Semiconductors: Moore's Law
Most people who have lived through the age of the internet are familiar with Moore's law (ML). Gordon Moore, one of the founders of Intel, noticed that the number of transistors per square inch on integrated circuit boards doubled every 18 months. In other words, the speed and capacity of computers would double every 18 months, which in turn led to the growth of the internet and new technologies. This law, not to be confused with the laws of physics which is a definable calculation, is an observed hypothesis or a "First Principle" which has shown to be predictive in nature. Moore's Law (ML) ended up being an oracle over the last 30 years by successfully predicting the explosion of computing power and technology. As an investor, if you applied this first principle law, perhaps you would have invested in Intel, Apple, and Nvidia with tremendous success as computation power has exploded. But Moore's law really only explains part of the premise of successful adoption of technology as an investment thesis.
Death of Moore's Law?
As computing power has continued to grow, proving Moore's law to be prophetic, the last decade has led many people to speculate that this exponential growth couldn't continue and the ML would finally lose its relevance. This prediction has turned out to be premature and the law remains prescient today. However, when it comes to investing tools, a similar and lesser known law has also shown tremendous predictive value. This law may become considerably more important in the future for judging future technology advancements as they become increasingly embedded across all industries. This law or hypothesis, which shares similarities with ML, has also been predictive of technological growth and is known as Wright's law.
Flying with Wright
In 1936 Theodore Wright wrote about a linear and measurable production of airplane wings and the costs associated with the expansion of production. Essentially Wright discovered while studying airplane manufacturing that the cost of an airplane wing is decreased by a measurable and sustainable levels as production doubles. What Wright produced was a statistical tool for analyzing production and efficiency. This production of goods tool can be applied to many products, but technology has really highlighted this principle in recent years. The importance of this principle is that having a predictable measurement of cost, as production ramps up, indicates the potential for both revenues and margin growth.
"Moore" likely the death of combustion engines?
One of the most exciting applications of Wright's law is to the electric vehicle (EV) sector.
We have seen an increase in both EV companies as well as technologies like batteries and charging stations supporting the rise of these cleaner vehicles. We could reasonably argue that Wright's Law is demonstrably excellent at explaining the momentum of EVs as the price of production continues to decline. We are at an inflection point between EVs and the traditional combustion engine, especially when we factor in all the costs of maintenance and gas. According to the International Energy Association, the cost for lithium batteries has gone from 1,110 KW/H in 2010 to 126 Kw/h in 2020 while a typical battery has 37 kw/h to 60 kw/h meaning cars can travel a longer distance before recharging. Typically these trends that are supported by Wright's or Moore's laws tend to be robust and have long-lasting cycles. With further improvement to batteries, EV infrastructure, and the support of software to provide data, this trend toward EVs seems inevitable.
Other Applications?
One of the more striking examples of Wrights Law has appeared in the healthcare industry. Both data-driven intelligence and artificial intelligence could be huge drivers of cost reduction when it comes to DNA sequencing and personalized healthcare alternatives. The principal of Wrights Law is also applicable to the energy industry. We have seen this play out through the technological advances of locating and then the fracking of natural gas as well as in the production of solar panels. Additionally, capital markets may also make huge advances in cost reduction through new technologies. Blockchain software will bring about greater efficiency through automation by smart contracts.
Why should I care?
Marc Andreessen famously said, "software is eating the world". In other words, computing power has taken a foothold across every industry and is becoming more ingrained in every aspect of a business from decision making to supply chains. This is why when evaluating a business and its technology, Wrights Law may be the essential tool to predicting mass adoption and future success. As far as the auto industry, where increasingly cars have become more reliant on computer technology, EVs will continue to be competitive in both overall performance and price.
Are we at an inflection point where the future of the combustion engine is relegated to our memories and museums? Time will certainly tell, but I wouldn't bet against Moore or Wright.
I have often mused that at a point in time, a small percentage of investors will believe that Bitcoin(BTC) is equal to or a better a "store of value" (SOV) than gold. This would be a be significant shift for institutional investors as they throw out their old playbook and adopt a new asset class. Bitcoin is a unique store of value (SOV) which has a built-in payment rail and more importantly its own deflationary monetary system. This payment rail means you can easily store your bitcoin on a computer or device known as a hard wallet and move it around the globe over the internet, as opposed to golds bulky mechanism for storage and payments. Unlike sovereign currencies, which can be printed at the whim of the central bank or government, Bitcoin uses an open-source code which by virtue of design limits the amount of Bitcoin that can be created. The bottom line is, unlike fiat currencies, you just can't print more Bitcoin. It's open-source software code, which by virtue of its software design (rules), strictly limits the amount of Bitcoin that will ever be created to 21 million. In fact the last one that will be mined(created) will not be mathematically solved until approximately the year 2140 due to the fact that each block of transactions on the Bitcoin system are forced by the software to occur every ten minutes. These rules are enforced by the software code built on blockchain which by it's cryptographic nature makes the supply and security immutable. For example if you own BTC, you can determine your relative value through the formula of X/21mm, X being the amount of bitcoins in your wallet divided by the total supply. To determine your value of US Dollars(USD) using the same formula it would look more like X/&, where X is the amount of dollars you have, while the denominator is infinity, which represents the ability to print unlimited dollars by the US Treasury. The chart below shows inflow of investors into Gold exchange traded funds over the last several years in response to the centrals banks around the world debt issuance and money printing. The chart also shows the price of BTC priced in Gold which clearly demonstrates BTC dominance in price appreciation.
Store of Value
An asset that holds its value and appreciates over time is referred to as a store of value and is perceived as a safe haven. Historically this has been fine art, real estate and most often precious metals like gold and silver. During inflationary times, which is where the cost of everyday items gets more expensive, purchasing power is reduced in a native currency. This is the typical time that gold has seen its value rise to protect the value of assets as inflation debases the currency. As the world deals with the Covid-19 pandemic, the Central banks have unleashed unprecedented stimulus also know as "printed money". Over the course of history, this has led to rampant inflation and is an environment where investors look to hide or "store" value. So it's natural conclusion that investors would start making a larger allocation to these types of assets.
Money, Money Money
On August 15,1971, the United States terminated what was known as the Bretton Woods System which pegged the US Dollar (USD) to Gold. The USD on that day became a fiat currency, meaning its value was backed by the good faith of the US Government and its taxpayers. During this time in the US, stores of values expanded to very liquid and tradeable short term sovereign IOUs like Treasuries. At that time in the 70s, the rate of return was around 3.50$ for every 100$ for a duration of 90 days, today you would receive 10 cents for every 100$. Given todays risk return scenario, investors have been pushed into riskier assets for acceptable rates of return or have had to look to precious metals as a store of value. However, when we look a the recent price movement of precious metals and BTC, we start to see compelling evidence that investors are more inclined to be voting to store their value in BTC over Gold.
Inflection Point?
Andy Grove, Intel co-founder described a strategic inflection point as an event that changes the way we think and act. There is evidence to suggest we are in the midst of a strategic inflection point in how investors choose to invest their safe haven assets.
In the chart below we can compare how SOV assets have behaved over time. The white line represents gold returns, which have moved in a similar trend to silver and copper for the most part over 2020. However we see the relationship breakdown at the end of 2020 as silver rallied and the gold price faltered. This price dislocation also happened while BTC showed considerable strength in price.
When we introduce Bitcoin returns to the graph starting in August 2020, which capture its
meteoric rise, interestingly we notice the breakdown of gold prices in a similar time period. This is happening at a time where there is 2 trillion dollars of stimulus in the US which leads to more printing of more US Dollars. We would think in this economic atmosphere investors would be moving to safe havens like gold and silver. However, we see continued strength in silver, copper and BTC while Gold flounders.
Another interesting piece of data shows the correlation of silver and gold. Historically this relationship was around 82 pct., meaning the the price of the two metals traded in the same direction 82 percent of the time. In 2019 that percentage dropped to 79% which equates to a 3.5% move down. This decoupling accelerated 12.5% in 2020 through February 2021 as the correlation was measured at 69%. While this maybe a short term divergence, it's hard to ignore BTC's price movement at the same time as gold underperforms and decouples from silver. The two charts below shows the historical correlation of precious metals, BTC, equities and currencies.
*(XAU-Gold, XAG-Silver, XPT-Platinum, XPD-Palladium, XBT-BTC)
Markets
The legendary value investor Benjamin Graham, has said that "markets are voting machines in the short term, but in the long run, the market is a weighing machine". It was an explanation of equity markets price as being votes in the short term but the true value (weighing) of an asset accrues over longer time frames. Gold has a 7 trillion dollar market as a store of value while there is another 4 trillion used in jewelry or for industrial use. Bitcoin currently has a market value of just under 1 trillion as compared to Gold's 7 trillion. So will Bitcoin become the new store of value in the digital age? Given what we have seen of trading over the last several years, millions of investors, with billions of dollars are voting for BTC over Gold as a store of value. If this voting trend continues, it's not hard to imagine BTC "weighing" a whole lot more in the future.
Updated: Dec 22, 2020
Blank check
As the pandemic raged in April and austere measures to battle the spread of Covid were enacted, the economy moved into severe negative growth resulting in travel and hospitality business coming to a standstill. Citing massive losses and layoffs, the airline industry went to congress seeking a relief package to survive the crisis. This begs the question of why did they need so much money, so quickly after a ten year bull market and stable growing economy? Surely, they had plenty of capital in their treasury after so many good years to ride out the storm. Or why not go to the capital markets and raise new equity or debt?
50 years in the making
Post WWII and as the Cold War heated up, the democracy versus communism struggle was not just one of geopolitics but also of capitalism versus socialism and good versus evil. In 1962 famous economist Milton Friedman published a book "Capitalism and Freedom" which framed this argument for capitalism and how economic freedom leads to political freedom. In 1970 Friedman elaborated on these themes in his highly influential essay in the NY Times, "the Friedman Doctrine- The Social Responsibility of a Corporation is to increase it's Profits"* Friedman postulated the virtues of capitalism while arguing a corporations only moral obligation was to the shareholder. He argued that executives of a company that adheres to the doctrine of social responsibility is wasting company resources and engaging in the doctrine of collectivism. As MBAs infiltrated the boardroom in the late 70's and 80's with this economic philosophy in tow, corporations turned to financial engineering as a tool to raise the company's stock price by creating a new marginal buyer, the corporation itself. Financial engineering is (in context of corporate balance sheets) the mathematical practice of a company using the mix of equity and debt instruments to achieve a maximum stock price and thus fulfilling their obligation to the shareholder. The premise is by reducing the number of shares in the market, the stock looks attractive when compared to its earnings and thus a rise in the stock price. This is the capital principle called "maximum shareholder value".
Up Up and Away
So why did the airlines need capital infusion and what happened to all the cash in the airline corporations? aggressive stock buybacks to produce short term stock appreciation. Since around 2010 airlines have been using their cash and debt to go out a purchase their own stock which is called a "stock buyback". According to Bloomberg news, the airlines have spent 96% of their free cash flow** this decade on stock buybacks and in 2019 this went up to 104%. The airlines also issued massive debt while burning through cash for these buybacks which increases the risk of solvency through this debt which is known as leverage. Illegal? certainly not, but it bites of ethical impropriety where shareholders profit on gains while socializing losses through taxpayer bailouts. If we look back at Friedman's influence, we might conclude that there is no coincidence that this type of financial engineering magically became legal in 1982. Stock buybacks were previously illegal because it was considered to be market manipulation and deemed risky to the financial system. What changed? the belief in unfettered capitalism and that free markets are fairer markets. We must also concede there was aggressive lobbying from wall street and their army of MBAs which knew financial engineering and buybacks would be a profitable business.
Lender of last resort WHO? -YOU
While maximizing shareholder value is an important construct of a corporation, it falls short as a mission statement for an entity. It encourages short-term thinking and financial engineering to support quarterly earnings. It also leads to a moral dilemma where a company takes on more risk knowing that taxpayer money will bail them out in a time for crisis. This concept arguably was institutionalized by the Greenspan Fed in 1987 and is known more commonly by the moniker "too big to fail". We are at this inflection point once again as the airline industry looks for a second round of cash as the travel industry remains challenged from an unrelenting pandemic.
Reforming Capitalism
Two factors may accelerate the discussion that is already under way in this country about re-thinking capitalism. Corporate bailouts certainly will bring greater scrutiny to companies that have been engaged in buying back stock without preserving a rainy day fund. The second factor is wealth inequality which is at its greatest margin since the depression of the 20's and has been magnified by hard assets appreciating for the wealthy over the last nine months while incomes plunged for many. This inequality has brought rallying cries from activists and politicians which, too often leads to condemnation of capitalism as a whole. However, there are many in the business community and as well as academics that have recognized this issue as unsustainable and believe financial engineering as a means to an end must evolve. Companies must look to better align the risks and reward for investors and the managers while creating productive value as opposed to only financial value.
Goodbye Gordon?
In August of 2019 at Business Roundtable, the very issue of what a corporation's mission should be and who that corporation represents was discussed. Nearly 200 CEOs and executives agreed in principle for a new definition of a corporation in what is known as "stakeholder capitalism". In this mission or principle, the corporation recognizes the importance of stakeholder to the corporation. This means acknowledging that the customers, the employees, the suppliers and the local community alongside the shareholder all have a staked interest. The results have been mixed over the first year since the pledge has been signed and it's fair to say the Covid has slowed the process. The pandemic and the slowdown however will cast a brighter light on the stakeholder initiative and their attempt to give capitalism a makeover. In the 1980 movie Wall Street, Gordon Gekko played by Michael Douglas, delivered the famous line "greed is good" which epitomized not only the 80s but the shareholder principle. Will "stakeholder capitalism's" rebuke of Gekko lead to a reformation for a more inclusive form of capitalism?
time will tell....
** there are several ways to calculate free cash flow but in this example:
FCF = Cash Flow from Operations - Capital Expenditures(CAPEX)
