Author Archives: Scalper1

Economists Adding Up At Amazon.com, Microsoft, Google

As the tech industry gets ever more data-driven, a “Ph.D. in economics” is more often becoming a job requirement in the sector. Established giants and newer tech firms alike are enlisting economists to help with many crucial tasks. Companies that employ economists include Amazon.com ( AMZN ), Airbnb, IBM ( IBM ), Facebook ( FB ), Microsoft ( MSFT ), eBay ( EBAY ), Yahoo ( YHOO ) and Uber. Hal Varian was a consultant for Google (now part of Alphabet ( GOOGL )) going back to 2002, becoming its chief economist in 2007. And the trend has grown, as tech economists say there’s more demand and appreciation for the work they do. Hal Varian, Google chief economist. Amazon is a leading employer of economists, with “dozens” aboard, says Susan Athey, a professor of the economics of technology at Stanford Graduate School of Business and a longtime consultant to Microsoft. Amazon didn’t respond to a request for comment. Athey says Microsoft is another company with “at least a dozen” economists on staff. She knows of nearly 100 economists employed by tech firms, the big majority joining after 2010. Tech company economists must combine theory with practical application. “We use economic principles and economic theory, but we also use experiments, statistical data and other aspects of the real world to build systems that work and will stand the test of time,” said Preston McAfee, chief economist at Microsoft. These systems can address fundamental business questions, such as setting prices, as well as challenges brought about or exacerbated by the rapid rate of innovation in the tech industry. As firms expand, economists are increasingly working on public policy issues, including privacy issues and intellectual property topics. Economists Must Speak Both Tech And Non-Tech Economists have to analyze large amounts of data. Much of their value to tech firms is in helping to connect the engineering side with the business side. “Economists are trained in the intuition and goals of business, but they are also comfortable with data, statistics and the technical aspects of running a business,” Athey said. “A successful economist is multilingual.” A tech firm today might hire an economist when they struggle to navigate a new marketplace. “You might confront a business problem where you realize there’s no off-the-shelf HBS (Harvard Business School) case study or McKinsey rule of thumb you can apply to manage your unique marketplace,” Athey said. “It’s really an economics research project to figure out the business practices to operate the new platform.” Economists have helped Uber develop its “surge” pricing algorithm — basically, when demand exceeds supply, Uber’s prices rise — and have led Airbnb to offer professional photography services for hosts. While the platforms are new, these problems come down to supply and demand. One of the biggest and most famous contributions of a tech economist is Varian’s work on AdWords. As his first assignment, Varian helped Google develop its auction-based approach to selling ads, still by far the company’s largest source of revenue. Preston McAfee For economists, the fast-paced environment and variety of challenges are among the big draws of working in the tech industry. “I’m in this business because I don’t like routine. I relish having new challenges,” said McAfee. McAfee had been a professor for 28 years before leaving academia to join the tech industry in 2007 as chief economist at Yahoo. At Microsoft, McAfee is working to develop a new business model to sell technology developed by research units directly to customers, among various other tasks. “It’s a new take on a classic research model, and I’m happy to be a part of it,” he said. Google Economist’s One-Year Gig Now In Year 14 Varian had intended to stay at Google for a year while on leave from the University of California, Berkeley, but the excitement of the work at Google drew him away from academia. “We’ve got a great environment here where you have the infrastructure for developing projects and products,” said Varian. “Most of the things we’ve done have been of considerable interest to the company.” Besides AdWords, his other key tasks at Google included helping with its unusual “Dutch auction” style of IPO in 2004, designed to open the process to everyone and not just to favored clients of underwriters. He also collaborates with Google X, the company’s “moonshot” R&D factory, to help develop some of the business models. Michael Bailey, economics research manager at Facebook, looks at academia and tech as a difference between breadth and depth. “In industry, you are working on a larger variety of problems and projects and often need to take more multidisciplinary approaches so you are effectively building more breadth,” Bailey told IBD via email. Bailey, who joined Facebook directly after finishing his Ph.D., said his team is growing and that he expects the tech industry to continue hiring economists at a fast pace. Varian agrees. “A lot of people have developed an appreciation for the kind of economic analysis we do,” he said. The interest is mutual. Within economics, the community of people who study the high-tech economy has grown from a very small number to hundreds across academia, business and government over the last 10 years, Varian says. “We’re developing a new field of practicing economics in the real world,” said Microsoft’s McAfee. “Some of our big successes have been in auctions and pricing, but there are many more of those to come. And I think that’s a very cool thing to be a part of.”

The Buyback Binge: Is It Good For Shareowners?

By Paul McCaffrey Share buybacks haven’t been getting the best press of late. They’ve been dismissed as ” self-cannibalization ,” “corporate cocaine,” a recipe for conflict of interest, and a form of stock price manipulation – not to mention shortsighted and counterproductive . Yet share buybacks are incredibly popular. Since 2009, S&P 500 companies have spent more than $2 trillion on repurchases. From 2005 through late 2015, IBM (NYSE: IBM ) spent $125 billion on them. In the first three quarters of 2015 alone, Apple (NASDAQ: AAPL ) bought back $30.2 billion worth. Indeed, much of the credit for the post-financial crisis bull market of the last seven years can be attributed to the ubiquity of share buybacks. At bottom, repurchases are a way of rewarding shareowners. By buying up shares, a company raises the value of those remaining with its stockholders, which in turn will tend to boost earnings per share (EPS). At the same time, buybacks are more tax efficient for shareowners, than, say, spending the capital on taxable dividends. Share buybacks, proponents maintain, are also a good use of excess cash when business circumstances make the timing for other outlays, whether acquisitions, new research, expansion, etc., less than ideal. Critics argue that whatever the upsides of buybacks, they tend to be short-lived, adding no real value over the long term. Every dollar spent on buybacks is one less that could otherwise be used on research and development, acquisitions, etc. Management surely could find a more productive use of capital. And sometimes the repurchases are financed by issuing debt. The timing can also be problematic. Repurchases may make sense if a stock is undervalued, but if a stock is priced higher than its intrinsic worth, any buyback is a net loss. Buybacks can create a degree of moral hazard for management as well, skeptics claim. Pay packages are often tied to EPS, so executives may be incentivized to implement buybacks and sacrifice the firm’s future viability for a short-term boost in EPS. Similarly, if compensation is in any way a function of share price, executives might be inclined to use share repurchases to meet their targets. Buybacks can likewise be employed to facilitate share options programs for management, effectively transferring value from shareowner to executives. To get a sense of how investment professionals view share buybacks, we polled readers of CFA Institute Financial NewsBrief . Specifically, we asked them whether share buybacks were good for shareowners. Are share buybacks a net positive or negative for shareowners? A majority (53%) of the 814 respondents said that, on the whole, share buybacks constituted a net benefit to shareowners. Another 24% declared that they were neither positive nor negative, while 21% felt they were detrimental. Of course, the poll question and the results have a number of enigmas embedded in them. The degree of variation encapsulated in the word “shareowner” necessarily complicates the matter. Each shareowner is unique, with different inclinations and incentives. Certainly, share buybacks might benefit the shareowners anxious to unload their stakes. But those with a longer time horizon might have a vastly different take on things. It also brings up the whole concept of shareholder value, and by extension, shareholder value maximization and whether that it or isn’t a dumb idea . And what about the larger implications of share buybacks? Ultimately, the poll focuses on only one kind of stakeholder. Whether repurchases are beneficial to a company’s long-term health, its employees, the markets, and the larger economy are entirely different issues, and well worth further exploration. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Base Hits Vs. Swinging For The Fences

I just got done reading Jeff Bezos’ annual letter to shareholders , which is outstanding as it always it. As I finished it, I spent a few minutes thinking about it. He references Amazon’s (NASDAQ: AMZN ) style of “portfolio management”. He doesn’t call it that, of course, but this passage got me thinking about it. Since I wrote a post earlier in the week about portfolio management, I thought using Bezos’ letter would allow me to expand on a few other random thoughts. But here is just one clip from many valuable nuggets that are in the letter: Bezos has always gone for the home run ball at Amazon, and it’s worked out tremendously for him and for shareholders. Would this type of swinging for the fences work in investing? I’ve always preferred trying to go for the easy bets in investing. Berkshire Hathaway ( BRK.A , BRK.B ) is an easy bet . The problem, though (or maybe it’s not a problem, but the reality), is that the easy bets rarely are the bets that become massive winners. Occasionally, they do – Peter Lynch talked about how Wal-Mart’s (NYSE: WMT ) business model was already very well known to investors in the mid 1980s, and it had already carved out significant advantages over the dominant incumbent, Sears (NASDAQ: SHLD ). You could have bought Wal-Mart years after it had already proven itself to be a dominant retailer, but also when it still had a bright future and long runway ahead of it. So sometimes, the obvious bets can be huge winners. But this is usually much easier in hindsight. After all, Buffett himself couldn’t quite pull the trigger on Wal-Mart in the mid 1980s – a decision he would regret for decades. At the annual meeting in 2004, he mentioned how, after nibbling at a few shares, he let it go after refusing to pay up: “We bought a little and it moved up a little and I thought maybe it will come back a bit. That thumbsucking has cost us in the current area of $10 billion.” So sometimes, obvious bets can be huge winners. But many times, the most prolific results in business come from bets that are far from sure. Jeff Bezos has always had a so-called moonshot type approach to capital allocation. The idea is simple: there will be many failures, but no single failure will put a dent in Amazon’s armor, and if one of the experiments works, it can return many, many multiples of the initial investment and become a meaningful needle-mover in terms of overall revenue. Amazon Web Services (AWS) was one such experiment that famously became a massive winner, set to do $10 billion of business this year, and getting to that level faster than Amazon itself did. The Fire phone was the opposite – it flopped. But the beauty of the failures at a firm like Amazon is that while they are maybe a little embarrassing at times, they are a mere blip on the radar. No one notices or cares about the Amazon phone. If AWS had failed in 2005, no one today would notice, remember, or care. So this type of low-probability, high-payoff approach to business has paid huge dividends for Amazon. I think many businesses exist because of the success of a moonshot idea. Mark Zuckerberg probably could not have comprehended what he was creating in his dorm room in the fall of 2004. Mohnish Pabrai has talked about how Bill Gates made a bet when he founded Microsoft (NASDAQ: MSFT ) that had basically no downside – something like $40,000 is the total amount of capital that ever went into the firm. “Moonshot” Strategy is Aided by Recurring Cash Flow One reason why I think this approach works for businesses, and not necessarily in portfolio management, is simply due to the risk/reward dynamic of these bets. I think a lot of these bets that Google GOOG , GOOGL ) and Amazon are making have very little downside relative to the overall enterprise. Most stocks that have 5-to-1 upside also have a significant amount of downside. I think lost dollars are usually much more difficult to replace in investing than they are in business, partially because businesses usually produce recurring cash flow. Portfolios have a finite amount of cash that needs to be allocated to investment ideas. Portfolios can produce profits from winning investments, and then these profits can get allocated to other investment ideas, but there is no recurring cash flow coming in (other than dividends). Employees, Ideas, and Human Capital Not only do businesses have recurring cash flow, they also have human capital, which can produce great ideas that can become massive winners. Like Zuckerberg in his dorm room – Facebook (NASDAQ: FB ) didn’t start because of huge amounts of capital, it started because of a really good idea and the successful deployment of human capital (talented, smart, motivated people working on that good idea). Eventually, the business required some actual capital, but only after the idea, combined with human capital had already catapulted the company into a valuation worth many millions of dollars. There was essentially no financial risk to starting Facebook. If it didn’t work, Zuckerberg and his friends would have done just fine – we would have most likely never have heard of them, but they’d all be doing fine. If AWS flopped, it’s likely we would have never noticed. There would be minor costs, and human capital would be redeployed elsewhere, but for the most part, Amazon would exist as it does today – dominating the online retail world. Google will still be making billions of dollars 10 years from now if it never make a dime from self-driving cars. So, I think this type of capital allocation approach works well with a corporate culture like Amazon’s. Bezos himself calls his company “inventive”. They like to experiment. They like to make a lot of bets. And they swing for the fences. But the cost of striking out on any of these bets is tiny. And you could argue that any human capital wasted on a bad idea wasn’t actually wasted. Amazon – like many people – probably learns a ton from failed bets. You could argue that these failures actually have a negative cost on balance – they do cost some capital, but this loss that shows up on the income statement (which, again, is very small) ends up creating value somewhere else down the line due to increased knowledge and productive redeployment of human capital. So, I think there are advantages to this type of “moonshot bet” approach that works well within the confines of a business like Amazon or Google, but might not work as well within the confines of an investment portfolio. This isn’t always the case – I recently watched The Big Short (great movie, but not as good as the book ), and the Cornwall Capital guys used these types of long-shot bets to great success. They used options (which inherently have this type of capped downside, unlimited upside risk/reward) and turned $30,000 into $80 million. But I think this would be considered an exception, not the rule. I think most investors have a tendency to arbitrarily tilt the odds of success (or the amount of the payoff) too much in their favor with these types of long-shot bets. They might think a situation has 6-to-1 upside potential, when it only has 2-to-1. Or they might think there is a 30% chance of success, when there is only a 5% chance. It’s a subjective exercise – this isn’t poker or blackjack, where you can pinpoint probabilities based on a finite set of outcomes. So, I think many investors would be better off not trying to go for the long-shots – which, in investing, unlike business, almost always carry real risk of capital destruction. Berkshire Hathaway manages a business using a completely opposite style of capital allocation. Instead of moonshots, it goes for the sure money, the easy bets. It’s not going to create a business from scratch that can go from $0 to $10 billion in 10 years. But nor does it make many mistakes. There is no right or wrong approach. As Bezos says, it just depends on the culture of the business and the personalities involved. I think certain businesses that possess large amounts of human capital, combined with the right culture, the right leadership, and a collective mindset for the long term can benefit from this type of moonshot approach. They can, and should, use this style of capital allocation. Ironically, I think investments in such well-managed, high-quality companies with great leadership and culture are often the sure bets that stock investors should be looking for. Either way, from a portfolio management perspective, I think it’s easier to look for the low-hanging fruit.