Summary findings from AEA/AFA 2024

Last weekend I attended the American Economic Association and American Finance Association 2024 annual meeting in San Antonio, TX. I love this event, as its jam packed with thought provoking research with a strict 20-minute presentation, 10-minute discussant structure (where the papers are respectfully criticized).  There were roughly 6,000 economists and practitioners in attendance, and I wanted to share the most thought-provoking papers I saw presented that relate to my day job.

• Michael Greenstone, AEA Distinguished Lecture, Air Pollution is the most serious issue facing humanity in terms of its ability to reduce the total number of lived years.  The lecture had a number of helpful slides that describe the magnitude of the problem, American Economic Association: AEA Distinguished Lecture (aeaweb.org) (suggest watching at 2x speed); unfortunately, the effects of air pollution are not going to be felt equally around the world, air pollution is will disproportionately and negatively impact countries like India and regions in Africa that have the youngest and poorest populations. 

• Jeff Meli and Zornitsa Todorova, Portfolio Trading in the Corporate Bond Market, portfolio trading is a relatively recent innovation in the bond market. As we've all seen post 2008, bond liquidity has declined substantially, leading lots of hedge funds to bemoan the dangers of bond ETFs. Portfolio trading (PT) makes the fact that there are thousands of low liquidity CUSIPS less worrisome; and you can request pricing on a broad portfolio of CUSIPs rather than piece meal.  T-costs for PT trading are about 6 bps vs 14 bps for RFQ.  Also, time to execute for PT used to be 45 min to 1 hour, and now fixed income systematic investment firms have gotten PT pricing down to a few minutes.   Prior to 2018, less than 1% of all corporate bonds were traded via portfolio trading, 99%+ were traded as request for quote (RFQ). By 2021 PT accounts for more than 7%.  By trading large portfolios of bonds, you don't need to deal with matching problem on individual CUSIPs, but the ETF inflow linkage drives the benefits of low t-costs and also highlights PT's limitations.  If ETF flows are all one sided (outflows) like in March 2020, internal data from Barclays shows that the t-costs benefit of PT vs RFQ went to zero.

• Lily Fang et al, Limits to Diversification, the rise of passive investing limits the benefits of diversification. Correlated investor demand and trading generate excess correlation in asset prices relative to assets not included in index; in particular flows in and out of the index products (ETF/MF) leading to structurally higher correlation across stocks were analyzed using difference in difference. The degree to which passive funds hold a stock strongly predicts its beta and correlation with other stocks, pattern holds even when stripping out the 10 largest stocks. They also were able to rule out that the increased correlation could come from increased correlation of fundamentals, no evidence of it. Rise of passive investing isn't a free lunch, it means more correlation/less diversification benefits.

• Michele Dathan and Caitlin Dannhauser, Passive Investors in the Primary Bond Market, I was surprised to learn that passive bond ETFs are increasingly active in the primary bond market even though primary bonds generally have not been included in those indices yet.  Moreover, researchers presented evidence that passive funds allocation to primary issued bonds tend to underperform the primary bonds allocated to actively managed funds meaningfully.  The researchers believe the reason for this is that both underwriters and fund families (GPs) are intentionally steering the better issues towards actively managed bond funds and the overpriced/higher risk issues towards their passive (low fee) products.  Meaningful and consistent gross of fee outperformance detected for active bond funds in same fund families with respect to their primary bond market purchases.

• Hao Jiang et all, The Rise of the Mega Firms and Passive Investing, probably the most controversial paper in terms of number of follow up questions by the systematic investment community over post-meeting coffees.  Monthly flows into passive have been dramatic in the US over the last 10+ years.  The standard view of index flows is that inflows to index funds are neutral with respect to underlying constituent pricing. They develop a theory which claims that passive reallocation is not neutral because idiosyncratic risk is priced differently for the largest firms in the index compared to the hundreds or thousands of smaller firms. They believe this has been a contributing factor to the rise of so called super-star firms, first called, FANG, then FANGM, then Mag 7, etc. Their theory makes four predictions, which they tested in the data; 1. passive flows raise the stock return vol of large firms while barely affecting that of smaller firms; 2. effect of passive flows are more pronounced for over-valued firms among the index's largest companies, this is because investors hold short positions in these firms stocks which get amplified when they cover, 3. flows have an asymmetric effect in the cross section driving the stock market up even when those flows are driven by investors switching from active to passive; 4. when individual firms are added to an index tracked by passive funds, the resulting stock price increase is larger for larger or overvalued firms.  Over coffee, Hao told us that to the extent we believe the reallocation too passive to be fully played out, underweighting the top caps would be sensible, but to the extent you think the reallocation to passive continues as it has, overweighting the top mega caps should be sensible.  Keeping in mind that the expected vol for the top mega caps should be much higher than the overall market.

• Anthony Cookson et al, The Social Signal, using data from Twitter, StockTwits and Seeking Alpha, they find that after controlling for firm disclosures and news, attention is highly correlated across platforms but sentiment is not.  Social media consumption has been growing over the years, with Americans spending 3.6 hours per day on SM. For investors social media has become a primary source to obtain information.  The researchers wanted to know how similar both attention and sentiment were across platforms (as did many of the stat arb hedge funds in the audience). Attention was defined as volume of post, and sentiment was defined using several different NLP algos. Particularly interesting that sentiment had low commonality across platforms, but attention had high commonality.  Sentiment predicts positive future returns (short term), and attention predicts negative future returns (short term).  The data tables in this paper are fascinating.

• Sophie Calder-Wang et al, Pricing Neighborhood Amenities, this paper developed a new econometric method to price amenities relevant in the real estate market, like air pollution.  The problem with traditional econometric methods is that if you regress air pollution on home prices, you will find a positive coefficient on air pollution because more desirable places (large cities) tend to be more polluted, this is known as the wrong sign problem, even if you add per capita income to the regression as a control, you still get the wrong sign.  The researchers develop a new method that compares cities using the PageRank algorithm but applied to the migration flow data, such that places where people are moving to get a higher rank, and places where people are moving to from already high ranked places get an even higher score.  The researchers use this new variable as a control, and then are able to recover negative coefficients on air pollution.  The top 20 Geographic Page ranked counties are as follows. 

Bell, Calder-Wang, Zhong (2023); FWIW, I have been on real estate tours in Maricopa, Harris, Tarrant, and Dallas Counties and I can attest that for median-income people, the quality of life is very high.  A 3 bed, 2br in a good school district can be purchased for less than $400k in all these locations, and rents are generally $1800-$2500.

• Rongjie Zhang et al, Anti-Corruption Campaign and the Resurgence of SOEs in China, a lot of ink has been spilt on the performance of SOEs vs privately owned enterprises (POEs) in China over the last three years. A team of brave researchers at Tsinghua published a compelling paper that the anti-corruption campaign is casually related to SOEs dominance over the POEs over the last few years.  The anti-corruption campaign that began in earnest in 2013, but really got going in 2015-2018 is historically unprecedented. The researchers believe that it is commonly understood that POEs give larger kickbacks than SOEs real estate developers do. In order to avoid being perceived as corrupt, the response among government officials has been to disproportionately favor selling land to SOEs and not POEs even if the project, terms, or proposal were worse in all respects relative to a similar offer from a POE. After the Anti-corruption campaign SOE's saw a 61% increase in land parcels purchased (roughly 406,000 sample size of land parcel data). Keeping in mind that the RE is China's largest sector, the implications of this paper are pretty far reaching and worrying.  After anti-corruption campaign and big well publicized high level arrests, they see the share of SOE developers in residential land significantly increase. They see no effect in the control group, industrial land.  Industrial land is far cheaper than residential.  BC opinion, given the anticorruption campaign is core to President Xi's governance policy, we should not expect POE recovery, at scale, any time soon.

• Darren Aiello et al, Who Invests in Crypto?, the authors obtain bank and credit card data on 63 million US consumers from January 2010 to June 2023, this data contains labeled transaction level data (i.e. $400 sent to Coinbase, $16 sent to Five Guys, $10 sent to McDonalds, etc.), on average they are observing about 9 million unique consumers per month. About 20% of adults in the sample own crypto and 50% own stocks. Crypto currency owners span all income levels, with the largest investments coming from wealthier individuals, similar to stocks. High past crypto returns and personal income positive shocks tend to lead to more crypto investment. Because they have transaction level data they can calculate individual level inflation measures, individuals with higher household-level inflation, do tend to investment more in crypto, suggesting that people are using crypto as an inflation hedge.  For most US households, crypto investment behavior is similar to traditional investment behavior.

The Path Matters: Corporate vs Personal Finance Strategies

Today, let's unravel a topic that's often the subject of heated discussions in boardrooms and living rooms alike: the contrasting approaches to debt in corporate and personal finance. It's a fascinating contrast, especially for those of us who are able to play both games.

Corporate Finance: Embracing Debt as a Growth Lever

In the corporate world, debt isn't inherently a necessity; it's a common strategic choice. Traditional corporate finance wisdom tells us that to maximize the Internal Rate of Return (IRR), maintaining a significant level of debt is almost a given. This approach is rooted in the belief that the right amount of debt can fuel growth and enhance shareholder value. Think of it as a high-stakes game where companies balance on the tightrope of debt, aiming for greater heights.

The Transdigm Approach to Risk Management

Corporations often embrace this perpetual debt cycle. They're constantly re-leveraging, using debt as a tool to fund new ventures, acquisitions, or expansions. This strategy banks on the idea that the returns will outstrip the costs of debt. It's a bold move, and when it pays off, it can lead to impressive growth.  One of the most conspicuous examples of this sort of approach is TransDigm. TransDigm has consistently used debt to fund acquisitions, expanding its portfolio and market presence. This strategy is a textbook case of corporate finance's perpetual debt approach: taking on debt not as a burden, but as a tool for growth. Of course they combine debt with a cost synergy playbook and wait for a price that gives them an advantage, but without running 7x Debt to EBITDA, they would not be a household name among stock wonks. This feels very much like a “ladies and gentlemen, don’t try this at home” kind of strategy. TransDigm earns 50% of its profit from DoD contracts and they claim that US defense spending almost never gets reduced during recessions. They structured their debt payments such that their DoD revenues alone are enough to cover their interest payments.

Personal Finance: A More Prudent Path

Switching over to personal finance, the narrative changes significantly. Here, debt is often approached with a healthy dose of caution. KOLs like Dave Ramsey encourage cutting up credit cards and prioritizing a debt free life. Consider how most of us handle a mortgage, for instance. The goal is usually to pay it down steadily, rarely if ever considering the option to re-leverage our homes for additional financial risk. It's a more conservative, grounded approach, focusing on long-term security rather than immediate, high-risk gains. When it comes to a personal residence, I am squarely in the Ramsey camp, once paid off, it strikes me as highly unlikely that I would ever consider a cash out ReFi and throw the proceeds into another venture.

This difference in attitude towards debt in personal finance is partly due to the nature of our income sources. Most businesses have a diverse customer base, which spreads out their risk. In contrast, an individual typically relies on a single primary income source, making their financial situation much more susceptible to idiosyncratic risks.* Unless you feel your income is as certain as a DoD contract, high levels of debt are imprudent. This inherent difference in concentration risk exposure is a crucial factor in how debt is perceived and managed in personal finance. In the personal finance context, I prefer to keep my debt-to-equity ratio substantially below 45% (equivalent to a BBB rating, lowest IG). Once we get into junk land of 200%+ or tread into a negative debt to equity ratio situation like Transdigm, then we are just asking for trouble. Inflexible capital structures like this are not robust enough to survive life’s inevitable crisis periods.

The Path Matters

The principles guiding corporate and personal finance, especially regarding debt, are not interchangeable. In the corporate sphere, debt is a calculated gamble, often supported by thorough analysis and strategic foresight. In personal finance, however, the stakes are more immediate, with direct impacts on individual lives and futures. At least for me, anything higher than 50% debt to equity strikes me as uncomfortable and anything higher than 100%, is shackling. Running the negative equity playbook might work if you had extreme confidence in the certainty of cash flow, but these days, that seems like an overly optimistic perspective baring conspicuous counter examples like obtaining a tenure-based academic contract or a lifetime judicial appointment.   

While modern corporate finance tactics can offer some benefits to corporations (especially concepts like limited liability, not cross-collateralized, non-callable, etc.), they need careful adaptation - or should be IGNORED ENTIRELY - when applied to individual financial decisions. In summary, we only get to roll the dice a few times, and the path matters.

* Dual income, or multi-income households, where participants are in different sectors may be able to diversify human capital income risks, and could rationally prefer higher debt to equity ratios.

Observations and Learnings from India: What’s changed from 2019 to 2023?

I spent a week in India after having yet to visit since 2019.  Naturally, curious to see how business culture and consumer behavior evolved, Indian contacts and friends were happy to share their perspectives. On the one hand, there have been some palpable changes over the last four years, including payments, tech wages, and remote work.  On the other hand, much has stayed the same, including frugality, caste, and chrysophilia.  

Business Culture

• The Indian government's decision to adopt and implement UPI, an instantaneous cash transfer system similar to WeChat Pay, at this point, largely obviates the need to carry cash.  I feel safer walking around India without taking a lot of cash.

• Like the US, white-collar workers work remotely about 1/3 of the time, and firms are having trouble getting software engineers to return to the office at all.  This has resulted in significant demand for more extensive flats for additional home office space requirements. 

• Before COVID, some firms felt that production could only take place from the office and were generally skeptical of remote work. Post-COVID, firms are far more open to the idea of partial or fully remote work than they were previously.  Once you get comfortable with fully remote work, the willingness to consider cost-reduction-oriented BPM increases dramatically. Global companies are even more willing to outsource aspects of their business to Indian business process management firms than ever in the past.  Interestingly, BPM firms are some of the most well-equipped to benefit from recent developments in AI and may be able to handle more business with fewer employees going forward. 

• Indian tech companies struggle with retention. Top product engineering and research talents effectively command wages like those in leading US firms.  This has made hiring and retaining the best engineers much more costly; however, firms still believe keeping these people is worth it because a top engineer can be more productive than 100 average-quality engineers.  Also, note that graduate degrees are not required for Indians to get paid at the highest wage bands. 

• Ten years ago, top graduates from IIT would have wanted to move to the US vs. stay in India at a rate of 95% to 5%.  However, now that wage rates for top engineers have normalized with US levels, I learned that the situation has flipped.  Today, about 90% of top IIT engineers want to stay in India, and only those wishing to pursue PhDs in CS or engineering would like to move to the US for further study. It seems that choosing $225k in Bangalore over $350k in Mountain View is an easy decision for most Indians. 

• We’ve heard that young Indians are more willing to take entrepreneurial risks than their parents or grandparents generations.  Becoming a lifer at Infosys or The Ministry of Railways may have been viewed as the dream job in the past, but that may be changing.  Combined with the relative wage rates, a desire to stay local, and an increased willingness for younger people to take entrepreneurial risks, the prospective environment for venture capital may be better in India than in the previous few decades.

• The female labor force participation rate has always been one of the biggest challenges for India.  However, in the last five years, the rate has been increasing modestly for the first time since 1994. If India can better enfranchise women into the economy, it could be a tremendous tailwind; however, many sociological and religious barriers remain; from the women I talked to, traditional gender roles and the expectations to conform to them remain very strong in most parts of India.

Consumer behavior

• Indian consumers remain incredibly conscious of value-for-money tradeoffs. Indians will hunt to save 100 INR and try to take advantage of all possible VC CAC. I heard stories of people taking free trips around India paid for by Uber shareholders; one customer bought 300 cheap mobiles from Jio and received 300 free rides in sign-up bonuses from Uber.  Upstart coffee chains like Third Wave Coffee have grown in popularity specifically because they offer bean quality near Starbucks, a slightly trendier atmosphere, but offer a price point of 10% to 20% cheaper. 

• While people enjoyed ordering takeout during COVID, with takeout/delivery firms enjoying triple-digit growth for a time, broadly consistent with most other countries, food delivery-related businesses have generally struggled over the last year as people returned to pre-COVID takeout trends.

• Notwithstanding demonetization and other policies related to limiting gold hoarding.  Indians remain gold-hungry, particularly around marriage ceremonies. Due to gold’s strong outperformance during COVID, many Indians feel vindicated that it can hedge inflation and remain a resilient investment during challenging times. 

• The Caste system remains alive and well. Marrying outside of one’s Caste remains extremely rare. When I asked friends how often they have seen this happen, the most common response was when an Indian marries a foreigner. Marriage continues to be primarily intermediated by matchmakers within the family, not dating apps as is expected in the US.  Four years ago, dating apps were reputed to be taking share, but it seems it was mostly for casual sex and shorter-term relationships.

• Coming from Philadelphia, the level of poverty present throughout Mumbai and Bangalore remains overwhelming.  Seeing badly malnourished children sitting in the streets picking trash breaks your heart.  

• Economic development has certainly improved people's lives in significant ways.  At this point, about 50% of Indians have access to the Internet, and almost everyone at least has a feature phone.  For 3,000 INR per year ($37.00), users can enjoy 2.5 GB/per day of data and 4G service, which is affordable for most Indians.

Observations and Learnings from Israel's Start-up Ecosystem

History

• The seeds of Israel as a Start-Up Nation were planted in the 1980s with the passing of an innovation authority law.  All resources concerning innovation were to be overseen by a single, non-political authority known as the Office of the Chief Scientist.

• The law’s text was very forward-looking and mentioned key endogenous growth theory aspects more than 10 years before Paul Romer’s seminal work.

• Israel provided equity capital to entrepreneurs seeking funding to help catalyze new business formation in the high-tech sector.

• Overall, Israel’s tech sector grew from low single digits and today accounts for 16% of GDP and employs about 5% of the population.  Israel’s R&D spending as a fraction of GDP is the highest of any country. The start-up nation policies of providing equity capital to start-ups, minimizing frictions, and encouraging entrepreneurship are all fascinating but unlikely to be replicable to other countries for at least 3 reasons:

  • In the early 1990s, after the fall of the Soviet Union, more than 1 million Jews left the USSR and made Aliyah to Israel.  Many of these Russian Jews were highly educated and so were able to move to Israel, bringing world-class technical knowledge, and were poor enough where there was nothing to lose by taking startup risk.  Many of these immigrants were key to founding the first generation of Israeli start-ups between 1990 and 2000.

  • Israel’s government was transitioning from a planned socialist economy to a market socialist economy in the mid-1980s, this was a hard transition, but the country was in such disarray that people were willing to be experimental and try anything to right the ship. There were a large number of engineers in the Israeli SOE sector that were working in inefficient aerospace and defense industries.  Due to the economic liberalization efforts, these engineers were freed to form their own companies.

  • The Office of the Chief Scientist, while wielding a huge amount of power, has been largely insulated from politics. The Chief Scientist tries hard not to pick winners and has invested in many unsuccessful and successful startups.  The expectation is that there will be many failures, and in most countries’ political theater, failure, especially numerous failures, is very hard to tolerate.

The role of the military

• The Israeli Army (IDF), which conscripts all men and women upon turning 18 for 3-7 years, places its smartest recruits into an intelligence unit known as 8200.  In this unit, soldiers are taught computer engineering and given project-based assignments requiring engineering acumen, resource management, and a sense of entrepreneurship.  The training expenditure on the soldiers’ behalf could range from $500k to $1m, a huge investment given they will only be working in the IDF for a few years.   I spoke with several veterans of Unit 8200 to learn more about their experiences.  Examples of IDF projects might include “using no more than $3 million worth of resources, figure out a way to hack into the enemy’s communication system over the next three months.”

• The IDF has a culture of practicing post-mortems whenever mistakes are made.  Soldiers must explain to their commander and comrades what happened, how the mistake occurred, and what they plan to do to learn from the experience.  Soldiers are not punished for mistakes, rather, they are process driven to learn from them. 

• Upon graduation from 8200, these engineers are heavily recruited by existing startups (40% of Israeli startups came out of 8200), found their startups with financing from VCs (many of whom also came out of 8200), or join one of the 400+ MNC research and development offices based in Haifa (proximate to Technion, Israel’s MIT).  Some 8200 veterans do attend university after their military service, but by and large, their training is considered so strong that additional formal education isn’t necessary.   

Current situation

• Prior to 2016, there were fewer than 100 R&D centers in the country, and the only way to make a lot of money was to launch your own start-up and hope your firm is one of the 10% to 20% that generates a successful exit.  However, now that R&D centers have proliferated from 100 to 400, the war for talent has gotten out of hand.  Engineers can expect to earn >$300k with just a few years of experience from an R&D center. 

• As MNC R&D centers have grown in the count, the number of start-ups has declined meaningfully from around 1200 in 2016 to about 300 in 2022.  The decline in start-up formation does trouble the government to an extent and the Office of the Chief Scientist is closely studying the issue.

• After years of cyber warfare and recruitment from units like 8200, some of the largest internet security companies have matured. Mobileye is the most prominent example, resulting in a $10+ billion takeout.  Other examples like Waze and Fiverr have been successful outside of security.

• One of the disappointing aspects of the high-tech sector in Israel is that its success has not had meaningful spillover effects on other sectors of the economy.   Israel’s non-tech sectors are still meaningfully less productive than OECD averages. Increasing traditional sectors’ productivity through tech enablement remains an elusive goal.

Venture Capital Ecosystem and Migration

• Israel has a vibrant Angel, Pre-seed, and Seed stage VC market.  There is much less domestic VC capital focused on the later-stage rounds.  This results in Israeli entrepreneurs moving to the US to pursue later-stage capital and scale their businesses in the US. 

• While moving to the US has long been viewed as positive for the ecosystem as a whole, particularly its valuations, some in Israel are concerned.

• One of the reasons that tech tends to employ relatively few people concerning its GDP contribution is that when Israeli firms are successful, corporate headquarters are moved to the US.  Following the HQ relocation, Israeli firms tend to fire their local sales, marketing, human resources, and finance, functions and move these jobs to the US.  This means that the biggest beneficiary of Israeli start-ups from a jobs perspective tends to be the US.  The government is now considering further incentives to encourage companies to stay in Israel, but it is likely to be challenging until the Israeli VC market matures enough to provide ample late-stage liquidity.

Areas of opportunity

• Unlike Jews, Israeli Arabs are not drafted into the IDF.  Instead, they have the option of attending university when they turn 18.  Interestingly, over the last 20 years, Arabs have made great academic strides.  Today, roughly 30% of Technion’s student body are Israeli Arabs.  2/3 of this 30% are women. 

• Arabs historically have been very underrepresented in the start-up ecosystem.  Arabs founded fewer than 1% of Israeli start-ups. 

• Some in Israel are trying to change this, Takwin Capital has been operating in Haifa, Nazareth, and is intentionally trying to fund Arab-led startups.  Early results seem very promising.

What has changed about China since the pandemic began?

I’ve tried to present a balanced perspective that offers opportunities for further improvement.

• Chinese people seem dramatically more critical of China’s decision to maintain pandemic controls that primarily protect aged senior citizens from early death at the expense of young working people who want to pursue their dreams. 

• International students who had intended to return to China after spending time in the US are more frequently choosing to remain international knowledge workers.  Many of these students are China’s most talented that have won scholarships to pursue their intellectual passions.  

• The gaming industry, one of the most honored past-times for the younger generations, has been prevented from releasing most newly developed titles.  China should recognize its gaming industry as a national source of strength. Strategic game development should be encouraged to cooperate via partnerships with the former after-school tutoring industry to redevelop the Chinese education system into an incredible in-game experience.  Currently, the public-education UX in China is tough to scale as teacher-student ratios are high by international standards.

• High youth unemployment is one of the highest-skew trends I see in China today.  Millions of college graduates are having trouble finding jobs this year.  The government must prioritize education and training of the younger generation to re-adjust skill sets to be more marketable or foster new company and social enterprise formation to increase economic output.

Arbitrage in the Philadelphia Housing Market

After nearly six months of searching, my wife Sophie and I recently bought a home in Philadelphia. Over this period, we learned about each other’s preferences and how to communicate those preferences peacefully. To prioritize our time, we decided to develop a checklist to evaluate each house. We developed a more nuanced understanding of what we were looking for through many conversations and property tours. In response, our checklist grew from eight criteria and ended with 14. For simplicity, we equal-weighted our checklist criteria and focused our list on immutable aspects, things that cannot be changed with money. Our final checklist is described below:

1. Location

2. Neighborhood

3. Immediate surroundings

4. School quality

5. Commuting to Radnor and Wharton

6. Southern exposure

7. Layout of home amenable to kids, remote work areas, guest room

8. Outdoor space

9. Parking

10. Distance to a Park

11. No obvious water damage

12. Owner-occupied

13. Proximity to grocery store

14. Noise level

Tactically our approach was to use Zillow at 6:00 am every morning and monitor for homes that met at least 80% of our checklist criteria. If we found a home, we’d try and see it that day. Apparently, other buyers had a similar approach. For example, we identified a home in Fitler Square early one Saturday morning in June that met about 90% of our criteria. We toured the property later that morning and made an offer by late afternoon. Two other buyers made offers, which triggered escalation clauses, and another buyer was willing to pay more than we were.

Somewhat discouraged, we continued looking. About two months later, Sophie happened to stumble across an intriguing opportunity. While reading an email from Redfin suggesting a few homes that met our browsing pattern, she found a home that looked interesting. She cross-referenced it with Zillow and to her shock, realized that the home was incorrectly listed almost a mile away from the actual location, in a different (and incorrect) school zone. After finding this data inconsistency we immediately went to tour the property, found it met more than 90% of our criteria and made an offer for the asking price later that day. The next morning, the seller accepted our offer. We had no competition, there were no other offers.

After finding this inconsistency, we further cross-checked the USPS Address data and Philadelphia Property Tax data. Again, both of these data sets had substantial inconsistencies. Even Google Maps did not have a record of the property. After speaking with our agent, we learned that many properties in historic neighborhoods like Logan Square, Old City, Rittenhouse Square, and Fitler Square exhibit this pattern. Because Philadelphia is hundreds of years old, and many plots have been subdivided many times. There is no complete unified database of all subdivisions. When subdivided plots go on sale, Zillow pulls data from MLS and occasionally parses the locations incorrectly. When this happens, you should move fast!

Red circles indicate potential arbitrage opportunities.

Now that we purchased the property, we are going to do a bit of shareholder activism to effectuate a liquidity arbitrage. We need to update Google Maps and fix the inconsistencies that lead to Zillow misidentifying the home. Assuming we fix the data errors, we can greatly improve the odds that more potential buyers will see the home relative to when we purchased it. More buyers means more liquidity and as Sam Zell always says, “liquidity equals value.”

Regaining Taste

While recovering from COVID, I lost my sense of taste and smell for 35 days. Over this period, I lost weight at a rate of ~ 1.5 kg per week.  I lost weight because I enjoy eating.  When you are sick with COVID, food tastes like water.  Drinking water past the point of feeling full is unpleasant.

Normally, eating provides two distinct benefits, nourishment and pleasure. Once you lose your sense of taste, eating past the point where your stomach is full feels downright nauseating.   I realized that less than half of what I ate when I was healthy was required to fuel my body. The rest was simply hedonism.

For the first two weeks, I thought I’d try to use my lack of taste to my advantage by eating cleanly.  Not surprisingly, after about two weeks, I caved in and went to grab a slice of pepperoni pizza.  I sat down outside in the make-shift booths erected for outdoor dining to comply with COVID restrictions, ordered a slice and water, and once the server arrived, I sniffed the pizza; nothing.  Still optimistic, I folded the slice and took a bite; nothing.  Undeterred, I ate more, hoping for a glimpse of something other than the taste of water.  Deliberately, I used my tongue to explore all around, longing to detect a trace of the pleasure that I knew was in there. Nada. Water, water, everywhere and only it to drink.

Last week, I prepared dinner for Sophie and quickly noticed a change. I could smell the mapo tofu I had boiling on the stove! Just like that, out of nowhere, my sense of smell came back.  I grabbed a spoon and sampled the sauce. Wow, I used way too much salt! 

Though I could only taste the tofu at about 10% of my usual taste clarity, I knew I turned the corner. At this point, I have about 60% of my taste back.  My normal appetite has returned, and I’m regaining some of the weight that I lost.  I’ve learned that smell, taste, and body weight are deeply related.  Weight gain is a side effect of our tastebuds and our will to indulge them.

Supply Curves and Cycles

While most goods and services have an upward sloping supply curve, there are several informative exceptions to this pattern. This post will explore the shape of the supply curve of four different assets, bicycles, residential real estate in Las Vegas, residential real estate in New York City, and bitcoin.

Bicycles are widely understood to be a normal good produced in a competitive market. The supply curve for bicycles is upward slowing and elastic. For any given shift in demand, producers can quickly increase or decrease production in the short-term.

Unlike bicycles, the supply curve of residential real estate is kinked at the origin. The supply curve for housing has a kink at the existing level of housing because housing is durable and does not diminish quickly when demand falls. (Glaeser and Gyourko, 2005) The slope of the supply curve for residential real estate to the right of the origin is related to the ease with which developers can increase the housing supply in the short to medium run. Building in New York is far more difficult due to land scarcity, zoning, and regulatory complexity among other factors relative to Las Vegas.

Bitcoin’s supply curve is among the most inelastic of all known assets. This is because the supply schedule of bitcoin is fixed. Even if additional miners enter the market, the mining difficulty will increase, slowing the subsequent rate of new production.

Supply Curves (Red), Demand Curves (Black)

If we assume an equivalent rightward shift in the demand curves for the four assets depicted in the chart above, we can conclude that the steeper the supply curve, the greater the expected increase in price.

Supply Curves (Red), Demand Curves (Black)

If we assume an equivalent leftward shift in the demand curves for the four assets depicted in the chart above, we can conclude that the steeper the supply curve, the greater the expected decrease in price.

As is clear from the above two charts, assuming an equivalently sized shift in demand to the right, bitcoin’s price volatility is expected to be the largest of the four assets. Assuming an equivalently sized shift in demand to the left, bicycles exhibit the smallest price decline. This is because bicycle manufacturers can easily cut production to limit price declines. On the other hand, bitcoin and real estate should experience comparable price declines that are far steeper than that of bicycles. Unless cities resort to large-scale demolition programs, real estate supply persists through time even if demand falls. Like real estate, bitcoins persist through time. In fact, the only way for bitcoin’s supply curve to shift to the left is for private keys to be permanently lost.

Unlike real estate and bicycles, we also know the shape of Bitcoin’s long-run supply curve. The number of bitcoins will continue to increase at a decreasing rate until such time that the number of bitcoins reaches 21 million around the year 2140. In the early years, bitcoin’s supply curve was moving to the right rapidly, but at this point, only about 900 newly mined bitcoins are produced each day (26 million USD at current prices).

Cycles are caused by both changes in fundamentals and changes in expectations about future fundamentals. In the case of bitcoin, supply fundamentals and expectations about future supply fundamentals are both known with a high degree of accuracy and precision. Therefore, all future price changes will be caused by changes in demand fundamentals and expectations.

Like real estate and public equities, bitcoin markets have both short-term traders and long-term investors. As the proportion of short-term traders grows, the higher the probability that there will be a reduction in prices, once these traders decide to “take profits” or borrow to engage in short selling.

Unchained Capital, using data from bitcoin’s blockchain charted what they call HODL Waves. As the percentage of bitcoin that has transacted recently increases relative to the share that has been dormant for long periods, we should be wary of a bubble.

The colored bands show the relative fraction of Bitcoin in existence that was last transacted within the time window indicated in the legend. The bottom, warmer colors (reds, oranges) represent Bitcoin transacting very recently while the top, cooler colors (greens, blues) represent Bitcoin that hasn’t transacted in a long time. The chart has been normalized by the BTC in existence at each date (left y-axis). The black line shows the USD/BTC price (logarithmically, right y-axis).

As is evident in the far right of the chart above, it looks like another bubble is in the early stages of forming. However, we don’t know whether recent buyers are likely to hold for many years or sell in a few months. There is some reason to suggest that the composition of buyers these days may be more long term oriented relative to the previous cycle.

Nonetheless, Google Trends data and Twitter Trends data below also suggests that hype is growing materially.

Bitcoin is about 31% as searched relative to its peak search interest in late 2017. The data suggest a clear upward trend.

Bitcoin is about 50% of its Tweet frequency as the peak of the previous cycle. The data suggest a clear upward trend.

Overall, we have strong theoretical reasons to believe that bitcoin prices will be cyclical over time. However, if we expect high price volatility and cyclicality, perhaps our expectation of the events will serve to attenuate them. I believe we are entering the early stages of a cycle which will likely lead to a meaningful increase in price. However, along with this belief, I understand that a 50% decline in price is entirely possible and well within expectations. I’ll be watching the Google trends, Twitter trends, and HODL Wave data closely.

“The secret to happiness is having low expectations.”

— Warren Buffett

BYD's Blade Battery

In consumer surveys, the two biggest concerns people have when considering an EV are safety and range. Any firm that can solve both of these problems will be poised for meaningful success.

In March BYD published the following video explaining their breakthrough battery design known as the “Blade Battery.” The primary purpose of the blade design is its superior safety relative to the two other primary EV battery designs. The Blade is so safe, that you can drill a nail straight through the battery and the surface temperature will not rise above 60C. If you were to conduct this test on NCM Lithium Batteries or Cubic Lithium Iron Phosphate Batteries, they would instantly explode or heat to 200C to 400C degrees, respectively. Causing enormous auto damage to the car and possibly killing the passengers.

In addition to a huge improvement in safety, the Blade has the added effect of compressing 50% more energy into the same amount of space relative to previous-generation batteries. Increasing the average range from 400 km to 600 km. Keep in mind that the average gas-powered car has a range of 400 km.

Recharge time, while important, is not as critical as safety and range. Nonetheless, Blade can be charged from 10% to 80% in about 30 minutes. With a range of more than 50% greater than the average gas-powered car, and safety greater than any other EV on the market, and a fast-charging time; BYD may well be able to convince consumers to switch to an EV.

The video begins with Wang Chuanfu explaining the high-level development, followed by He Long giving a technical explanation, and then they conduct a live nail test.

Banking in China: Joint-stock banks vs SOE banks

Using data from 2018 financial statements, compared with SOE banks, joint-stock banks pay more than double the wages. It stands to reason that it would be easier to both attract and retain talented finance professionals if you can pay more than double the wages of your competitors.

The Federal Reserve's Balance Sheet

Every Thursday the Federal Reserve releases its balance sheet. It is a trove of information and especially interesting to compare over time. I also wanted to compare the Fed with one of the largest US banks, JP Morgan. A leverage ratio is a measure of how much equity capital a bank has relative to its assets.

During the current recession, the Fed’s leverage ratio has increased to an all-time high of 178x. For every $1.00 of equity capital, the Fed has $178.00 in assets.

四个月的新型冠状病毒 - Reflection on COVID 19

去年十二月份我去了中国出差。我去了北京， 上海，苏州和深圳。以前对于病毒的情况中国人的感觉很放松，因为经济发展的很快，所以每个生意人都觉得贸易战很快会结束。我回到美国，感到乐观。但是两个星期以后，早上我在我的厨房喝了咖啡，看了南华早报。在南华早报，我读了一个令人不安的故事；在湖北省，武汉市很多的人感染了病毒，跟萨斯病毒很像。

八年前，我住在深圳。我记得我的同事们告诉过我萨斯病毒的故事。在萨斯病毒的期间所有的广东人都很担心，他们很长的时间不能出去，并且每个人需要带口罩。   虽然很多人带口罩，但是还是有一千个人死亡了。死亡了的人不但有老人还有小孩儿。从那时起，我知道病毒会坏社会。

在一月九号，我的 同事问我：“大宝宝，你觉得新型冠状病毒严重吗？” 我告诉他：“我觉得会有一万多的人死亡。“ 他说：“不可能！如果有一万多的人死亡了，那么我们的世界张会有经济危机。” 不幸的是，他说的很对。

在过去两个月中，世界出现了很多健康危机。无数的企业破产了，成百上千的人感染了病毒，数十亿人被隔离。每个人都至少有一个生病的朋友。每个人的内心都感到担忧。

最后一个月，我每天在家，不能出去。我不仅在家工作，而且在家做饭，还要在家锻炼。这是我第一次在家工作。与在办公室工作相比，在家工作有一些好处。比如在家我会开始做工作比较早，能做更长时间的工作。因为不用浪费时间去办公室。我也会在家里做健康的菜。希望病毒结束以后，我也能一周几天在家工作。

在投资方面，我拥有大量现金流和少量债务。我希望我的投资能够保持偿付能力。因为我的投资组合公司有超过两千亿美元的现金。我希望我的投资组合公司能够找到投资机会。

Public Housing Garden's in Xi'an, China

My Chinese teacher, Minna Zhang, lives in Xi’an China.  Xi’an is the capital city of Shaanxi Province in Central China with a population of about 12 million people.  Minna grew up in a rural area (农村) about 4-5 hours from Xi’an. She is the first person in her family to graduate from college (Shaanxi Normal University in 2016).  

Map of Xi’an with subway lines (colors)

Upon graduating, Minna was worried about where she would live next.  Typically, fresh graduates make about 4,000 RMB per month in the Xi’an area and rents in the city center can easily come to more than 2,000 RMB per month. 

In the past, fresh graduates would often choose to live in partitioned houses (合租房) these homes are typically converted 1 bedroom or 2-bedroom apartments with shared bathrooms and shared kitchens for multiple units.  The rents for these homes are lower than the traditional housing market, but the living conditions can be challenging. 

Fortunately, Minna had the opportunity to participate in a new type of public housing program in Xi’an.  Starting in 2015, Xi’an began building public housing (公租房) targeting recent college graduates.  The purpose of this program is to attract and retain university students in the Xi’an area.  Minna’s apartment is a comfortable 43 m^2; 1 bed, 1 bath, kitchen, and living room. Her rent is 300 RMB per month and has not increased.  Her public housing garden (公租房小区) contains 25 buildings, each with 33 floors and about 25 units per floor (about 20,000 units).  Within the garden itself, they have public meeting areas and even a kindergarten, though it is mostly empty as most of the residents have yet to have kids.

Her public housing garden’s culture is warm and inviting.  Everyone in the garden is 22 to 26 years old.  Residents join WeChat groups for various interests ranging from singing, sports, studying, and group activities and trips.  Having so many young people around makes dating much easier and the party scene is strong.

The biggest drawback to living in her public housing garden is its location.  The garden is about a 1-hour drive from the city center.  Today, no subway line reaches their area; however, a subway connection should be completed within the next 3-4 years.  She was initially worried that the public housing garden would under-spend on maintenance, however she was pleasantly surprised.  The government contracted out maintenance (物业) to a third-party service that’s provided her with prompt repairs.

It remains to be seen whether the Xi’an government will allow her to purchase her home.  There are rumors that the government will allow residents to purchase their homes, but no firm indication as of Dec 2019.

Overall, Minna believes the public housing garden positives vastly outweigh the negatives.  She expects and is excited to continue living in public housing for many years to come. 

Understanding Opportunity Cost

“If we are all in agreement on the decision - then I propose we postpone further discussion of this matter until our next meeting to give ourselves time to develop disagreement and perhaps gain some understanding of what the decision is all about.”

— Alfred P. Sloan

Sloan encouraged his colleagues to think about the tradeoffs of alternative decisions. Only by continually thinking through a decision by trying to identify alternatives can we be sure we understand our preferred idea.  In economics, we are taught to consider economic decisions by thinking through the notion of opportunity cost. Opportunity cost is the next best option one chooses to forgo whenever they make a decision. Consider the following example:

Sarah has $50,000 saved.  She’s entrepreneurial, interested in do-it-yourself projects, and is good at detecting trustworthy from untrustworthy people.  Sarah wants to start a business and decides to acquire a property and become a landlord. Using Roofstock.com, she finds a property with the following characteristics.

She says to herself, “this investment sounds reasonable; I think I can achieve a 4% return plus inflation, which is well over the 2% I’m earning in my high-interest savings account.” Sarah considers a few other homes on Roofstock and determines this is the best one and buys it thinking its the best choice she’s found. Has she fully considered her opportunity cost?

Relative Opportunity Cost

Why buy a single-family home when you could buy a small slice of tens of thousands of single-family homes run by experienced landlords like American Homes 4 Rent or Invitation Homes?  These real estate investment trusts operate as scale landlords with likely lower acquisition costs and lower operating costs. It might be that the expected return on the scale players is higher than what she could do herself, not to mention the added benefit of liquidity.  It could also be that these firms are poorly managed and that Sarah’s entrepreneurial passion and handiness will overcome her relative lack of experience and enable her to earn comparatively higher returns. I’d encourage Sarah to at least think through the relative opportunity costs of a similar business model operating at a different scale. 

Absolute Opportunity Cost

Thinking about opportunity cost in an absolute sense, driven by checklists, is yet another technique that could help Sarah.  Sarah might want to try and become wealthy by employing an idea called 12% or pass. For every investment idea that comes across Sarah’s screen, if she cannot using reasonably conservative assumptions to achieve her absolute opportunity cost to take a risk, she instead holds cash. Under this approach, she needs to be disciplined and not swayed by others' success.  At parties, her friends might gloat to her that they’ve earned 10% that year, 8% more than she was making because she didn’t find a deal. I’d encourage Sarah to consider an absolute opportunity cost higher than 2% because she is entrepreneurial and observant. She is reasonably likely to find future deals that have a much higher return.  Knowing yourself well enough to estimate what sort of deals you are likely to see in the future can be done by taking the average performance of your past transactions. Then use that average as an absolute return hurdle. This process results in an absolute hurdle that becomes higher as you improve as an investor.  

Only after creatively considering absolute and relative opportunity costs should we make a decision. The best way to do this is to talk to your friends who are also interested in investing. Before doing a deal, I love to workshop the idea with my friends and ask them about their perception of the most appropriate opportunity costs. The more surprising their answers, the more I learn.

On Fishing and Investing

I spent the last week fishing on Lake Winnipesaukee in New Hampshire with my family. Fortunately, the trip was productive. We caught over sixty fish, including several species of sunfish, bass, perch, carp, and even a small pike. Throughout the trip, I realized how much fishing has in common with investing. I will share some of these similarities in this post.   

Dad with a fish

Fish the structures

• Some places are much more likely to have fish than others.

• "Structures" a term my dad likes to use to describe rock formations, docks, etc. are more likely to have fish than open water fishing. When you fish a productive structure the results are just awesome, a well baited hook in the right spot will feel like you’ve struck gold!

• Be intentional about how to spend time and only keep doing what works. Some parts of the capital markets are not amenable to active management, avoid those areas.

5 minute rule

• If you are fishing in a spot for 5 minutes and don't get a bite, then try another place.

• After one meeting, I can usually determine relatively quickly if another meeting is necessary. Usually a second meeting is not necessary. Occasionally, I prefer to tell a prospective investor, “I enjoyed our conversation, but I need another year of data to make a determination, lets talk again in a year.”

 Live bait works better than artificial lures

• Live bait, while much more expensive, is a much more effective method for catching fish than using artificial lures.

• In-person meetings are much more useful than phone conversations if you want to connect with a potential partner.

• Phone conversations while cheaper than in-person meetings are meaningfully less productive.

• Business leaders should encourage frequent travel to maximize the return on time.

Ask for help

• When you travel to a new lake, ask your Airbnb host for fishing spot recommendations. Our Airbnb host informed us that his dock (fish the structures) was an excellent fishing spot in the mornings and evenings. With minimal effort, we caught north of 30 fish off the pier.

• Remember, to ask the people you meet for introductions to other smart people they respect. Offer to make recommendations for them in return.

• After your fishing trip, give feedback to those that helped you with fishing spot recommendations. Most importantly, if you found a new fishing spot that was effective, let them know too!

 Hook the fish, and then reel

• It is tempting to reel furiously after you feel a fish make contact with your hook, but don’t do it.

• Hold fast, be patient, jerk the rod, and then hook the fish. 

• Once you've hooked it, reel steadily and get that fish on the boat.

• In investing, the due diligence process is similar to that of hooking the fish. You should not reel in an investment until you're confident that the due diligence process has been done up to your standard of quality.

 Casting into a return distribution

• Fishing is inherently probabilistic. The lake is a probability distribution, some parts of the lake have many hungry fish while other parts have no fish. Our job as a fisherman is to develop techniques, and routines to maximize the probability that we catch a fish within the time constraints of the trip.

• Whenever we invest, we are buying a probability distribution, a range of possible outcomes. Like in fishing, investors can design processes to improve the probability of success.

• When we identify a favorable return distribution, it is a strong signal that learning more may be a good use of time.

Industrial Internet and Cultural Resources

In May I spent two weeks traveling, one week in China and one week in Greece.  I want to share some of my learnings from both countries. 

China

In early May, I traveled to Shanghai and Suzhou.  On this trip, I met with investors, bankers, companies in the textiles, heavy equipment and shipping industries as well as cab drivers, Didi drivers, friends, and family.  Despite the widespread concern in the (mainly Western) press about the risks stemming from the US-China Trade War and putative economic slowdown, the Chinese business-people I met did not seem phased.  Many businesses have already diversified their supply chains across Southeast Asia and away from China. Companies have expanded production outside of China primarily due to rising labor costs, and to hedge against the sorts of political risks appearing today. 

Business-people across industries continue to explain their current and ongoing innovation programs excitedly. Under China's industrial policy, businesses across industries are adopting "industrial internet," or "manufacturing 4.0." The industrial internet is a collection of techniques that allow companies to take an empirical approach to production, quality control, innovation, and cost management. 

One instructive use of industrial internet applications comes from a heavy construction equipment company, called Company A.  Company A has 350,000 bulldozers and cranes in use across more than 10,000 customers.  Each bulldozer has more than 1,000 sensors spread throughout the vehicle.  Each vehicle is connected to the internet 24/7 and broadcasts all usage data (audio, visual, click-stream, etc.) back to Company A in real time.  Company A can observe how each of their 10,000 customers is using their products.  For example, they can see which parts of their bulldozers are undergoing the most stress or tend to break down fastest.  Company A can then work with its suppliers and encourage quality improvement in the areas encountering the most problems. With information on each component quality, Company A can better evaluate its suppliers and quickly replace them if necessary. Company A can recommend purchasing other machines that it thinks would be complementary to its customers' lineup.  Industrial internet applications like those I listed here are just the tip of the iceberg and potential for cost reduction and volume expansion are both sizable.

Moreover, many of the companies I met in China are happy to explain how they are reducing headcount by replacing low and middle-skill tasks with industrial robots.  Many of the manufacturers I met have already reduced headcount by 50% or more over the last decade and increased use of industrial automation (robots).  As companies further implement industrial internet to improve manufacturing, headcount will decline industry-wide.  Also, it may be the case that many of the production comparative advantages resulting in trade secrets developed by incremental innovation techniques in countries like Germany and Japan may reverse engineered through industrial internet.  Should these techniques prove successful, China may be able to move up various value chains even faster. 

While industrial internet may seem like an obvious next step across the manufacturing sector, implementation can be challenging.  To meet this challenge, leading city governments like the Shenzhen government, have developed an industrial policy to support the application of industrial internet techniques.  Shenzhen recognized that it is difficult for small and medium-sized companies to implement industrial internet techniques due to high fixed costs.  If small players in the value chain are unable to make necessary fixed costs investment quickly, it could slow the implantation or retard the efficacy of the industrial internet – both sub-optimal economic outcomes. Shenzhen is experimenting by providing small and medium-sized enterprises with resources (including capital and consulting) to make the necessary expenditures to contribute to the industrial internet in their supply chains.  Should these policies succeed, we should expect to see similar programs in other cities emerge.

Greece

In first grade, I enjoyed learning about Ancient Greece.  My parents bought me a book about the Trojan War. I was fascinated by many elements of the story, including the concept of a Trojan Horse strategy and that the most beautiful woman in the world at the time, Helen of Troy, was from Greece.

Bradley Calder, Grade 1

Later, in 11th grade, I began studying philosophy with Kristin Smith, and she encouraged my love for the subject by giving me many of her college textbooks. Two years later, in college, I decided to pursue a second major in philosophy.  Rochester had a small but excellent philosophy department where I had the chance to study ethics and ancient philosophy with Robert Holmes and Deborah Modrak, respectively, both brilliant scholars who further encouraged my interest in visiting Greece.  While reading the trial of Socrates, I could not help but wonder how unique Athens must be for Socrates to sacrifice his life to remain an Athenian?

Death of Socrates

Greece is a country with an abundance of cultural resources.  Since the time of Socrates, people have traveled to Athens to study, pursue business ventures, and admire the Acropolis.  Today, Greece receives nearly 30 million tourists per year (and growing). Tourists collectively contribute 20% of Greece's GDP.  Few activities are more beneficial to a country than tourism. Tourists are happy to pay for a place to sleep, the chance to eat local food, and the opportunity to take photos of cultural resources and themselves.  Providing tourist experiences tend to be high margin/high volume and in my opinion, tend to have a high reward to effort ratio.  The reward to effort ratio is exceptionally high in Greece, given that their distant ancestors paid the costs to create Greek cultural resources.  These ancient investments provide them Greeks with cornered resources that are non-rivalrous, excludable, and have benefited the Greek economy for thousands of years.  

Acropolis Amphitheater

However, over the last decade, life has been challenging for many Greeks.  Fiscal imprudence, a culture of tax avoidance and graft have taken their toll and resulted in a lost decade:

• The local stock market declined more than -90%

• Median incomes declined -30%

• Residential real estate prices fell -40%

• The employment to population ratio declined from an already low 47% to 43% as of last year (15 percentage points below the US)

Greece is attempting to stage an economic recovery in part by trying to attract more foreign tourists and property investors.  While on tour across Athens, Naxos and Santorini, I saw numerous WeChat QR codes and scanned many of them.  Products available include Santorini wedding services starting at €2,000 and apartments in Athens starting at €250,000.  Buying an apartment secures you a residency permit and travel rights throughout the Schengen Zone.  The Greek 10 year treasury bond has declined from 40% yield to less than 4% today. As interest rates fall, capital market participants are apparently more confident in Greece’s improving ability to pay its debts.

I expect the road to recovery might be slow for Greece. However, if you are looking for an outstanding vacation filled with world-class hiking, biking, food and wine, all at an affordable price, Greece is an excellent option. 

Residential Real Estate in Ho Chi Minh City, Vietnam

I first traveled to Ho Chi Minh City, Vietnam in February of 2011. At the time, virtually all vehicles on the road were motorbikes, side walk space was limited, and most real estate was two to four story residential buildings with the first floor used as commercial space. Vietnam's nominal GDP was $116 billion ($1,300 per capita).  Though poor, to a foreigner with experience living in China, Vietnam's Confucian work ethic was readily apparent. Everyone seemed to be constantly busy and moving fast.

Just last week, almost eight years later, I returned to HCMC and saw an enormous degree of change, cars, skyscrapers, branded clothing stores and Starbucks abound. According to the IMF's 2018 data, Vietnam's GDP grew to $241 billion (about $2,500 per capita) more than doubling since I last visited.  Vietnam's skyline is very different from when I last visited with many tall buildings completed and many more under construction. The percent of the population classified as urbanized has increased from about 30% to 35%, meaning an additional 4.5 million people have moved from rural areas to cities.

Education and Labor

Vietnam's education system has proved to be highly effective resulting in near universal literacy.  Additionally, Vietnamese students tend to perform well on standardized tests in math and science, exceeding the OECD average.

I heard throughout my trip that one of the few benefits of Vietnam's experience with socialism was that it resulted in a high level of female enfranchisement into the workforce.  This results in a situation where Vietnam is effectively utilizing all of its top human capital, rather than only utilizing human capital that happens to be male. 

Family Formation and Home Ownership

Vietnamese, like other East Asian cultures have a strong preference for home ownership.  Currently, home ownership rates in Vietnam are above 90%.  Given that incomes have been growing rapidly and both men and women work. Upon getting married, Vietnamese couples will have both the resources and desire to move out of their parents' home and buy their first apartment.

Vietnamese Real Estate Industry

Entrepreneurs anticipating Vietnam's demographic and cultural preferences for new homes have formed real estate development companies. Both foreign and local real estate companies compete for land, development licenses, tenants and capital in Vietnam.  One helpful heuristic that I’ve found to quickly understand the nature of a local economy is to look at the industry sector weights by market capitalization. The chart below indicates that 38% of Vietnam’s market capitalization came from the real estate industry.

MSCI Vietnam IMI, January 2019

Furthermore, two of the three largest public companies by market capitalization in Vietnam are in the residential real estate industry, Vinhomes and Vingroup.  Both are controlled by the same entrepreneur, Pham Nhat Vuong, the richest person in Vietnam.  Clearly residential housing demand is a big business opportunity for sophisticated real estate developers and institutional investors; but I wondered if it was possible for foreigners to buy property in Vietnam?

Buying a home in Vietnam on WeChat

I used WeChat to locate a real estate broker named Sarah Gui (WeChat: sarah7_722) who caters to Chinese people that are interested in buying property in Vietnam.  During my conversation with Sarah we discussed regulation, taxation, where to buy in HCMC and what opportunities are currently available on the primary market.

Firstly, it is possible for foreigners to buy property. In 2015, the Vietnamese government clarified the law and set up a system to allow foreigners to legally purchase property.  There are some important distinctions between the property rights of local Vietnamese and the property rights of foreigners.

Incidentally, I was told that the primary reason for preventing foreigners from levering their purchases is to reduce the risk of a housing bubble and to maintain home price affordability for local buyers who are much less capitalized.

HCMC Location Guide

HCMC is separated into many districts as indicated on the map below. I also included a satellite view of HCMC taken by astronaut Scott Kelly.

District 1, D1 is best thought of as the intersection of main-street and main-street. As HCMC’s central business district and the most densely populated area, life here reminds me of Puxi, Shanghai. Recently, a Hong Kong based company called Alpha King bought up 30% of the land in D1, resulting in a doubling of property values in the last three years.

D2 and D7 are both popular with foreigners because of their strong international schools as well as a less dense environment.  A significant component of D2 known as the Thu Thiem peninsula remains undeveloped. Nonetheless, Chinese buyers and developers are excited for the day when Thu Thiem get’s the green light from the government and they can try to create another Pudong. The chart below describes the long term plan for Thu Thiem.  

Proposed developments in D2 Thu Thiem.

D7 has much unoccupied land and is being developed by a Taiwanese company.  One project on the market in D7 is called Eco-Green Saigon, it has 4,000 apartments and 6 total buildings. I attached the marketing materials for Eco-Green Saigon here.

D4 is an older district popular with many local people but with aging real estate and limited land supply for further development, however the location is considered excellent due to close proximity to D1’s CBD.

D9 is HCMC's high tech zone and is the direct recipient of much of the technology and manufacturing FDI going into Vietnam. Today, companies like Intel, Samsung, Schneider all have large manufacturing, design and engineering offices there. Vinhomes/Vingroup is building the largest residential real estate development in all of Vietnam in this area.  The massive project called “VinCity” will have 44,000 units and 71 total buildings.  I attached the VinCity marketing materials here and the master plan is below.

Red dots represent apartment buildings

During my conversation with Sarah, I asked her to sketch out the current prices and yields in each district. She described the following prices below. Property prices in Vietnam are significantly cheaper than China’s first and second tier cities, and likely explains the strong Chinese demand. Very high yields relative to what is available in their home countries likely explains demand from Japanese and Korean buyers.

3/1/2019

Deal or no Deal?

Suppose one wanted to buy a 75 SQM apartment in VinCity and act as a land lord for the next 35 years, under what conditions might this proposition result in an attractive investment? I constructed a basic financial model to help frame the problem. I estimated a probability weighted, unlevered, IRR of 7.8% and MOIC of 6.4x. Note that there are no capital gains taxes in Vietnam.

Supply and Demand Elasticity

D1’s housing supply will likely remain inelastic. Because Vietnamese own their property and land freehold, large scale redevelopment in D1 is susceptible to hold out problems. In contrast, supply elasticity should be much higher in D2, D7 and D9 given the large quantity of undeveloped land. As such, I reckon one should be relatively more cautious about owning property in these areas.

In summary, Vietnam has improved dramatically in the last eight years. People are getting richer, moving to the cities and buying homes. I am optimistic that Vietnam will be able to learn from China, Korea, Taiwan, Singapore and Japan’s development experience, resulting in continued growth.

My friend translated this article into Chinese, click here for the Chinese translation. 

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Observations from the American Economic Association Annual Meeting

Last weekend, Sophie and I attended the 2019 American Economic Association Annual Meeting in Atlanta, Georgia.  AEA brings together thousands of economists from across the world for a weekend of lectures, networking, hiring, reunions, and fun with friends old and new.  The atmosphere is enthusiastic, respectful and curious. Each day at AEA, I have a small sense of wonder because it is possible that I might unexpectedly hear an argument that changes my mind.  Remarkably, the cost of admission for this three-day world-class event is a mere $75.00. What a bargain.  I attended many talks, and I'm delighted to share some of my observations with you.

Labor Economics

Work of the Past, Work of the Future; David Autor

David Autor gave the annual Richard Ely Lecture which focused on topics including the economic returns to education by location, urban/rural divide and speculates (with data) on the future of the labor market. David began by noting that the decline in inter-state mobility, which has been widely discussed in the press has been something of an economic puzzle.  It is puzzling because standard theory suggests that people will move from low opportunity areas (low population density areas) to higher opportunity areas (high population density areas).   Before attending this talk, the leading explanation for this puzzle was that rents are too high in cities for low skill people to move there.  Why are rents high? Because cities often have significant supply restrictions on new housing starts, which leads to supply constraints and high rents.  Thus pricing out low skilled people from moving to opportunity, so the story goes.

David’s talk presents a much more nuanced view of this story and even a novel partial solution to this puzzle. Using data on wage premiums for people with different levels of education in both low and high population density areas.  He found that while people with a high school degree and below (non-college people) used to earn a wage premium in cities relative to rural areas in the 1980s and 1990s, however by the 2010s, they no longer do.  Further, he shows that people with college degrees and above tend to move to high-density areas and stay there (in contrast to the out-migration we used to see).  In effect, he concludes that the reason there is less inter-state mobility is because non-college people do not have superior economic opportunities in cities relative to rural areas.  

I found these results somewhat disheartening because it implies that people with lower levels of education do not have opportunities to move to cities and receive a wage premium for their skills and there is already limited opportunity in low-density areas for low skilled people. 

Macroeconomics and Finance

Joint Interview with Ben Bernanke, Timothy Geithner, Henry Paulson

Ten years after the financial crisis, three of the most influential fiscal and monetary policymakers of the time held a public conversation about their memories of the crisis.  Early in the talk, the interviewer posed the question, why did you choose to save Bear, but not Lehman?  They explained that while JP Morgan was willing to acquire Bear (with substantial Fed support) early on in 2008.  The US Government was not able to find a buyer for Lehman toward the end of 2008.  While Barclays did come close, they were not able to consummate the transaction.  They were resolute in that the same process was used in both cases.  Paulson also, rather candidly, noted that he intentionally misrepresented the seriousness of the crisis to the public in late 2008 early 2009 (with full support of the President), saying that the government decided "not to throw gasoline on the fire" and further erode the public's confidence in the government's ability to manage the crisis.  We should continue to be skeptical of our public servants' public statements.  Also, B-G-P wanted to emphasize that the government's ability to come together in a crisis was at first begrudging, TARP measures were unpopular in Congress when introduced and failed. However, America came together in the end with an aid package, TARP was passed, QE was approved, and we socialized our losses. 

Investing

Trading and Arbitrage in Cryptocurrency Markets, Igor Makarov, Antoinette Schoar

Using a proprietary data set from 34 exchanges in 19 countries accounting for 85% of trading volume, Igor and Antoinette identified tradable arbitrage.  These observations seemingly violate the strong form of the efficient market hypothesis.  They noticed that these spreads were wider across exchanges in different countries relative to spreads on exchanges within a particular country. This may imply that barriers to inter-country capital mobility may explain the mispricing.

Furthermore, they noted that the width of the spreads is correlated with Bitcoin bull markets; the more excitement about cryptoassets, the more demand for leverage via derivatives (wider spreads).  Interestingly, they estimate relatively low transaction costs at 50 to 75 basis points.  Igor and Antoinette also mentioned that there are significant barriers for institutional investors (managing external capital) from investing in cryptoassets, but that proprietary investment firms are active in these markets. 

Real Estate

What Drove the 2003-2006 House Price Boom and Subsequent Collapse? Disentangling Competing Explanations; John Griffin, Samuel Kruger, Gonzalo Maturana

There are two primary explanations for what caused the housing boom during the early 2000s: 1. credit supply and 2. speculation.  The authors attempt to explain housing prices with two sets of variables that are more indicative of one explanation or the other.  To illustrate a credit supply story, they use the share of sub-prime lenders as a percent of total lenders in a given area.  To explain a speculation story, they considered the fraction of mortgages that were non-owner occupied, as a percent of total mortgages in a given area as well as considering percent of homes purchased by an out of town buyer.  These are just the flavor of the explanations considered (seven total).  Their results indicated that a credit supply story better explains the variation in home prices.  One surprise that came out of this research was that there was no observed year on year momentum in house prices.  The authors' main concern about their results is that perhaps credit supply is picking up because lenders are anticipating price increases.  It may be impossible to disentangle speculation from credit suppliers' decision making process.     

Fun Fact on Urban Economics from Edward Glaeser
The best single predictor of gentrification in the US is the number of Yelp reviews of laundromats in an area. 

Best food in Atlanta: Gus's

It was so good that we went two days in a row!

AEA is in San Diego next year, hope to see you there!

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Observations from China

I recently spent two weeks in China and visited Xian, Suzhou, Shanghai, Shenzhen, and Hong Kong.  On my trip I talked with my friends, family, business contacts, cab drivers, tailors and even robot engineers. My objectives for this trip included learning more about day to day life in China, how people spend their time online and offline, better understand various industries, practice Mandarin, and compare what I learned to my previous experiences in China over the last eight years.

I especially enjoyed my time in Xian. Xian has been a culturally distinguished city for more than 3,000 years and today has a population of more than 12 million.  Incomes range from 3,500 RMB for lower skilled people to 10,000 RMB for high skilled people.  The price of new real estate is about 10,000 RMB per SQM.  Rents are about 1,500 RMB to rent a 100 SQM apartment. This implies a roughly 2% cap rate, consistent with cap rates I observed in Suzhou last year. The city center is widely built out with apartments from the 1990s-2000s. Therefore, developers are building 30+ floor residential real estate towers in lower density locations, in some cases more than an hour drive from the city center. Subways should be coming soon.

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Xian’s primary industries are the military industrial complex and tourism.  Xian has heavily invested in its cultural heritage and is a premier tourist destination in China.  Xian’s city walls span 12+ km and young people enjoy riding bikes around the wall. The Muslim culture street and the Terracotta Army are both outstanding places to visit.  Comparing the Terracotta Army Museum, a UNESCO Site, to a popular second tier city and tourist destination in India such as Jaipur’s Hill Forts is enlightening. China is decades ahead of India in tourism development, accessibility of the site, quality of the experience, and supporting ancillary shopping experiences.

I even got to enjoy a special dinner with my Chinese teacher Han Chen. She treated me to a Xian Muslim hot pot. We first ate a fish stew with Sichuan flavors. After enjoying the fish, the waiter added soup base and we ate hot pot, talking and eating slowly, 慢慢吃.

Whether you are in Xian, Suzhou, Shanghai, or Shenzhen, Meituan is everywhere.  Meituan, has changed the streets of China. Delivery men with yellow helmets and electric bikes are swiftly moving about cities. Meituan’s effect is visible inside the home as well.  Many of the people I spoke with told me they are cooking at home less often these days than ever before, they are ordering delivery more frequently due to Meituan’s sheer speed and convenience. 

Meituan on the move.

WeChat Pay and Alipay have subtly changed society.  Imagine sitting down at a restaurant, scanning the QR code on the table, a menu appears on your screen, and you select your food.  The waiter comes a few minutes later with your dishes. You scan the QR code again to pay and then you leave.  Notice that during your entire restaurant experience, you did not actually have to speak to a waiter. Next, imagine you are at a bar, and you order two cocktails. The bartender holds up a QR code scanner, you hold up your QR code on your phone, she scans it, and gives you your drinks.  She no longer must waste time making change, you no longer worry about leaving your credit card at the bar and you only need your phone to go out.  Carrying cash, or even a wallet is considered uncool.

Hong Kong taxi cabs now accept RMB, how things have changed!

Wealth in China is inextricably tied to housing. Several of my close friends in Shenzhen who were lucky to buy property in in Futian district ten to twenty years ago have become wealthy from home price appreciation.  The return profile resembles that of venture capital (50x or more in some cases).  Homes bought for 1,000 RMB per SQM twenty years ago can trade for well in excess of 50,000 RMB per SQM.  This situation puts much pressure on younger people moving into Shenzhen, wages for higher skill people could range from 10,000 RMB to 20,000 RMB per month, buying a house at current prices will be very challenging.  The rents are damn high too.  A one bedroom 60 SQM flat in a nice area of Shenzhen can cost 5,500 RMB per month in rent.

Real estate development is a challenging business.  Land is auctioned by local governments and property developers must bid in open auctions, both SOE and private developers compete to win development rights.  Materials costs and labor can be forecasted with reasonable accuracy, but a significant component of a real estate developers margin is determined by the government, namely the selling price of the home.  In order to further national home affordability objectives, the government may cap the selling price of a home only a few percent above a developers’ costs or potentially force them to sell at a loss-making price by setting a price ceiling (price cap) too low.

Few people feel that the US/China trade dispute has had a meaningful effect on their life.  Most people are not bitter about it and think of it like a business negotiation.  Some people told me that they believe US is less credible going forward because it is no longer leading the vanguard for free market capitalism.  Many said that China would have to further their efforts to produce American core technologies in China or find more reliable trading partners abroad.

In response to broad-based asset price declines, the government has enacted both accommodative monetary and fiscal measures including lowering the required reserve ratio and increasing the minimum income level for income taxation (fewer people will need to pay taxes).  Price inflation on essential items such as food and clothing has been modest to flat recently.  Those I spoke with only noted home price inflation as exceptional and substantial.

Regulations limiting the amount of time children spend on video games are viewed favorably, especially by parents with young children.

During a conversation with a robot engineer at the China Hi-Tech Conference in Shenzhen, I asked if her robots could harm humans?  She explained that her robots for the consumer market cannot harm humans, and that only military robots can harm humans.

Hairy crabs, while challenging to eat, have a unique, naturally occurring sweet and salty taste.  Traveling to Suzhou in November to eat golden haired crab is worthy of a special journey.

Golden Haired Yangtze River Crab

While local economic sentiment is clearly negative due to modestly slower economic growth, uncertainty about trade relationships, deleveraging and a general sense of pessimism, from my perspective as a foreigner, I remain optimistic. People in China continue to work hard and innovate. I wonder when we will start to see some of the innovations (such as Meituan or Ant Financial) that the Chinese take for granted begin appearing in America?

On China: Traveling Abroad or Avoiding Recession

After college, I moved to Shenzhen in part because I wanted to understand China better. If you are a curious economist, then Shenzhen is a fascinating city to live and work. Shenzhen is one of the most capitalistic places on Earth and surely rivals New York City. Everyone is always talking about business, who is making money, how they are making money and what risks they are taking are all frequent topics of conversations among both Chinese and expats.

Lianhua Mountain, Statue of Deng Xiaoping

What surprised me most during these conversations was that unlike America where famous entrepreneurs are often behind most businesses, in China many of the dominant firms in each industry are actually State Owned Enterprises (SOE) jointly owned by public investors and the government. Many of these companies are profitable because they are monopolies or oligopolies and all of the competing firms within the oligopoly are SOEs. From an investment perspective, Chinese SOEs monopolies or oligopolies are potentially excellent investments, but one needs to take an empirical approach to figure out if they are being managed to maximize profit or maximize utility.

If they are being managed to maximize profit, then I’d think hard about what valuation would provide an adequate margin of safety. If the SOE is managed to maximize utility, then you’d have to understand the government’s utility function. One could imagine a scenario where the government might want to run a monopoly electric power company to provide electricity for the highest number of people such that running it at a loss might be socially optimal for a period of time but detrimental for shareholders. Furthermore, the government’s utility function can change over time (political objectives change over time), and an investor in this company must spend time talking with industry participants to observe changes and handicap impacts.

Regardless of whether or not dominant SOEs are maximizing utility or profits because they are monopolies they surely have pricing power. Pricing power is the option to price their product significantly above marginal cost. Their customers will continue to buy this overpriced product because there are no substitutes (in the case of monopoly) or all the substitutes raise their prices in kind (in the case of oligopoly). I recently realized that this microeconomic observation has implications on the macroeconomy. In effect, because the Chinese government controls SOEs, and those SOEs have pricing power, then the Chinese government can partially control inflation without influencing the money supply.

Most governments can create inflation by increasing the money supply, but most governments cannot force firms to raise prices. The Chinese government can do both, and I believe their ability to do both is an underappreciated yet important nuance that underpins China’s approach to economic policy.

One other limiting factor on the use of inflation to engage in monetary policy is the quantity of foreign denominated debt. The press is quick to point out China has a high level of debt, which stands at multiples of its GDP. However, China has issued relatively little foreign debt relative to its GDP. In 2015 the State Council claimed that it had issued about $1.7 trillion in foreign denominated debt or about 15% of 2015 nominal GDP ($11 trillion). China USD denominated debt trades for around 30-100 bps over US Treasury debt. Given the state of Chinese trade balance (large net export position), it seems very likely that China would be able to come up with $60 to $70 billion per year to cover its interest payments on the foreign denominated debt. Therefore, the amount of foreign debt is unlikely to be a limiting factor on the Chinese government's ability to manage its economy while juggling inflation.

Ultimately, inflation will harm Chinese citizens in many respects. For example, a weaker currency makes it much more costly for them to travel abroad to countries with stronger currencies. Cash savers will be harmed in lockstep with inflation, and I suspect this concern is one of the primary drivers behind residential real estate demand. All things considered, if the government is forced to choose between making it easier for people to travel to Switzerland for leisure tourism or preventing a recession by creating inflation, I believe they will act to avoid a recession.