ALL THE THINGS I'VE ALREADY
BOUGHT that I still own. As we get richer and the marginal utility
from additional TVs goes down (and the things I buy get more durable),
the extra days of my life are more relatively attractive. This means
that healthcare innovation is NOT an "economy anchor" in the future -
it's an economic allocation. I've seen a paper that says that
allocation is at least double what we have now, in equilibrium.

Now, one very good thing to look at would be innovation from a
cost-effectiveness perspective as well as from a scientific
advancement perspective - the innovation we get is largely "cure this
disease better than any treatments we've had so far", because that's
the way the FDA operates, that's the way imaging operates, that's the
way devices operate. So you could slow growth by changing FDA rules
and changing other medical rules so that approved devices, drugs and
techniques can EITHER a) cure this ailment better than any treatment
we've had so far OR b) cure this ailment at the same level than
treatments we already have in an identifiable set or subset of
patients for a much lower cost. Innovation can still go up - we can
cure new things - but we also "innovate" cheaper products.

The problem with all of these things is that our government is not set
up to deal with a greater societal allocation towards healthcare or
towards caring about cheaper innovations. Centralized healthcare
requires a lot of tax revenue, and our tax system is notoriously
inefficient from an incentive level.

Understanding all of that, an economically viable long-term healthcare
plan needs to instead raise the money in a way that doesn't
disincentivize growth and doesn't devastate the government fiscally.
I've posted before on what I think a reasonable plan is, but it would
have to be something like this:

- we pay $5000 (for example - a constant amount) to every citizen to
buy a reasonably basic insurance plan on a private market
- anyone can spend more than that if they want
- if people don't select an insurance plan, they are put into a
default plan selected by an independent grading organization - so the
default is based on an assessment of quality
- no preexisting conditions or dropped coverage
- a cap on the number of people insured by one healthcare plan
(monopoly prevention so innovation isn't crushed)
- a reward for insurance companies that hit the cap (for example,
split them in 2, but before that, give them a very large bonus payment
to compensate shareholders and management for doing a really, really
good job making their insurance plans attractive to people)
- Federal funding to hospitals depends on how their doctors are paid -
a lot of very in-depth studies would have to look at how doctors
should be paid. This may involve changing how insurance companies pay
hospitals - for "time spend caring for the patient" instead of for
procedures, or something ridiculous like that - in fact it'd almost
certainly have to be a hybrid, because any individual metric you pay
them on is abusable via incentives.
-reform of medical approval agencies to additionally incorporate cost
as a metric of "improvement" when evaluating a drug or imaging
procedure or technique

I have others, but this is the core. For more, feel free to peruse my
other healthcare posts, or leave a comment and I'll answer it.

Right there, you have a system which doesn't require intelligent
allocation by the government, it doesn't limit healthcare coverage (an
individual choice), and it's SCALABLE - plans compete to eliminate
waste (level), the amount you pay out can just increase by inflation
every year, it doesn't bankrupt the government or incentivize crappy
bureaucracy, nobody gets too much market power, innovation isn't
harmed, etc - you've taken out the levels argument, but you've also
left room for innovation to be cheap and growth to be as effective as
possible. You moderate growth and definitely get more bang for the
buck in a manner that increases over time.

That's a plan that is a) sustainable for the long term, no matter what
our increased healthcare allocation is, b) addresses some of the
levels inefficiencies, c) adds social justice to the equation, and b)
can actually bend the cost curve where it can be done without
affecting healthcare quality.

The plan we got looks NOTHING like that, and has none of the good
features except the social justice ones and arguably (people fight a
lot, I tend to think it doesn't include) the inefficiency levels

Thus, this whole healthcare bill was a masked version of social
justice legislation, anyway... and given the costs added to the
system, it's a fundamentally anti-economy plan, both in the long run
and the short run, because you're introducing uncertainty, spending a
lot more and not fixing the structural impediments to scaled-up
allocation. Also, the availability and likely the quality of
healthcare for people who already had healthcare just got way worse,
which never had to happen.

That's why I get so frustrated with these discussions, especially when
people start screwing up the social justice stuff with the economics
part. People don't like black and white - if they like the social
justice aspect of the bill, they can't disagree with its economic
implications, that would be inconsistent! (That was sarcasm, if it
wasn't clear). The sad part is that the social justice stuff is
important, but ironically, it's the easy part to understand. It's easy
to figure out you want to give everyone healthcare, it's easy to
figure out you want to get rid of preexisting conditions or dropped
coverage. The hard part is figuring out an economically sound way to
shift healthcare to incorporate all of that, and when you start with
social justice you NEVER get the right way because you build a crappy
system around it.

This raises concerns for me - as an investor and a citizen - about the
ability of the current administration to deal with the mandate it got
yesterday. If Obama (and the Democrats, but Obama, for now) thought he
was addressing the long term economy, it means he has trouble thinking
about the economy. If he thought he was addressing social justice
issues and decided to frame it as an economic bill, then it makes
perfect sense, but it means he's ideological enough to pay no
attention to his timing, which was the worst possible timing - also
not a great indicator of economic prowess. Maybe he's learning on the
job and he'll do better moving forward - honest to heaven I hope so -
but this pattern has played out in a number of other areas as well
(the stimulus, the budget, large swaths of financial reform/consumer
"protection", etc) - so I'm concerned that maybe he's not.

I'll leave this with a more general point about people's
interpretations of healthcare's size as a portion of the economy.
Saying healthcare is "too big a percentage of the economy" strikes me
as a very, very dangerous form of social engineering. You can't "fix
the economy" by plotting its path - to an extent, in our society, you
can only lay the groundwork. I'll drop a factoid: If you had to guess
the single biggest economic driver since 1990, what would you guess?

Most people say "the internet" or "computers", some others will say
"housing" or "healthcare", but the actual answer is kind of shocking:
According to a number of papers (you can Google them, I forget
authors), it's Wal-Mart. Wal-Mart has made everything so much cheaper
for Americans, creating so much new disposable income, that studies
have credited it with a stunning 15% of GDP growth.

If you asked anyone in 1990, they would not have predicted Wal-Mart.
Again, I use this as evidence that social overengineering to promote
the "economy of the future" is doomed to fail because people just
don't know what the economy of the future is going to look like. This
goes for me as well - I have no overarching theory on whether things
will get better fast or get better slowly. I do have opinions on
certain pieces (I think China's in a bubble, and I get the sense we're
underbuilding housing, even given the massive foreclosure backlog) and
I do have directional opinions (whatever was going to happen to the
economy, I am pretty sure that the healthcare bill made it worse, and
I'm pretty sure the stimulus helped far less than its dollar amount
could have).

That said, whether or not policy can really drive growth (I withhold
opinion), creating an ecosystem that can PERMIT growth is important
and is something policy can affect.

From this perspective, I'm dubious as to how healthcare reform
affected the ecosystem.

Tuesday, October 19, 2010

An alternative to "expected returns"

This is a follow-up to the "volatility is not risk" post from last week, found here:
This viewpoint makes research harder because you can't really use fixed time-period returns data that well anymore - one year returns are sort of meaningless in a flexible timeframe environment, because I don't care what the one year returns are, I care what the annualized return between now and the time I choose to sell is. There's a continuous option to sell in the interim, so one year returns aren't that helpful.
It's "one year returns" (or some other fixed time horizon) that make volatility work, which is probably why people got sidetracked onto that path.
As an alternative, perhaps we can look at the price arc after purchase- something like "time to reach estimated intrinsic value" (or, more accurately, some discount to estimated intrinsic value, the discount being relative to uncertainty surrounding intrinsic value.). If you needed to model that, I suppose you could model with something stochastic, with a drift towards expected value whose magnitude is as a percent of the distance to expected value? Something like that? That lets one mathematically model what is more anecdotally obvious.
One can model "discount to estimated intrinsic value", as well - just as we care about having positive one year returns, we care about a narrowed discount to estimated intrinsic value - but that doesn't account for the amount of time it takes you to narrow that discount.
Just food for thought as a replacement for "one year return" data as a Y variable (where you'd probably want to transform "time to reach estimated intrinsic value" so that better investments are more positive - but there are a number of easy transforms for that).

Friday, October 15, 2010

Volatility is not Risk

This is something economists seem to have a very hard time with, and I've been meaning to write about for a while.
Imagine an asset, "Safey the Asset", that pays out $10 a year forever. First payment is immediate.
The value of this stream is 10 + 10/d + 10/(d^2)...
After each payment, the value of the stream drops (the 10 up front goes away) by a factor of d, and then increases at a constant rate back up to initial value before dropping again at the next dividend. Volatility of the stream is low; incorporate the dividend and reinvest it at d, and the volatility is 0.
Now imagine a company, "Nukey the Power Plant", that with 99% probability pays out $10 and lets you roll again next year. First "dice roll" is immediate.
There is a 1% probability that it will pay out nothing and its assets will explode, never yielding any more cash.
For discount rate d, the value of this stream can be determined probabilistically:
There's a 1% chance this is worth 0
There's a 99%*1% chance this is worth 9.9
There's a 99%*99%*1% chance this is worth 9.9 + 9.9/d 
There's a 99%*99%*99%*1% chance this is worth 9.9 + 9.9/d + 9.9/(d^2)
The exact value of the stream depends on d, but you'll notice that the value of this stream can stay pretty close to constant. In exactly one year, if the assets didn't explode, the value of the stream will be determined by:
There's a 1% chance the rest of the stream is worth 0
There's a 99%*1% chance this is worth 9.9
There's a 99%*99%*1% chance this is worth 9.9 + 9.9/d 
There's a 99%*99%*99%*1% chance this is worth 9.9 + 9.9/d + 9.9/(d^2)
The price will be the exact same in one year as it is today. Like Safey, it will fluctuate in the interim only due to time value of money effects, which is determined by the size of d, and is pretty small - for a d of 10%, the value of the stream drops 10% when the money is paid out, and then climbs at a constant rate back up to initial value until the next dividend is paid. Again, observed volatility of the stream is low; incorporate the dividend and reinvest it at d, and the observed volatility is 0.
Of course, there's that pesky 1%  - if you get very unlucky, your entire asset is destroyed.
You'll notice here that observed volatility and risk have nothing to do with one another. You could go for 100 years constantly just seeing 10% price fluctuation ignoring the dividend as you win every time - on an observed volatility basis, Nukey and Safey are identical.
Perhaps the "intrinsic volatility" of Nukey is higher, because it incorporates unseen events, but intrinsic volatility is a) completely unobserved and b) completely uncorrelated with observed volatility.
This link between observed volatility and intrinsic volatility is an assumption of most finance papers, but I'd posit that it's very, very wrong.
In case you think I'm making up random examples, this "Nukey the Power Plant" asset fits the profile of a lot of different types of assets - oil rigs and power plants (ignoring energy price fluctuation - the point is the stream continuing or not), tech companies (you have unmatchable products with no competition and incredible margins... until someone comes up with something better and you lose your profit stream), event-related insurance (super cat, property, reinsurance, etc), banks (hello last 3 years), pharma (FDA pulling approvals), even fashion (you're the hip look til you're not), etc... there's almost no types of company this type of risk is NOT relevant for. I'd say the "it could go to 0" component of the risk is a much more important risk than the "look at the price of the asset oscillating" risk.
More theoretically, volatility requires semi-strong-form efficient markets hypothesis to be useful on open-ended assets.
I define open-ended assets as assets without a fixed point at which you sell or exercise the asset. So an American option is a closed end asset, because you have a specific amount of time to derive value from the option but can do so anytime in the interim. I think it's pretty easy to see why volatility matters. A bond is similar.
However, equities can be held until whenever it is that their price is good - if you can observe an underlying value that others are not seeing, this value is increasing, and that price moves stochastically with a drift towards the intrinsic value, you can buy an equity and hold it for as long as it takes to get to the intrinsic value. If the price drops, or undergoes a lot of volatility in a region that is nowhere near intrinsic value, that doesn't imply more risk, because value keeps increasing and price will eventually move towards underlying value. The longer it takes, the higher value is and the more price appreciation you'll see. The path doesn't affect the endpoints.
Thus, observed volatility is only relevant to risk if there IS no disconnect between price and value. In this case, prices need to constantly reflect all public information, at least, meaning you require the semi-strong form EMH.
I'd caution you against subscribing too strongly to semi-strong EMH. These are the same people who think that Renaissance Capital and Warren Buffett and George Soros "just got lucky" - I'd recommend "The Superinvestors of Graham and Doddsville":  I can imagine a response of either "Buffett's cherry picking" or "they just chose a method which happened to randomly work for that time period but there's no proof it will continue...." You're welcome to your opinion, but the theoretical grounds for the method were there before the method worked, were justifiable by economic theory excluding EMH, and were not rationalized ex-post. As I say to dedicated members of political parties all the time, watch out for your own confirmation biases when it comes to EMH.

Tuesday, October 12, 2010

Is Gencor an Accounting Fraud?

I'm looking at Gencor (ticker: GENC), a company whose market cap is
significantly less than current assets minus total liabilities (a
"net-net"), and seems to actually have a legitimate profitable
business making capital equipment for asphalt production, as well.
Obviously, as an investor, this piqued my attention, but there are
some really funny things going on:

1) Doubtful accounts receivable runs about 1/3 of their entire
accounts receivable and has for the last 8 years. It looks like a
normal 30 day payment period (I'm sure this is buried somewhere in the
footnotes, but receivables turnover is in the general vicinity of 10),
so its not a "it collects its bills so fast that the only ones left
are doubtful ones' story (which I've never heard of but would be
theoretically possible). Thus, I can't figure out why they keep
selling to lousy customers. Perhaps there's a legitimate reason why
this would happen other than fraud (if it's fraud, for example, why is
it declared as doubtful - normally that stuff gets hidden), but it
does inflate revenues when announced and the writeoffs are less

2) For some reason their marketable securities purchases are listed as
operating cash flow when clearly municipal bond and equity investing
are investments, not operations, for an asphalt equipment production
company. I can't figure out why this is happening, I've never seen
this in a company whose business was not in the financial sector and
had no idea this was allowed. This is weird, because it makes their
Operating Cash Flow look way too low and Investing Cash Flow look too
high. Most frauds fake high operating cash flow, not low operating
cash flow.

3) At the end of 2008, they had one CFO resign "for personal
interests" after working there for 8 years (this is a tiny company, I
doubt he's rich enough to retire), replaced him with someone else (not
interim, as far as I can tell, because they don't say so and they go
out of their way to mention he actually relocated with his entire
family from Connecticut to Florida), and then 5 months later the new
guy quit with no warning and no publicized letter or reason. 3 months
later they announce another new CFO. The departure of the second CEO
is found in an 8-k with an accompanying press release on the SEC
website, but that press release is not listed in the section for press
releases on their website, though all the surrounding ones from the
same time periods (earnings reports, etc) are. There are just two "New
CFO!" press releases.

4)  They had an activist investor who accumulated a big position,
joined the board, supposedly (according to the CEO) never went to a
meeting, and resigned from the board suddenly and sold everything a
few months later. Unlike most board resignations ("It's been an honor
to work with these people and I am sure the company will see brighter
things to come", or something like that - as seen in the first CFO's
resignation), his resignation letter was about as terse as it gets:
"Dear Sir or Madam: I hereby resign as a member of the Board of
Directors of Gencor Industries, Inc. effective May 7, 2008. Sincerely,
Lloyd I. Miller, III"

5) I know I'm not Obama's biggest fan, but the CEO directly rips into
least, it's unprofessional.

6) The CEO also insults investors in official press releases. This is
an actual press release from the company. Read it word for word,
you'll miss some gems if you read too fast.
some quotes:

"In view of the accelerated trading of the Company's stock [after the
resignation], and for the benefit of those who persist on remaining
uninformed in spite of all of Gencors (Nasdaq:GENC) SEC filings,
10-K's, 8-K's, Proxy Statements, Annual Reports and Press Releases..."

"The Company is actively engaged in exploring acquisitions, and when
one such is under contract the information will be issued" (Firstly,
what a terrible way to run a company, but secondly, it's been two and
a half years, with more bargains on the market than anytime in
history, and they have cash to burn, and still no acquisitions...)

"Mr. Lloyd Miller only attended the Board meeting immediately after
being elected to the Board on March 6, 2008. At that Board meeting he
was elected to the Audit Committee but never attended one of it's
meetings and then resigned from the Board on May 7, 2008, and based on
recent conversations with management, he did so purely for personal
reasons and convenience and maintains a professed high esteem for the
company, its management, and its future." (If you say so...)

"Disinformation and rumors only serve the purposes of the self-serving
speculators preying on the uninformed investors."

7) They quote a "James Zeller, US Asphalt" as saying they are
wonderful about service when US Asphalt bought equipment. I googled
James Zeller, and saw a Jim Zeller on the Sales team at a different
asphalt company. Not a major finding, but most sales guys don't buy
capital equipment, and he's changed his company if it's really him. I
have to imagine it's the same guy - there can't be too many James
Zellers in the US working in asphalt.

8) In other trivial but interesting findings, they claim to have a
24/7 help desk but don't have the number anywhere (what, does every
contractor know the number by heart?)

9) I cannot find a single place other than a nebulous "contact us"
form with no other information given to figure out how to BUY THEIR
PRODUCTS. They don't list distributors, they don't say to email them
for a quote or call them for a quote, they don't pop up on google when
I write "Gencor purchase" or "Bituma purchase" (one of their brands).
I understand their products aren't exactly going to pop up on Amazon,
but usually places like this will give you the ability to contact
their sales staff. There's a general corporate line on their website,
which a person does pick up. I haven't pursued anything by phone further.

10) Despite the amount of cash they have, they have had no dividends or buybacks at all. At best, this is a symptom of bad management, but in context, it makes you wonder how much actually exists.

11) In their defense, their corporate headquarters does in fact pop up
on google maps, and the street photo clearly has their logo. It looks
like they have equipment there, though there's no guarantee they don't
share the building.

I'm wondering if maybe the CEO wants to run a mutual fund or
something, which is why he holds the cash and makes Investing cash
flow look too high, etc. But that's reaching at straws, it's not a
normal thing. This is really, really weird. None of this stuff
individually screams "fraud" but all together it starts getting
interesting. The problem, of course, is that shorting a net-net that
also generates cash is asking for trouble if the company is real. I'll
keep investigating.

Monday, October 11, 2010

Economics in Real Life: How (Basic) Recessions and Stimulus Work

Another in a series of "Real Life Economics" examples I've been putting together for people interested in economics, or taking introductory economics, for how economics actually affects the real world.
Credit for this one goes to Paul Krugman, pre-intellectual suicide, and Greg Mankiw.
First, Krugman:
This is the "most basic" scenario of how a recession happens, laid out by Krugman. The link also introduces things like interest rates to complicate this basic outline
"The Sweeneys tell the story of--you guessed it--a baby-sitting co-op, one to which they belonged in the early 1970s. Such co-ops are quite common: A group of people (in this case about 150 young couples with congressional connections) agrees to baby-sit for one another, obviating the need for cash payments to adolescents. It's a mutually beneficial arrangement: A couple that already has children around may find that watching another couple's kids for an evening is not that much of an additional burden, certainly compared with the benefit of receiving the same service some other evening. But there must be a system for making sure each couple does its fair share. 
       The Capitol Hill co-op adopted one fairly natural solution. It issued scrip--pieces of paper equivalent to one hour of baby-sitting time. Baby sitters would receive the appropriate number of coupons directly from the baby sittees. This made the system self-enforcing: Over time, each couple would automatically do as much baby-sitting as it received in return. As long as the people were reliable--and these young professionals certainly were--what could go wrong? 
Well, it turned out that there was a small technical problem. Think about the coupon holdings of a typical couple. During periods when it had few occasions to go out, a couple would probably try to build up a reserve--then run that reserve down when the occasions arose. There would be an averaging out of these demands. One couple would be going out when another was staying at home. But since many couples would be holding reserves of coupons at any given time, the co-op needed to have a fairly large amount of scrip in circulation. 
       Now what happened in the Sweeneys' co-op was that, for complicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple's decision to go out was another's chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further. 
In short, the co-op had fallen into a recession. 
       Since most of the co-op's members were lawyers, it was difficult to convince them the problem was monetary. They tried to legislate recovery--passing a rule requiring each couple to go out at least twice a month. But eventually the economists prevailed. More coupons were issued, couples became more willing to go out, opportunities to baby-sit multiplied, and everyone was happy. Eventually, of course, the co-op issued too much scrip, leading to different problems ... 
If you think this is a silly story, a waste of your time, shame on you. What the Capitol Hill Baby-Sitting Co-op experienced was a real recession. Its story tells you more about what economic slumps are and why they happen than you will get from reading 500 pages of William Greider and a year's worth of Wall Street Journal editorials. And if you are willing to really wrap your mind around the co-op's story, to play with it and draw out its implications, it will change the way you think about the world....
...Above all, the story of the co-op tells you that economic slumps are not punishments for our sins, pains that we are fated to suffer. The Capitol Hill co-op did not get into trouble because its members were bad, inefficient baby sitters; its troubles did not reveal the fundamental flaws of "Capitol Hill values" or "crony baby-sittingism." It had a technical problem--too many people chasing too little scrip--which could be, and was, solved with a little clear thinking. And so, as I said, the co-op's story helps me to resist the pull of fatalism and pessimism."
And secondly, Mankiw. You'll notice that this "babysitting economy" requires two sides - it requires both someone willing to work (babysit) and someone willing to consume. Imagine that some people had accumulated lots of babysitting coupons and others had accumulated very few - in other words, there is "poverty" and "wealth" in the economy. Imagine that each year, the 10% with the most coupons had to give 20% of their coupons above the average amount to the 10% with the least coupons. How does this affect willingness to work for everyone involved? (For Graham this question is not optional).***see stars below for one answer***
Which brings us to Mankiw's column today, already cited earlier in my blog:
"HERE'S the bottom line: Without any taxes, accepting that editor's assignment would have yielded my children an extra $10,000. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family's marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?
By contrast, without the tax increases advocated by the Obama administration, the numbers would look quite different. I would face a lower income tax rate, a lower Medicare tax rate, and no deduction phaseout or estate tax. Taking that writing assignment would yield my kids about $2,000. I would have twice the incentive to keep working. "
***This is not to say that we shouldn't help out people who need babysitting, but it does very much skew the incentives to work - those with few coupons don't need to work as hard because they'll get coupons (and the more they work, the less they'll be given), and those with lots of coupons don't want to work as hard because for each "coupon" they earn, they're actually only earning .8 coupons. The Mankiw article indicates that for many, they're actually only earning .1 coupons... which should make everyone very worried about the babysitting equilibrium put forth by Krugman...

Finally, somebody doing tax math

Food for thought.
"HERE'S the bottom line: Without any taxes, accepting that editor's assignment would have yielded my children an extra $10,000. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family's marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?

By contrast, without the tax increases advocated by the Obama administration, the numbers would look quite different. I would face a lower income tax rate, a lower Medicare tax rate, and no deduction phaseout or estate tax. Taking that writing assignment would yield my kids about $2,000. I would have twice the incentive to keep working. "

Thursday, October 7, 2010

Economics in Real Life: Affordable Housing Laws

Periodically I come across things that I think are good examples of why studying econ is useful. Time for a pop quiz. Explain what is wrong with this assertion (the entire email is below, if you need more information on what the law actually says):
What does the Law say?
Known as Chapter 40B the law says that all communities must have a minimum of 10% affordable housing and streamlines the permit process for construction as a way to eliminate exclusionary zoning processes and prevent individuals from being priced out of their communities. [MY NOTE: In practice, this means that 10% of the rooms in every building is reserved for "affordable housing"].
What happens if this [mandated affordable housing] law goes away?
12,000 affordable homes will never be built. This will cause the state to [lose] jobs and individuals across the state to not have access to adequate housing. Essentially NO affordable housing will be built outside of the major cities and Habitat for Humanity will not be able to adequately operate in MA. 
Graham this is not an optional response for you.
(answer below- scroll down)
My response looked something like this:
"Setting aside whether affordable housing laws do good things (there are legit arguments on both sides - I tend to think they're an inefficient solution to poverty and should be replaced with more impactful poverty policies, but I see the argument for them)... how does a mandate that developers make 10% of their units unprofitable drive away jobs? Eliminating affordable housing laws, thus making units more profitable, actually would create construction jobs because projects that couldn't be viable now would become viable..."
[I'm also very interested in hearing why Habitat for Humanity would be forced to cease operation... is it a land issue?]
On Thu, Oct 7, 2010 at 2:29 PM, ****** <*****@****.*****.*****> wrote [on a "democrats-talk" email list]:
Did you know affordable housing in Massachusetts is under attack? Question 2 on the November 2nd ballot seeks to eliminate MA's primary affordable housing law

What does the Law say?
Known as Chapter 40B the law says that all communities must have a minimum of 10% affordable housing and streamlines the permit process for construction as a way to eliminate exclusionary zoning processes and prevent individuals from being priced out of their communities 

Has the law been successful? 
Yes. the law has created 58,000 affordable homes for seniors and working families. The law has helped 51 cities in towns get to 10% and incentivized another 150 to come up with a plan to reach that goal. 

What happens if this law goes away?
12,000 affordable homes will never be built. This will cause the state to loose jobs and individuals across the state to not have access to adequate housing. Essentially NO affordable housing will be built outside of the major cities and Habitat for Humanity will not be able to adequately operate in MA.

Why should you care?
A study from Northeastern shows that the cost of housing for recent graduates will skyrocket if the affordable housing law is removed. MA is an expensive place to live and under the law a single individual making up to $44K a year qualifies for affordable housing. 

The law has also been used to help seniors who do not have pensions remain in their communities and is  part of the "housing first" solution to homelessness. Furthermore it provides stability to families and entire communities in a time where the economy can put someone at risk of losing their home. 

Who is protecting affordable housing and Voting NO on 2?

Over 1,500 individuals and organizations including all 4 candidates for MA governor, the League of Women Voters, Habitat for Humanity, the YWCA, City of Cambridge, and Catholic Archdiocese.  

Who came up with the idea for question 2?
An organization known as the Slow Growth Initiative, funded by the New England Coalition for Sustainable Population that advocates for population control (We literally can't make this up)

How you can help? 

Please e-mail **** or ****** for more information or if you have questions. 

Whether you have 5 minutes or 5 hours, any time you can give protects our seniors and working families. 

Thanks and we look forward to working with you.

Friday, October 1, 2010

Uh oh, Tesla...

Zion Oil and Gas drills for oil in Israel based on where the Bible and "Creation Science" says they should:
Which made this notable:
The quote that had me blown away:
"Interestingly, CAPS members think Zion has a better chance of finding oil in the Middle East than Tesla has of making it as a mainstream car company."
In that case, Tesla must be much, much worse of a company than I had ever realized. Uh oh. Not to say they can't turn it around, but if CAPS investors are even reasonably on top of the fundamentals of the companies (which is reasonable - maybe they're imperfect as predictors, but as reflections of current state, they're not bad)... bye bye, Tesla...

Wednesday, September 29, 2010

Brad DeLong should stop insulting Megan McArdle about her Math Skills


Brad DeLong really misses the point here.


When you're looking at PERCENTAGE OF GDP, you're looking at A sub t over GDP sub t.


When you look at the present value of these, however, and you're using different discount rates because of different growth rates, you end up with distorted percentages. This is very simple math.




Monday, September 27, 2010

Exercises in "Strict Rationality"

This is on strict rationalism. This is not coming from an emotional place, it's coming from a questioning place. Sorry for the very "Robin Hanson" style posts today.

I've always thought it's strange that people try to make me feel better on a bad day with "Well, if it's any consolation, (insert their bad news here)".
Your misery is uncorrelated with mine, and is strictly negative for me if I like you. How is that supposed to make me feel better? Making me feel like I'm not alone is stupid, because I WISH I were the only one in the whole world having a crappy day. I'm sure Robin Hanson would have something to say about the anthropological background to this, perhaps a reason that may be strong enough to counteract my "strictly rationally, this is stupid" reaction, but I'm guessing that whatever effects he'd bring up would be secondary to the primary logic. The intention of them saying it is clearly good - they want to signal that they understand my pain, and to help me feel not alone - and that intention can make me feel good, but isn't there some better way of signaling that intention without a negative factual?
Another example (which seems to me to be intuitively related, but I'm not quite sure how) is that it's rationally strange that people don't put "single" on facebook when they're single and would prefer a relationship. It should not be embarassing being single or wanting a relationship (these are part of being human in modern society), and reducing search cost should be a good thing for people with whom you may be compatible.
I understand the signaling value of looking like you could be in a relationship, but the person you're eventually getting with is going to find out anyway.

The only explanations I can think of is either a knee jerk preference for privacy (which I doubt, given the amount shared by many people online), or a "commitment and consistency" thing where people have to work to figure out if you're single, which increases your "mystery" and makes people want to act consistent with the initial effort they've put into figuring out if you're single - that you're worth time.
Relationships are hardly rational, so it's not quite so important to adhere to rationalism when seeking for one, but I know my initial reaction to someone who is single but doesn't have "single" up is that they don't really want a relationship and won't really put effort into finding or maintaining one - something strictly negative. My next reaction is "they're too self-conscious and don't have any confidence", and my next one is "well, if neither of those are the case, they think very tactically/politically". None of those three things should be things you want a single person you could be interested in to think. I don't know if this overpowers the commitment/consistency motive. Perhaps it depends on the person you're trying to attract - if you want someone very commitment/consistency oriented, it's good, whereas if you want someone adaptable, it's bad. I've always associated adaptability with intelligence, so if you want someone commitment/consistency oriented, it means you value bullheadedness. That means I still shouldn't really want you.

You could also argue that someone who posts single really wants a relationship more than normal and that is a negative signal. Someone who wants a relationship but not more than normal doesn't want to look "desperate", so they post nothing. Jury's out on this one, but it's certainly an unusual and unfortunate equilibrium - nobody has incentive to deviate now, but if the equilibrium were on a less negative interpretation, everyone would be better off, still with few obvious reasons to deviate. One could argue this equilibrium was reached by chance, but I doubt it - there's something "negatively emotional" in posting "single" and reading "single" that forces everyone to live in a suboptimal equilibrium.
Conforming to the equilibrium that may or may not exist, it's more of a tradeoff between the quantity of people reached with your message vs the quantity of people who filter you as "desperate". This may still be a confidence-related issue, as confident people may not worry about being seen as desperate when they're not desperate. It's all worth thinking about, at the very least.
A final example would be the extreme negative reaction of some people to hearing someone else say "I love you."  "I love you" is a factual statement and has two meanings to a listener: 1) the speaker claims to love the listener and 2) there are emotions that person is feeling that has led them to say "I love you".
Both of those things are good things for the listener - being loved is good, and having emotional attachment is often good. Sometimes, perhaps, a negative reaction can come from a feeling of "Oh no, I don't feel the same way to the same extent and I will have to hurt this person" or even "Oh no, I'm going to get attached and then they will hurt me one day", but I think we all know couples whose relationships that were going along wonderfully and had both people excited about the long term until one person said "I love you". This negative reaction by the other person is not a "rational" one.
This isn't to be judgmental - people are welcome to do or think what they like - as long as it doesn't affect anyone else directly, it doesn't matter to me, and people should do what makes them happy or comfortable. There's a difference between judging someone for being a weak person and judging someone for being a person. But these are three behaviors that require "irrationality" to make sense. More constructively, this isn't a statement of "people are irrational and that's stupid", it's a question: "How can I, as an imperfect and irrational person, 'practice' being rational, and when will it improve my behavior?" In these situations, that should be a good thing - for being happy, for finding love, or for nurturing it.

Prospect Theory and Utility, Price and Rights

Talking with my friend Damien over lunch today, I got to thinking about some very stupid questions:
1) Let's say someone offered you a sum of money, $X, to not wear jeans at all for the next year (presume it's suitably enforced so that you will always comply). How big would X have to be for you to accept?
2) Let's say someone offered you a sum of money, $X, to never use a fork or fork-like object (spork, etc) for eating ever again. Presume it's suitably enforced so that you will always comply. How big would X have to be for you to accept?
I'd expect significant variation in peoples' answers to both questions (I don't get to wear jeans to work anyway, for example, so not wearing jeans would impact me less than others - though I like jeans a lot more than most people do, I think. Women have more alternatives to jeans during leisure time - dresses, skirts - and I know some girls who never wear pants, ever. A lot of people are better than I am with chopsticks.), but the interesting part is how those sums relate to sums in the rest of my life.
Damien posited that about $100,000 would be enough to make him give up forks forever. (He claims that $200-$300 would be enough to give up jeans for a year, but I doubt that's true, given that he has spend that much on a pair of jeans before...). My answers were higher on both counts - at least a million for the fork question.
The funny thing is that a million dollars is a LOT of money (surprise!) - would I really forgo a lot of years of cumulative earnings just so I can use a fork, a utensil for which there are plenty of substitutes?
The reason for my answer, I think, comes down to a few things -
1) I'm young, live cheaply / don't have trouble managing my budget because there aren't that many things I really want to buy, and am probably wildly overoptimistic about my future earnings capacity relative to future expenditures (wedding, house, childrens' college, etc), and thus estimate that the marginal utility I will get from spending a million extra dollars over the rest of my life will be less than the marginal utility from using forks (the "rational" response except only a blind idiot would project future expenditures that low, and thus discount one MILLION dollars, and in any other context, I wouldn't make that discount),
2) path dependence - I have used a fork for my whole life and am good with it, but am much worse with chopsticks. A stupid reason, because I'm sure I'd get very good at using spoons or knives or chopsticks as replacements pretty quickly - I probably underestimate the ease of transition, which is part of...
3) prospect theory. I significantly overvalue potential losses and undervalue potential gains. As an investor who pays a lot of attention to the psychology that goes into my own decisions and my psychological reaction to risk and opportunity cost, I sometimes like to think I'm a little more immune from prospect theory than most, but apparently, I just suffer from overconfidence, just like everyone else...
Food for thought and self-reflection. Lunch break's over, back to work.

Thursday, September 23, 2010

Pharmaceutical Business Model

Historically, the Big Pharma business model has been that of a fully integrated pharmaceutical company, complete with basic research and development, clinical trials, sales and marketing, focused on the development of blockbuster drugs. This model has recently been roundly criticized.

A research article issued in January from Morgan Stanley (MS) titled "Pharmaceuticals: Exit Research and Create Value" created a stir when it called for Big Pharma to toss out all small molecule research. A group of MDs, PhDs, MBAs, and CFAs calculated that reinvesting internal research to in-licensing would result in a three-fold increase in returns. This process, they said, would even triple the number of new drugs reaching the market each year. Research and Development, Morgan Stanley said, should be replaced by Search and Development. The core competency of Big Phama should shift from in-house research to late stage development and commercialization.

Aside from the first extreme suggestion of divesting all research, there isn't much new in this prescription. Big Pharma has already shifted a large percentage of their early stage research spend outside the company. Pharma is in the midst of transferring ever more research to both CROs and biotechs alike. Where at one time only relatively simple functions were outsourced, nearly all research and development functions are now carried out by third parties to some extent.

The fastest growing trend today is outsourcing biology research and transferring development work to lower cost markets, especially Asia. It has been estimated over $300 million can be saved by performing drug development in India(1). In-licensing has increased to the point where approximately 30% of current Pharma revenue now comes from in-licensed compounds(2).

Forest Labs (FRX) is an example of a fully in-licensed pharmaceutical company. It did well for some time, but has recently suffered from the same problem as the rest of Pharma with its own pipeline gaps. Two drugs, Lexapro and Namenda, approved in 2002 and 2003, accounted for 87% of 2009 sales. Revenue growth is in the mid single digits, and its operating margin, at 18% is far below that of the average Pharma company- peculiar considering Forest has only 5000 employees and has no need to conduct discovery research. The stock has dropped by half since its 2007 high.

In any case, in-licensing is unlikely to be Big Pharma's savior. As this trend has intensified, the cost of quality compounds has gone up. Pharma historically favored in-licensing compounds post Phase II to reduce risk, but with increased costs, they have turned to earlier stage compounds. Today, even these have become pricier. Many companies backed by VCs have begun pushing for buyouts for their portfolio companies due to the inability to access the IPO market, further increasing the cost of acquiring compounds.

In-licensing allows Pharma to access novel technologies and may have some cost efficiencies for now, but it will only buy time for Big Pharma as costs spiral upwards. While ROI for Pharma compounds is a lowly 5%, the increasing costs combined with increasing failure rates of in-licensed compounds has reduced the ROI of compounds licensed at the Phase III stage from 12% in the 1995-2000 period to just 6% from 2000-2002(3).

Even as Pharma pays higher prices for biotech compounds, they will need to increase their diligence in selecting them. As Harvard Business School Professor Gary Pisano noted, biotech is even less efficient than Pharma in developing drugs(4). Pharma will certainly need to retain a highly innovative research group, and I imagine that is the case, if not for the sake of drug discovery, then at least to maintain the know-how to thoroughly vet compounds from biotech companies.

Another suggestion has been for Pharma to focus on limited therapeutic areas, citing biotech as examples of companies with core focuses that lead to greater levels of success in drug discovery. It appears this is not the case; a look at maturing companies such as Amgen (AMGN), Gilead (GILD), Genzyme (GENZ), and Biogen Idec (BIIB) shows they are all dependent on drugs discovered years ago. Indeed, they have all broadened their disease focus in recent years in an attempt to boost sagging growth. Of the largest biotechs only Celgene (CELG) has maintained its focus on its core disease area. However, when it comes to successful drug discovery, Celgene is no different from the others, with only a single drug developed in-house driving most of its growth.

Genentech (DNA), often highlighted as the epitome of innovative biotechs, has some of the world's best researchers, but even they have not developed a new drug since Avastin was approved in 2004. Their most recent attempt for accelerated approval with the antibody-drug conjugate T-DM1 has just been denied by the FDA- the new anticipated filing date is now 2012. Two other late stage molecules target HER2 and CD20, the same targets as Herceptin and Rituxan, two approved Genentech drugs. Contrast this with BMS, market cap $45 billion; since the start of 2005, it has received approval for five NMEs. It may receive approval for the novel cancer vaccine Ipilimumab as early as the end of this year. Pharma does not lack for innovation. The difference between Genentech and BMS? Genentech has yet to be hit by generic competition.

An interesting report from Accenture draws a line between two Pharma business models: Innovative Medicines and Integrated Therapeutics. Innovative Therapeutics companies focus on discovering novel medicines for high unment needs using world-class drug discovery capabilities. Integrated Therapeutics companies on the other hand provide a suite of medical solutions that include risk-sharing pricing contracts, drug delivery devices, companion diagnostics, or care management services. In this report, the authors suggest that companies must choose between these or models such as generics and OTC medicines(5).

I believe the pure Innovative Medicines model can no longer survive in the long run in the current regulatory and business environment. In the current environment, there will continue to be pipeline gaps due to shortened patent exclusivity, generic competition, and difficulty in developing new drugs. Depending on discovery alone will lead to highly cyclical earnings. In a model by researchers from Kellogg School of Management, a company aiming to maintain 18% earnings growth over a period of 15 years would need to increase its number of drug launches five fold, with each launch reaching double the average peak sales of the original drugs. This is not sustainable. In the period from 1992 to 2002, only "a handful of companies" were able to bring on average one or more NMEs to market per year(6). Even if one is lucky or resourceful enough to develop a drug, the regulatory environment is difficult, competition is fierce, and switching costs are low.

By deploying a model focused around Integrated Therapeutics, meaningful value is added to the product. The molecule alone is no longer the only differentiator. Done correctly, this creates a higher barrier to entry for competitors from both makers of novel drugs and generics. At the same time, it generates greater benefits for the many parties involved, including patients, payers, and drug makers.


  1. Pharmalicensing: The Productivity Tiger - Time and Cost Benefits of Clinical Drug Development in India
  2. McKinsey & Co: The New Math for Drug Licensing
  3. In Vivo: Rebuilding Big Pharma's Business Model November 2003
  4. Gary Pisano: Science Business: The Promise, the Reality, and the Future of Biotech
  5. Accenture: The Era of Outcomes- Emerging Pharmaceutical Business Models for High Performance
  6. Kellogg School of Management: Strategic Alternatives in the Pharmaceutical Industry

Wednesday, September 22, 2010

The Problem with Political Frustration on the Left

When I write "left" and "right", I somewhat interchange meanings. The first is "the Democrats who are actually in Congress and the White House" and "the Republicans who are actually in Congress". The second is fiscally speaking - the left being more statist and opposed to corporate America, and the right being more decentralized and favorable to corporate America. In this particular case, especially in the characterization of the "left", these are reasonably interchangeable.

I've said a million times before that just because your intentions are good doesnt mean your execution is. Stimulus, healthcare, energy and finreg are the right targets, and there's not some fundamental moral separation behind any of them (excepting climate deniers, who Congress very much should be ignoring).
Just because you want universal healthcare (largely a good idea) doesn't mean that there aren't implementations that are worse than the status quo and other implementations that are better than the status quo. The Republicans have a lot of very, very good ideas on the economy and healthcare that Democrats, by virtue of being much more statist, will not generate by themselves. I genuinely believe after midterms things will get much better because you wont have this nasty "we have to stick together or this country's going socialist" mentality on the right and you wont have this "we have massive majorities, we get whatever we want!" entitlement on the left.
In fact, the left blaming the right for being "the party of no" is, at least in my mind (with the bias that i am an investor, first and foremost), the single biggest impediment to good policy, and similarly a major impediment to recovery because it has meant that every single policy coming out of the left turns into a left pipedream with no real compromise. None of the policies brought out so far has attempted to integrate Republican ideas because everyone just decided from the get-go that the Republicans wouldn't listen. Thus, it becomes a self-fulfilling prophecy.

The attitude of "the Republicans messed up royally under Bush, so now they have to sit back and shut up while we fix everything" is really, really destructive, for both Democrats (whose polling numbers are equivalent to the Republicans', and who will almost certainly (rightly) be held responsible for massacring the recovery) and for the Republicans (who are being hijacked by crazy people as everyone reacts to Democratic policies). This is bad for the country.

Thus, it's hard for Republicans to not oppose everything when they've been ignored from the get-go. There are 41 Republicans in the Senate, some of whom are from NH and MA and liberal states. Getting them all to unify in opposition is like herding cats unless you set off a bomb from which all the cats run away. So I don't buy this "Republicans are all to blame" argument from Democrats, because no attempt was really made to integrate their ideas. Plus, when you have 60/59 senate votes and a house megamajority, you're responsible for your policy, end of story.
Anyway, the idea of identity as Dem vs Repub, and of being entitled to implement your own policy if you have a majority, are way underrated pieces of the trainwreck that has been the Obama economic recovery policy.
By the way, some of you may be surprised to know that I voted for Obama, and typically vote Democrat 80% of the time, largely because I find conservative social policy distasteful in a lot of areas (gay marriage, religion in schools, xenophobia, etc).

Keys to Investing in Tech Stocks

"To make real money in tech your company must do three things. Two out these three and the results will be (at best) inadequate.
You need to have an idea that effectively changes the world in some way (even small ideas are OK as there are surprising profits if you can pull the next two tricks).
You need to execute – that is you need to bring the idea to reality.
And you need to keep the competition out.
Of these normally number 3 is the thing that trips up tech companies – they work really hard to get the idea implemented and then someone with less expense – and with the benefit of watching your failures, trials and tribulations – copies the idea (usually slightly better or less clunky) and the margins go to zip. Microsoft is such a fantastic company not because they have the technology right – but because people build on them proprietary software (developers, developers, developers) and that makes people reluctant to change even if the new product is superior.
But a tech company can easily be tripped up on the execution phase as well. (Anyone remember Friendster? Remember when their site took 2 minutes to load a page because they couldn't get the IT implemented properly? And look how valuable the position they lost is…)."

Tuesday, September 14, 2010

Gender Equality and Sports Locker Rooms

I have a question. I hear all the time about issues surrounding women
reporters in mens' locker rooms - harassment, trysts with athletes,
general assertions of gender equality, etc.

I would be interested to know if it works in reverse. Are men allowed
inside women's locker rooms for interviews? I understand womens'
sports aren't as popular, generally, and the ones that are tend to be
individual sports with no "locker room" to enter. However, certainly
womens' college basketball and the WNBA are significant enough to
warrant news stories. Are male reporters allowed into those locker
rooms? Because if not, it's hard to argue that gender equality is
being respected.

On another note, why does it make us (including me) so uncomfortable
to consider men doing interviews in womens' locker rooms, but not the
converse? Does it have to do with stereotypes of gender roles (men as
self-confident, don't-care-what-people-think-of-me vs. women as demure
and vulnerable)?

Similarly, why do Clinton Portis' comments make us so uncomfortable? He said:
"You know, somebody got to spark her interest, or she's going to want
somebody. I don't know what kind of woman won't, if you get to go and
look at 53 men's [bodies]," Portis said. "I know you're doing a job,
but at the same time, the same way I'm going to cut my eye if I see
somebody worth talking to, I'm sure they do the same thing."

If a woman on a sports team said that a male reporter made her
uncomfortable because "of course he'd be checking some of us out", I
don't think anybody would dispute that. Why is Clinton Portis held to
a different standard?

I'm not necessarily agreeing or disagreeing that Portis was offensive
or that reporters of other genders in a locker room are appropriate or
not, just pointing out that 99% of people respond very differently
depending which gender is in which position.

Liquidity and Fast Traders: Real World Questions

This post is more inference than proof. Take it as you will.

The following are share counts executed on a trade I tried to fill
today, with times. "limit" indicates that those shares were executed
at my limit price. "limit - .01" means that I bought at the limit
price less one cent. The trade was posted at about 1:30pm, adjusted at
2:01pm for a higher limit price, and did not fill in its entirety. My
limit was top of the book for most of the afternoon (meaning I was
offering the best price of anyone displaying the shares they were
willing to buy).

This is a stock with a very low share price, for those who note the
large number of shares.

09/13/2010 02:01:13 PM    300.000        limit - .02
09/13/2010 02:01:13 PM     345.000       limit - .01
09/13/2010 02:09:20 PM    200.000        limit

09/13/2010 03:46:28 PM    381.000        limit
09/13/2010 03:50:05 PM    17.000          limit
09/13/2010 03:50:28 PM    1,000.000     limit
09/13/2010 03:50:40 PM    13.000         limit
09/13/2010 03:51:10 PM    26.000        limit
09/13/2010 03:51:40 PM    23.000     limit
09/13/2010 03:52:15 PM    17.000     limit
09/13/2010 03:52:50 PM    11.000     limit
09/13/2010 03:52:52 PM    100.000   limit
09/13/2010 03:53:20 PM    6.000     limit
09/13/2010 03:53:55 PM    3.000     limit
09/13/2010 03:54:25 PM    2.000     limit
09/13/2010 03:55:00 PM    2.000     limit
09/13/2010 03:59:50 PM    98.000    limit

Note the large number of small share-count trades executed after 3:45pm.

The market closes at 4pm. The last 15 minutes of the trade day are
filled with traders trying to unload shares they've picked up over the
course of the day so they avoid overnight exposure. Notably, these
traders picked up the shares after the day started, and ditched it
before the end of the day.

Interestingly, the bid-ask spread was just a penny, but if I had
executed my entire (small) order of 3333 shares, I would have spiked
the price 52% without hidden liquidity (which I'm sure would have
stopped the ascent at under 10% - still a big spike, but far less).

What does this tell us? Three things:
1) bid-ask spread is a crappy measure of liquidity
2) fast traders are a HUGE percentage of the market. Look at what
percentage of my shares came from traders unloading!
3) there is a lot of liquidity hidden from the market (largely either
fast traders themselves, or hidden by institutions to prevent fast
traders jumping ahead of large orders).

It's also instructive to note that fast traders are largely very
profitable, and they're making their money off of longer-term
investors (like me). I did a back of the envelope based on the depth
and change-frequency of the various bids and asks in the order book,
and I'd be surprised if HFT cost me less than 1%, and possibly 2%, of
my trade value - this was a micro cap (well under $70mm mkt cap), so
this shouldn't be a shocking number.

Thursday, September 9, 2010

Wise Words from Strange Places

From Michael Lewis' most recent piece on Greece:

"After about two hours I work up the nerve to ask him. To my surprise he takes me seriously. He points to a sign he has tacked up on one of his cabinets, and translates it from the Greek: the smart person accepts. the idiot insists.

He got it, he says, on one of his business trips to the Ministry of Tourism. "This is the secret of success for anywhere in the world, not just the monastery," he says, and then goes on to describe pretty much word for word the first rule of improvisational comedy, or for that matter any successful collaborative enterprise. Take whatever is thrown at you and build upon it. "Yes … and" rather than "No … but." "The idiot is bound by his pride," he says. "It always has to be his way. This is also true of the person who is deceptive or doing things wrong: he always tries to justify himself. A person who is bright in regard to his spiritual life is humble. He accepts what others tell him—criticism, ideas—and he works with them.""

Fascinating look at Greece. He clearly has his agenda and his story about what's going on in America, but it's still a great read.

Carbon Tax Shifting

Ali, a friend who spends a significant amount of time researching climate science, asked me recently about environmental tax shifting.
A condensed version of my response is reprinted here:
So tax shifting (as I understand it) is "Pigouvian tax one thing you'd like to discourage and then take the money and return it by cutting broad-based corporate or income taxes" (or, in reverse, subsidizing one thing you'd like to encourage and raise the money by raising broad-based taxes). 
Though I don't see this discussed anywhere, I think a more interesting variation is the idea that you can even return the money in a lump sum to the industries you're taxing - basically, by punishing companies based on per-unit behavior and returning the money to the industry in a lump sum, you give each company an incentive to do better than its peers without crippling the whole industry. For example, if Nike and Reebok are competing, and Nike's a lot more efficient about carbon than Reebok, basically, Reebok will have to pay Nike proportionate to the amount by which Reebok is worse. Reebok has an incentive to improve so they don't have to pay money to their biggest competitor - which hurts way more than paying society generally - Nike has an incentive to improve so they can cripple their biggest competitor, and the US still has a very viable shoe industry.
Environmentally, I see the more general idea proposed all the time with carbon taxes and gas taxes accompanied by corresponding cuts to income taxes.  The idea seems, to me at least, to make a lot more sense with gas taxes than with carbon taxes. That's partially because I see gas taxes as incentive compatible with behavior we want, whereas I think carbon taxes are a worse alternative to a combination of gas taxes and smart grid/battery charging station buildout (largely because they ignore international concerns about industry and assume widespread Coasian equivalence). If carbon taxes were industry-targeted, I'd be much happier about carbon taxes (though still accompanying, not to the exclusion of, a more general gas-tax-for-income-tax-and-smart-grid shift).
Note that all of this is relative to other carbon-mitigation options, and none of it tries to compare to the status quo, except maybe a gas tax (which is similar enough to what we've seen that we can reliably estimate effects). Whether or not a standard carbon tax or cap and trade would be better than the status quo (mostly relying on supply-side R&D and marketing) is beyond my ability to assess.
As with everything, tax shifting only works if the Pigouvian Taxes you're placing are more intelligently designed (from an incentive perspective - both in behavior you're trying to prevent, and in general economic deadweight loss) than the corporate/income taxes they're replacing.
The problem is that measuring effects of carbon taxes is really hard. We know so little about what climate change is actually going to do, and effects of a carbon tax are not linear, at all. Going from 0 to 1 on carbon taxes may produce different results than going from 9 to 10, and it's hard to calibrate the right level. At a certain point, carbon taxes are no longer useful because the economic impact of taxing that much impedes economic activity, which in turn reduces a lot of necessary investment and R&D to actually get out of the patterns of producing carbon emissions. It's the same fallacy as what you can observe in the people who want to jack up income taxes a lot - not everything is scalable the way activists would like them to be.
If it's not obvious, I generally support intra-industry tax shifting, gas taxes and smart grid/battery charging stations, and am very skeptical that the cap-and-trade or carbon tax options brought up publicly can be effective without major side effects.