Equity without Capital

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"Test your students by asking them to value Internet stocks. If they give you an answer, flunk them."

--Warren Buffet

Arnold Kling, "Arguing in My Spare Time," No. 18

July 28, 1998

A theme of these essays is that the economic problem has been shifting from one of allocating physical capital to one of allocating human talent. Yet the institutional mechanisms that are being employed to solve the talent-allocating problem are anachronistic, in that they evolved to solve the problem of allocating physical capital.

One example that has been dwelled on at length is the institution of a corporate bureaucracy. Several arguments have been made to suggest that bureaucracy serves a useful function in managing risk when the problem is to make decisions about capital allocation. However, bureaucratic filtering of risks may be less effective than entrepeneurial decision-making when the issue is the allocation of talent to working on the correct problems.

This essay concerns another institution that may be maladapted to dealing with the talent allocation problem: the stock market. The case that the stock market is an anachronism is, if anything, stronger than the case against bureaucratic filtering.

Markets for financial capital, including the stock market, serve to channel funds from individuals and corporations with savings to corporations with the need to invest in physical capital. If a company does not need funds to finance inventories, plant, or equipment, then it does not really need financial capital.

One of Nobel Prize winner James Tobin's contributions was the "q" theory of investment. Tobin suggested that the ratio of the market value of capital to its cost of replacement, a ratio he called "q", would determine the level of investment in the economy. The theory is that when the market value is higher than replacement cost (q greater than 1), firms will want to invest in more plant and equipment in order to increase their market value. When market value is below replacement cost (q is less than 1), this is a signal to firms not to invest in new plant and equipment, because an additional $1 million of physical assets will increase the market value of the firm by less than $1 million.

Tobin's model is indicative of the close connection between physical capital, the stock market, and business investment. When stock prices are high, this is a signal to firms to increase their physical assets, and when prices are low it is a signal to be conservative.

Underlying Tobin's model is an assumption that the value of a firm is given by the value of its tangible physical assets. That is, if you add up what it would cost to build the plant and equipment of, say, General Motors, then you should come close to the market value of that firm.

But this model breaks down when the valuable assets of a firm are intangible. Surely, the cost of Microsoft's office campus, manufacturing facilities, and equipment is only a fraction of the market value of the company. No one would use "replacement cost" as an approximation of its value. To put this another way, no one would suggest that the high value of "q" for Microsoft is a signal that it should be building factories and buying machinery.

Many valuable companies today need very little physical capital. In fact, from a traditional perspective, companies like Microsoft and Netscape never should have bothered to go public.

Microsoft always has enjoyed sufficient earnings to finance its investments. It never really needed to "raise capital." I tend to believe that Microsoft is better off for having millions of investors, but for non-economic reasons. Can you imagine the lynch mob that would go after the company if it still were owned entirely by Bill Gates and Paul Allen, with the exception of shares given to employees in their compensation packages? Whatever the intent behind taking Microsoft public, the main impact has been to broaden its political base.

Netscape had even less need for capital than Microsoft. Microsoft still distributes software as atoms, so it needs to manufacture disks and shrink-wrap. Netscape invented the model of distributing software over the Internet, a model which requires no manufacturing facilities whatsoever.

For Netscape, going public was a marketing strategy. Netscape wanted to sell software to Fortune 500 companies, and credibility was a stumbling block. Creating a publicly-traded company with a high market valuation helped to enhance their ability to sell into their target market.

What was Netscape going to do with the money that it raised in the stock market? They wound up buying some other companies, and in that sense they acted sort of like a mutual fund or venture capital firm. But there was no need for plant and equipment on any large scale.

The main use that Internet companies have for capital is to fund operating losses. It seems as though every Internet business articulates what I call "The McKinsey business plan," which I define as any plan that projects two years of losses followed by an upward curve of profits rising to infinity. There is no change in strategy or operations during the transition from loser to winner: the graphs of ever-growing profits reflect the theory that once the company's product or service "catches on" it will become a cash machine.

As an aside, the McKinsey business plan reflects one of the most widespread economic misconceptions that can be found today. It is that because some products show increasing returns to scale (the more you can produce, the cheaper it is to produce it; or the more you can sell, the more people want to buy it) there now is a huge advantage to being first. People are acting as if it really is the case that having a superior product is a secondary issue compared to that of early market penetration.

Instead, the evidence as far as I can tell is that superior customer value wins out. What this means is that if Amazon.com and Yahoo find it costly today to maintain their leading positions in the market, then they probably will continue to find it costly to do so. Neither one is going to reach a point where its brand name has become so established that they have nothing to fear from innovative competitors. On the contrary, they will continue to be pressured to compete on technology, design, and price. For example, banner advertising, which a year ago might have been viewed as Yahoo's gold mine, has undergone a brutal price war. Even so, Forrester research pointed out that the share of advertising dollars going to the top sites is far out of proportion to their share of traffic, which suggests that more downward pressure on ad rates at the big sites is likely to be felt.

If the model is correct that you can throw a ton of money at a company, turn it into a market leader, and then coast to huge profits, then perhaps the stock market has something to contribute to the new economy. The stock market would be a vehicle for raising capital to purchase an asset called "a big lead" and then use that asset to earn profits later on. However, until we see an Internet company actually go through the loser-to-winner transition and stay on the exponential profit-growth curve for a few years, it makes sense to remain skeptical.

Suppose that we return to the thesis that physical assets are not as important going forward, and also that we discount the validity of the McKinsey business plan in which a big investment in "market leadership" will pay ever-growing future dividends. Then what does the stock market give to an Internet-based company?

In today's environment, the prospect of sudden riches may be luring talent into publicly-traded companies, such as Yahoo or Amazon. However, that strikes me more as a Ponzi scheme than as a true mechanism for allocating talent: company founders and leading engineers get rich; early investors who sell out at the right point get rich; but unless real value is created by the company, somebody ends up holding the bag.

My guess is that at some point we are going to run out of people willing to pay ever-higher prices for these lottery tickets called Internet stocks. At that point, we will realize that other solutions to the talent-allocation problem have more relevance going forward.