VenChar

Homeland Security spending dissected

I just finished reading an interesting paper by Veronique de Rugy of the American Enterprise Institute for Public Policy Research. The paper is titled 'What Does Homeland Security Spending Buy?'. The study looks at the growth of Homeland Security-related spending and where that money is going. It points out some glaring problems in the funding allocation process as well as in the projects that get funded. Pork-barrel politics rather than a sound cost-benefit analysis founded on risk management principles appears to be driving investment decisions:

While the quantity of funds is significant [Total spending directed to Homeland Security activities (est.) for FY 2005 is $47 billion], the funds are not being allocated according to a plan that was devised by security experts... In keeping with the way Washington spreads federal taxpayers' money to the states,... DHS follows in part a formula set by Congress that provides every state with a guaranteed minimum amount of state grants regardless of risk or need. Specifically, the formula written into law by Congress into the Patriot Act after September 11th guaranteed each state 0.75% of the total amount appropriated to DHS for state terrorism preparedness grants... It amounts to 40% of the total pot of money being divided up equally among the states, regardless of size, risk or need... The political formulas used now to allocate the money disconnect the funding from the risk of being atacked.

After this 40% ... is allocated to states, the 60 percent left over is apportioned among states based on population, not on risk.

This spending forumla translates to a per-capita spending of $5.05 for New York State compared to $4.69 for California and $35.30 for Wyoming.

Another interesting/scary tidbit: 95% of TSA's 2005 budget for 2005 (which is $5.3 billion) is devoted to aviation security alone (you know, checking people's shoes, removing plastic knives from carry-ons, that sort of stuff).

That would leave about $250MM for the other stuff - securing the public transportation infrastructure, installing WMD detectors at borders and ports of entry, shipping container security initiatives, etc.

End of Meritocracy in America - I think not!!!

The Economist is one of my favorite magazines.  I try to never miss an issue.   That is why it disappointed me to read their special survey on meritocracy in America.   Registration is sometimes required to access the article so for those who cannot access it, the Economist makes the following points:

1. Income inequality has reached levels not seen since the Gilded age
2. Past few presidential candidates have been "dynasty" candidates
3. Percentage of people who move from the bottom fifth of society to the top fifth has declined

And they end the piece with this conclusion:

In his classic “The Promise of American Life”, Herbert Crowley noted that “a democracy, not less than a monarchy or an aristocracy, must recognize political, economic, and social distinctions, but it must also withdraw its consent whenever these discriminations show any tendency to excessive endurance.” So far Americans have been fairly tolerant of economic distinctions. But that tolerance may not last for ever, if the current trend towards “excessive endurance” is not reversed.

I feel they have made quite a few leaps of logic to make this conclusion:

1. Income inequality is by itself not an indicator of lack of meritocracy.  If meritocracy means that people are rewarded on the basis of merit that unless we all had the same merit, we should get rewarded differently.  In fact rise of income inequality might actually signal more meritocracy because we have figured out better how to reward merit and punish non-merit!!
2. Looking at Presidential candidates to make a conclusion is the kind of anecdotal arm chair analysis that you don't expect of the Economist.  Better statistics to look at are the stats for congressmen and senators as well as the stats for city and state seats.  In the last 10 years the percentage of women in politics has gone up considerably in America.  If you look at anecdotal evidence, Louisiana elected two Asian congressman in 2004 (one Asian Indian and one Arab American).  That's anecdotal progress
3. Percentage of people moving up from the bottom to the top is not meaningful unless we also know some thing about their ability or merit.  Meritocracy does not mean musical chairs.  It means society rewards people based on their merit rather than based on their race/class/pedigree. 

From a personal standpoint, I find the Economist article very off base.  Every week I meet close to approximately 10 companies looking for money and more than half of them have been founded by entrepreneurs who are immigrants or folks from modest backgrounds.  Of the five companies I sit on the board of, 3 are founded by immigrants who came to this country with no money and no connections. I am sure my experience is not dissimilar from other venture capitalists.

My Economist correspondent you are wrong with your conclusion and if you don't believe me, just head down to Silicon Valley and check out some of her startups.

Fortune at the Bottom of the Pyramid

As a follow up to my post on Innovation Blowback, I have found another interesting set of analysis by C.K. Prahalad and company that covers a different form of business innovation.  Prahalad talks about the opportunity that multinationals have in trying to create products for the very poor for counterintuitively the poor are actually:

1. A big enough market worth trying to satisfy
2. Companies have been able to build a reasonable size business trying to satisfy the very poor e.g. Hindustan Level, Standard Bank of South Africa, etc,
3. <>

   The innovations to satisfy the very poor can be then applied to more developed markets which is similar to the point John Hagel is trying to make.

The full article on this is Download bottompyramid.pdf

 

The Economics of Customer Businesses

Read a recently article by Michael J. Mauboussin called "The Economics of Customer Businesses"  which I highly recommend.  For those not familiar with Legg Mason, they run a bunch of world class mutual funds which subscribe to a value philosophy and have terrific long term records.  Michael is the Chief Investment Strategist for Legg Mason.

In his most recent piece, he analyzes consumer businesses such as Netflix, Sirius Satellite, DirectTV, etc. and has some non-obvious insights.  Some of them were:

1. Aggregate churn rates in these high growth consumer businesses can be misleading early on.  The more relevant information is to look at churn rates for various cohorts i.e. customers who joined during a particular time frame and then track that over time.
2. Not all customers are equal.  There can exist a whole spectrum of wildly profitable to wildly value destroying customers in your customer base.  The trick early on is finding out who is profitable and keeping them while getting rid of the "unprofitable" bunch.  For example, Amazon recently launched an online DVD rental service in England very similar to Netflix except for one crucial difference - while Netflix allows unlimited rentals in a month, Amazon only allows a limited number of rentals in a month.  Any customer who rents more than 9 "new" movies a month is a money loser for Netflix and they "eat" that loss for the value of the "unlimited rental" message.  Amazon is cleverly sucking away some of the "profitable" customers away from Netflix with their modified positioning
3. There are also some diffusion equations that can predict customer adoption well.

Stock Option Expensing

This is going to be all over the news wires tomorrow and you can almost hear all the tech lobbyists starting their Pandora cries - FASB has decided that all companies must expense stock options.  Call me ignorant and naive but I don't understand what the hullabaloo is  - stock options are a form of compensation that transfer value from shareholders to employees.  We expense salaries and other benefits that provide value to employees, why should we then not expense options?

I know, I know  - you are now going to say that this is going to result in companies issuing less stock options to employees and thus take away the "engine of wealth growth."  I disagree.  This law is going to have minimal impact for startups.  Startup options are priced low enough that its not a big deal to expense them.  For public companies it is going to have an impact but the big grants post-public are given only to senior management e.g. CEO, VP's.  I actually think that this accounting change will put a brake on runaway executive compensation and force compensation committees to think longer before giving their favorite CEO a huge swath of options. 

Outsourced prayer

This is funny (via Marginal Revolution, I think):

With Roman Catholic clergy in short supply in the United States, Indian priests are picking up some of their work, saying Mass for special intentions, in a sacred if unusual version of outsourcing. American, as well as Canadian and European churches, are sending Mass intentions, or requests for services like those to remember deceased relatives and thanksgiving prayers, to clergy in India.

About 2 percent of India's more than one billion people are Christians, most of them Catholics. In Kerala, a state on the southwestern coast with one of the largest concentrations of Christians in India, churches often receive intentions from overseas. The Masses are conducted in Malayalam, the native language. The intention - often a prayer for the repose of the soul of a deceased relative, or for a sick family member, thanksgiving for a favor received, or a prayer offering for a newborn - is announced at Mass.

While most requests are made via mail or personally through traveling clergymen, a significant number arrive via e-mail, a sign that technology is expediting this practice.

Predictably, this has all sorts of people in a tizzy:

But critics of the phenomenon said they were shocked that religious services were being sent offshore, or outsourced, a word normally used for clerical and other office jobs that migrate to countries with lower wages.

In a news release, David Fleming, national secretary for finance of Amicus said the assignment of prayers "shows that no aspect of life in the West is sacred.''

VCs and extra-financial value

It is part of the received wisdom that who you get money from is often more important than the terms of the financing. Top-tier VCs arguably provide the following items of "extra-financial" value:
* certification: especially for first-time entrepreneurs, affiliation with a big-name backer can confer a degree of credibility that is useful in dealing with customers and suppliers, recruiting employees and attracting follow-on investors.
* VC network: access to high-quality managerial talent, strategic alliances and partnerships, etc. (The "value-added" component often touted by VCs)
* Mentoring

Given these sources of extra-financial value that present ways for VCs to differentiate their "value-adds", it is reasonable to suspect that VCs who enjoy a higher reputation and are more plugged-in would be able to price deals at a discount with respect to their competition. Via Infectious Greed comes a link to this study which asks (and attempts to empirically address) the following two questions: "Is there a market for affiliation with reputable partners? If so, what are the prices for such affiliation?" In other words, given the sources of extra-financial value identified above, how much of a discount does a reputable VC command (in terms of price paid per share) compared to less-reputable investors? The analysis looks at 149 Series A deals of which 51 received multiple financing offers. Interestingly,

only 43% of the start-ups among those receiving multiple offers accepted their best financial offer. Moreover, the start-ups not accepting their most generous financial offer left a considerable amount of value “on the table,” amounting to $173.9M in aggregate pre-money valuation. This was calculated as the sum of the differences between their best financial offer and the accepted offer. For the group of multiple offer firms declining their best financial offer, the foregone pre-money value as a fraction of the accepted offer ranged from a low of 3.6% to a high of 217%, with an average of 33.2% for the sample.

The punchline of the analysis seems to be that "A financing offer from a high reputation VC is approximately three times more likely to be accepted by an entrepreneur. [Moreover], highly reputable VCs acquire start-up equity at a 10 to 14% discount."

Of course, there are a number of possible objections to the results obtained, many anticipated by the author: (1) sample size and selection biases, (2) measures of VC reputation, (3) use of the pre-money valuation as the sole measure of deal pricing (excluding other dimensions of the termsheet such as liquidation preferences, ratchets, warrants, etc.), etc. However, given the lack of transparency around deal terms and the offers received by startups, this work represents an interesting start.

eBay auction data and the economy

Via Infectious Greed comes this very interesting USA Today piece. I had written earlier about eBay's stated move towards licensing its auction data and what that might mean. Well, this article takes a look at the year 2003 through the lens of eBay auction data. Some excerpts:

There are many ways to analyze 2003. You can sift through major news events. You can chart best-selling books and top-rated TV shows. You can dissect the stock market. But if you want the gestalt of America — the unified essence of this nation at this time — there might be no better place to turn than the massive databases that run eBay.

There sits a repository of culture and commerce unlike any before it. No executive decides what eBay sells. Instead, millions of individuals post items on the Web site in response to shifting nuances in the marketplace. Because it is so fluid, the site captures the collective mood and unique extremes of the 86 million people who use it.

Though government numbers show the economy is rebounding after more than two years of doldrums, the eBay economy suggests something different. In fact, it seems to show a lag effect. People and companies downshifted as 2003 wore on.

For instance, eBay tracks searched words, which in turn are indicative of what buyers are looking for. Word searches for all of 2002 reflect a society still spending freely. Among the top 10 searches for the year were BMW, Louis Vuitton, Prada and Coach. Similar terms dominated the top 10 into early 2003, until August, when there was a sudden shift. The Iraq war was dragging on. Companies were still cutting jobs and keeping raises flat. The blackout hit. California was in political chaos with its recall vote. And just then the luxury names dropped off eBay's top 10, replaced by more mundane words such as Ford, Chevy and diesel.

In September, "salvage" made it to the top 10.

"I don't see any huge economic recovery," says Neal Sherman, whose company, The Advantage Group, uses eBay to liquidate goods for companies and public entities. It recently listed the entire contents of a supermarket, minus the food, and sold a yacht for the state of Maryland for $275,100.

"Take coffee equipment and mixers — a good operator in flusher economic times would buy those new," Sherman says. "When times are tough, they save money and buy it in the aftermarket." From everything Sherman sees, the aftermarket for used business stuff is turbocharged.

Some other tidbits about 2003 from the eBay files:

* The Aug. 14 blackout in the Northeast shook confidence in the power grid. In the week after the blackout, sales of portable generators jumped 67% vs. the previous week. But it wasn't just a knee-jerk spike. Generator sales on eBay are running at an annualized rate of $12 million, up 191% over 2002. It seems we're sure another outage is coming, and we want to be ready.

* The war proved a boon to eBay's category for pieces of gold. Sales are up more than 70% over a year ago. People generally buy gold when they believe bad times will drive down the value of the dollar.

* In October, when the Cubs seemed on the way to their first World Series championship in more than 80 years, everyone wanted a piece of that, too. EBay's sales of Cubs paraphernalia shot up more than six times over the year before.

* During Arnold Schwarzenegger's campaign for California governor, everyone wanted a piece of him. EBay's sales of Schwarzenegger-related items — from a 1969 Iron Man magazine with him on the cover to Terminator 2 talking dolls — climbed 1,500%.

* eBay's industrial products market took off in 2003. As an example, doctors and dentists, squeezed by insurance companies, turned to eBay in 2003 to buy medical equipment. In general, medical professionals are wary of buying used equipment. But the category is up more than 100% over last year.

This is a treasure trove of information: about the medical equipment market, about the market for used cars, the likelihood of success of gubernatorial candidates and sports teams, estimates of the likelihood of power failures, and consumer confidence and spending. There should be a rich aftermarket for eBay auction data analytics.

Layaway programs

The NYT writes about wage stagnation and the double-edged sword that is Wal-Mart:

"Wal-Mart is a double-edged sword, and both edges are quite sharp," Mr. Bernstein of the Economic Policy Institute said. "On the price side, consumers wouldn't flood Wal-Mart if there wasn't something there they liked, the low prices. On the other hand, by sticking solidly to the low-wage path, they create tons of low-quality jobs that dampen wage and income growth, not just for those who work in Wal-Mart but for surrounding communities as well."

It is a cycle that sustains itself. Edward Wolff, a professor of economics at New York University, said the shift to discount stores "reflects the growing financial strain on families." He added: "Part of the growth in Wal-Mart and discount stores in general is being generated by the stagnation in wages." As the economy has slowed, discount stores gain sales, often at the expense of department stores and specialty retailers.

In an era of stagnating wages, programs such as Wal-Mart's layaway plan (pay 10% down and pay the remainder over 60 days before being able to take the purchase home) are enjoying increased popularity with the discount-shopping demographic. More discussion of discount retailers offering layaway programs here:

Layaway shoppers put down a deposit and make payments but don't pick up the goods until they have paid in full. That's an increasingly quaint concept in a buy-now-pay-later society.

Still, layaway is far from extinct. The old-fashioned service attracts a small but ardent following. Among the big discount chains, Wal-Mart and Kmart offer layaway, but Target does not. Nowhere is layaway more popular than at Wal-Mart. By paying a 10 percent deposit, customers can put almost anything on layaway other than clearance items and hazardous materials.

Layaway appeals to people who like to do their holiday shopping early but don't have the cash in hand to pay for it. Some people use layaway because they don't have a credit card or because the cards they have are charged close to their limits. Many others just don't like paying credit card interest.

Mispricing in information aggregation markets

I recently read a survey paper on behavioral finance (written by Nicholas Barberis and Richard Thaler at the U of Chicago and available here). One of my key takeaways from reading the paper was the idea of limited arbitrage (subject of my previous post). The basic idea is that mispricing may persist because arbitrage is costly and/or risky.

I've also been watching information exchanges and information aggregation markets (such as the Hollywood Stock Exchange, the Iowa Electronic Markets, the aborted terrorism futures market, etc.) with interest and the problem of mispricing is an especially important one in this context. This raises the following question: Is it possible to create controlled market environments (either through the intelligent design of tradable securities or through qualifying traders who are allowed to participate, etc.) such that the probability of enduring mispricings is reduced significantly? This would seem to be an important question. From reading the survey paper it would seem that reducing implementation costs, making substitute securities available, reducing the number off noise traders, etc. are obvious ways to reduce the effects of mispricing. Anyone out there know of any pertinent research?