How Business Happens: 13 November 2005

Folks,

I pulled this off or dailyreckoning.com today, somewhat surprising since someone
in France
has parallel views to mine on essentially "competing on design" and what it
means
macroeconomically. I was a little alarmed reading this since it sounded like
they beat me to
the point of my next book with their present book... whew..as I see, not quite.

Anayway, here is the article, somewhat edited by me for brevity:

“Unfortunately, History is of little help to this understanding. We have to draw
solely on logic,
and the help of our friends and clients. With this in mind, we kindly ask that
you contact us if
you see a flaw in any of the arguments that we present. Again, this is a work in
progress, the
final aim of which is to help us understand the world we live in so that we can
deploy our
capital more efficiently.”

So, what makes it different this time? GaveKal suggests a number of things.

First, there is a new business model. Just as industrialists were new in the
late 1700s, there is
now a new model developing. GaveKal calls this new model “platform companies.”

The old model was to design or find something, manufacture it, market it and
sell it. (Think
Ford, Caterpillar, 3M, oil, mining.) The new model keeps just the high value
added parts and
ditches the rest. The new model focuses on research and development, treasury,
marketing,
and the business process and out sources as much of the low margin work as
possible. Think
Dell, Wal-Mart, IKEA, Li and Fung. Most hotel chains now do not own their
properties.

The new model is to “produce nowhere but to sell everywhere....Platform
companies know
where the clients are and what they want and where the producers are. Platform
companies
then simply organize the ordering by the clients and the delivery by the
producers (and the
placing of their logo on the product just before delivery).”

Production is the least profitable of all the processes. It ties up capital,
means a lot of volatile
(and costly) inventory, it is labor intensive (and subject to all sorts of
problems when there is
a slowdown (unproductive labor costs) or a quick need for more product and
overtime costs).
The market does not give manufacturing companies the same investment multiple as
they do
the platform companies. Platform companies have more stable incomes and profits.

Who would you rather be? The Chinese and other Asian companies that make the
iPod at a 2-
3% margin or Apple who sells it at a 40% margin?

But this process means manufacturing jobs leave the developed world (the United
States,
Canada, Old Europe, Australia, New Zealand and Japan) and move to the developing
world,
primarily Asia and Eastern Europe. This is not seen be many observers as a good
thing. Take
for instance good friend Marc Faber’s recent writing:

“I am fully aware that some observers will argue that it doesn’t matter that
U.S. companies
are increasingly moving their own plants overseas, or outsourcing altogether,
because the
improved profits that result from the outsourcing accrue to the parent
company... However,
what about the long term? How beneficial is it going to be for Western
industrialized
companies if IBM were to lay off 13,000 people over the next twelve months in
the US and
hire 14,000 in India...I suppose even a non-economist could see that the
movement offshore
of sophisticated manufacturing and well-paid service jobs has to have some
negative macro-
economic consequences...”

And indeed jobs have been lost. But more have been found. Some would argue that
we are
seeing lower paying jobs, but the reality is that tax receipts, at least in the
United States, are
always and everywhere up, even as the Federal government cut taxes! No one pays
more
taxes than they absolutely have to. Higher tax receipts means people are making
more
money. Not everyone, of course.

Is the platform company model something that will pass or is it the new wave?
GaveKal
asserts that the model depends upon four things.

1. Free trade, so that products can be produced wherever costs are lowest.

2. Technological progress, especially in communications, which allows a company
to
decentralize its process.

3. Recurrent overcapacity in most industries, which allows the platform company
to never run
out of goods to sell.

4. The ability to move goods easily (needed infrastructure like airports, ports
and highways).

The above items are all part and parcel of a capitalist economy. “So in a sense,
‘platform
companies’ are the children of the capitalist system.”

And where does growth in a capitalistic society come from? It either comes from
what is
called Ricardian growth (from economist David Ricardo), or the growth that comes
from a
rational organization of talent, where each person contributes at his best level
of skill.
Countries that do not allow for free movement and advancement of its workers are
less
profitable than those that do. How much talent is wasted in countries that do
not allow
women to work, or do not educate their poor universally? Growth is clearly
better when those
with the best skills and services are allowed to thrive, free of protectionism.
This is true
whether it is on a personal level or on a country level. If China can
manufacture something
cheaper than is the case in the United States, then why should consumers be
required to pay
more? And if something costs less, then more of it will be bought. Thus
Ricardian growth.

Yes, that does result in some workers losing jobs, but in a fluid and free
economy, they find
others. While some find jobs with less income, as noted above, incomes on
average are up.
And yes, we have fewer manufacturing jobs, but we are manufacturing more “stuff”
than ever.
We have become more efficient, as technology has made our manufacturing
processes in the
developed world more productive.

Then second type of growth is what Schumpeter calls creative destruction. It is
the growth
that comes from new ideas and inventions driven by entrepreneurs. New ideas mean
new
products that create whole new levels of demand. It can also mean that some
products
become obsolete. There was a time when my fax machine hummed all day. Now, we
get 2-3
faxes a day, at most. I no longer have a home phone, as we all use cell phones.
Things
change. They go the way of the buggy whip.

For Ricardian growth you need low trade barriers. For Schumpeterian type growth,
you need
low regulations, low taxes, access to capital and the ability and right to fail.
To the degree
which countries encourage such things, they prosper or grow more slowly.

The real danger to the platform model? Governments and protectionism. As they
point out, a
Dell computer says “Made in China” but it is really more accurate to say
assembled in China.
It is made from parts and software from a score of countries. Of course, the
“trade deficit” is
counted as China’s. Yet, Senator Schumer regularly bashes China, appealing to
his union
supporters, but fails to notice things like this. Should we also get upset with
Korea and
Taiwan and Russia and Sweden and the rest of the countries who contributed? We
live in a
world where our ability to measure economic reality is becoming more and more
limited.

In a world where the U.S. government counts Microsoft physical exports as
“plastic” because
the disks are plastic and only worth a few dollars at most (Dennis Gartman
swears he was told
this by a government official who was physically counting export shipping at a
port), how can
we trust the numbers?

Regards,

John Mauldin
for The Daily Reckoning

“We live in a world where our ability to measure economic reality is becoming
more and more
limited.”

by John Mauldin

The real danger to the platform model? Governments and protectionism. As they
point out, a
Dell computer says “Made in China” but it is really more accurate to say
assembled in China.
It is made from parts and software from a score of countries. Of course, the
“trade deficit” is
counted as China’s. Yet, Senator Schumer regularly bashes China, appealing to
his union
supporters, but fails to notice things like this. Should we also get upset with
Korea and
Taiwan and Russia and Sweden and the rest of the countries who contributed? We
live in a
world where our ability to measure economic reality is becoming more and more
limited.

In a world where the U.S. government counts Microsoft physical exports as
“plastic” because
the disks are plastic and only worth a few dollars at most (Dennis Gartman
swears he was told
this by a government official who was physically counting export shipping at a
port), how can
we trust the numbers?

But let’s let the GaveKal guys make their own conclusions. I quote this passage
at length,
because it set’s up the argument and some key points:

“As mentioned [in the book], one of the first implications of the ‘platform
company’ model is
that industrial jobs (those close to the hearts of our bearish friends and left
wing politicians)
in the ‘creative world’ disappear, only to reappear in Mexico, China etc… Over
time, the job
market in the developed economies moves to a minority of very creative
individuals who work
for themselves, and a majority of fellows who work in the service industry for
the creative
minds and/or the tourists coming in from the industrial world….

“If we assume that a new part of the world is getting richer (China, India,
Russia, Brazil, etc.),
then we should probably assume that some entrepreneurs in those countries are
making it
big. This assumption is not a stretch; there is enough anecdotal evidence to
support (if you
doubt that some new entrepreneurs are making it big, go to the Louis Vuitton
store in
Shanghai on a weekend). If we further assume that, in the countries getting
richer, we will
start to witness the emergence of institutional savings (pension funds, mutual
funds, family
offices, etc.), then we should expect big ‘savings flows’ from the rapidly
growing developing
world into the Western world.

“In simple words, the emerging markets’ newly rich will feel like investing a
part of their
newly created wealth in regions of the world where property rights are well
protected and
where there is a rule of law. The excess trade balances earned by the
‘industrial world’ have,
in fact, little choice but to be reinvested in the assets of the ‘creative
world’. The pension
funds of the ‘industrial world’ will buy the companies which give their
countries work. The
successful individuals in the ‘industrial world’ will also buy real estate in
the ‘creative world’
(because it also happens to be the ‘fun world’). This implies that the assets
in the ‘creative
world’ and especially the prestige assets will always border on the overvalued.
Similarly,
given the ability to change a producer if he becomes a little bit too demanding,
asset prices
in the industrial world will remain a little bit undervalued at all times…

“Which brings us to the following point: balance of payments consists of two
parts:

1) The Capital Balance: if the above holds true, that part will always be
positive for countries
with well developed financial markets.

2) The Current Account: since the two parts add to zero (by construction) it
means that the
current account in countries with well developed financial markets (US, UK, HK
etc.) should
always be in deficit, and massively so…

“Taking this a step further, we can assume that, as a result of the constant
capital flows, the
countries with a well developed capital market will have an overvalued currency
and a very
low level of long rates. Which in turn leads to robust real estate markets and
higher asset
prices.

“We call this ‘the dollar asset standard’. Basically, diversified and safe
assets in the Western
world replace gold as the standard of value in the eyes of new savers in Asia,
Latin America,
or Eastern Europe.

“The first implication of this new ‘dollar asset standard’ is that overvalued
currencies,
combined with a low cost of money (i.e. low barriers to entry), will prevent
anybody in the
‘developed financial market world’ from making any money in industrial goods.
In turn, this
development will ultimately force companies in the developed financial market
world to move
to the ‘platform company’ business model, specializing in design and in
marketing, and
letting someone else produce the goods.

“But this is where it get interesting: once they make the switch to the
‘platform company’
model, a number of companies will likely realize that they should domicile their
research and
marketing activities in countries with low marginal tax rates, both for their
shareholders and
their employees.”

This latter point is already happening, of course. Just this week, the Wall
Street Journal ran a
front-page story on how Microsoft saves billions in U.S. taxes each year by
having an Irish
subsidiary. Ireland has seen significant economic growth because of its low tax
status,
especially compared to the continental Old Europe. More and more companies are
moving
their operations and subsidiaries to low tax countries.

That is enough for this week. Next week we look at why the United States does
not really
have a cash deficit, as assets are rising faster than our trade deficit. This,
according to
GaveKal, can make the current deficit last a long time. Why does this happen?
Also, rising
incomes throughout the world will change trade and manufacturing. 300 million
Chinese with
cell phones? How should we then invest? Tune in next week.

And for those who think this all sounds crazy, we will then spend some with Bill
and Addison,
as they tell us it is never different. That there are consequences to poor
economic policy and
central banks playing with the money supply and interest rates, and that bubbles
do not end
happily.

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