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

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

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

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. 

Octopus 1.png

 

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

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.

Vietnam Real Estate Chart.png

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.

Alpha King

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.

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

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

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. 

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. 

Yelp Laundromat

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!

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.

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.

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

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

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.

Life at Peabody

There is something magical about waking up early on a summer Sunday morning in Peabody. Observing the sunrise from the kitchen, simultaneously opening the window and the platform door creating a cross breeze.  I finish making coffee.  Before drinking a cup while sitting on the terrace, I feel peaceful.  

Porch

Josep Lluís Sert, the Dean of the Harvard Graduate School of Design, designed Peabody Terrace in 1964. Sert wanted to create a sense of community among the graduate students at Harvard while maintaining high population density with more than 500 apartments.  Sert's plan provided ample outdoor amenities including a playground, a kindergarten, green fields for yard games and a sense of security and privacy within the outdoor experience. Communal meeting rooms with weekly events and parties year-round surround the grounds.    

Sert's approach to interior design well anticipated the needs of married graduate students. Each room is comfortably sized. All windows extend from floor to ceiling. Thoughtfully designed closets in the bedrooms and living room provide ample storage space.  A mix of concrete and sheetrock walls add cool character. Most rooms have two to four electrical outlets, enabling multiple combinations of furniture and technology. Perhaps most brilliantly, Sert designed all apartments at Peabody with a spacious terrace accessible off of the living room so you can be both outside and at home.  

Let's play some bocce ball.

Let's play some bocce ball.

We've been able to customize our home in a way that suits our interests.  We've mounted whiteboards in the living room to enable spontaneous brainstorming.  Additionally, we added a light fixture on the ceiling above the whiteboard to make the place more useful at night. 

Sert made some curious architectural decisions that result in early confusion.  Elevators throughout Peabody stop on every third floor only.  On the one hand, this decision allows for additional apartments by eliminating the need for numerous hallways, on the other hand, some apartments can only support smaller pieces of furniture because they have to fit through the narrow stairwells connecting the elevator floors to the walkup floors.  

At the top of each 22 story tower is a comfortable study room with expansive views of Boston and Cambridge. These rooms tend to be well used throughout the year, but become more like 24-hour cafes during exam periods.  Comfortable reading chairs, collaboration desks, and whiteboards on wheels all scatter the area.  The feeling of scholarship is palpable. 

Over the time I've lived at Peabody, a few friends who are now Harvard graduate students told me stories about their time growing up in Peabody while their parents were graduate students. I was happy to hear them recount their memories of attending kindergarten on the first floor and playing on the playground below my apartment.  I wonder if Sert imagined the children in the pre-schools he designed would one day be attending Harvard themselves living life at Peabody?

Write a Letter Today

While I was in high school, my Grandpa David Calder wrote me letters.  The prospect of receiving a letter from him motivated me to pick up the mail on my way home from school. Grandpa Dave’s letters frequently included a kind message and a chess puzzle that he had cut out of the local newspaper, gently challenging me to work on a chess problem.  

Letter.jpg

My Grandma Clara Calder preferred to focus on persuasive writing.  Grandma Clara wrote letters to politicians from local government officials to US Presidents.  She wrote in support of the civil rights movement and workers rights too.  In high school, I vehemently opposed the war in Iraq, and she encouraged me to write to my congressman and ask him to support an immediate end to the war. Chris responded to my letter below. 

Letter from Chris Smith.jpg
Letter from Chris Smith 2.jpg

In most respects, I find letter writing far superior to email.  Because letters are more costly to create, we are likely to receive fewer letters than emails, making each letter we receive feel special.  While traveling, I enjoy sending postcards to my friends, family, and colleagues; I hope they continue to write to me too.

Sending a well-written letter vastly increases the probability of receiving a response relative to other alternatives.  While job hunting in 2013, my boss Ryan Tie told me to write to the portfolio managers of the endowment funds that I wanted to work for and explain: who I am, why I want to work for them, my comparative advantage, and offer to come in any time for an interview.  Remarkably, I wrote five letters and received two responses.  Relative to any other job search method, letter writing had the highest return on time.

Recently, I tried my luck at corresponding with one of my heroes. Each year, Warren Buffett, the Chairman, and CEO of Berkshire Hathaway encourages his shareholders to write him a letter if they have an idea for an acquisition.  Earlier this year, I had an idea that seemed like a promising acquisition candidate: a sizeable world-class company, trading for a bit less than $0.65 on the $1.00, and would likely add strategic value to Berkshire.  I told my boss Trevor Graham about the idea, and he thought it was brilliant (his words) and so we wrote a letter to Mr. Buffett together.  After several drafts, we settled on a message, signed it and sent it to Omaha via two-day FedEx on a Wednesday afternoon.  Two days later on Friday morning, much to my surprise, I received an intriguing response from Mr. Buffett.  The letter still sits on my desk and motivates me to remain observant in the capital markets. 

My grandparents taught me that writing letters could help you build friendships and influence people.  My experience on the job market taught me that well-written letters can create job opportunities.  Writing to and receiving a letter from Mr. Buffett taught me that even the wealthiest and oldest people in the world spend part of their morning reading and responding to thoughtful letters.  At the very least, I encourage you to write to someone you care about a letter today.

One Man's Trash is Another Man's Treasure

Adam Smith reminds us in The Wealth of Nations that “a jack of all trades will never be rich.” Specialization allows us to develop comparative advantage in the production of goods and services. Once we have a comparative advantage in production, we can exchange our goods and benefit from trading with other people who have developed their own comparative advantages. David Ricardo expanded on Smith's ideas and explained that there is mutual benefits from trade even if one country is more competitive in every area than its trading counterpart and that a nation should concentrate resources only in industries where it has a comparative advantage.*

Aside from comparative advantage in production, there is another reason why nations trade. Suppose neither the US nor China had an absolute or relative advantage at chicken production, would it make sense for them to trade?  Counter-intuitively, the answer is yes. 

Trade

The reason both China and the US stand to benefit from trade, even though they have no advantage (absolute or comparative) in chicken production, is because both countries have comparatively different preferences.  Suppose that Americans prefer to eat white meat chicken breasts and Chinese prefer to eat chicken feet.  From the American perspective, chicken feet are a byproduct of the chicken production process, without access to the international chicken market American farmers would need to sell chicken feet to local buyers who value chicken feet at a lower value than the Chinese.  Barriers to trade would make the American chicken farmers poorer than they otherwise would be if they were allowed to sell their chicken feet to the Chinese. Conversely, Chinese people prefer not to eat chicken breasts because they view them as less delicious than dark meat and less fun to eat because they lack bones.  Without access to international chicken markets, Chinese farmers would need to sell their chicken breasts to local buyers who would pay less than the Americans.  Therefore, if the Americans trade chicken breasts and the Chinese trade chicken feet, even if production costs were identical, gains from trade would occur.

Ricardian trade theory assumes homogeneous preferences.  However, traders often have heterogeneous preferences.  Heterogeneous preferences encourage trade because it may be possible to satisfy both traders varying preferences even if they have the same production costs. 

One way for Americans to explore trade driven by heterogeneous preferences is to go to a grocery store in Shanghai.  While walking through the store, you will likely see items that surprise you including but not limited to piles of fish heads, rows of pigs feet, and boxes of chicken hearts.  American grocers don't stock these items because there is no demand for them, but in China, they are all considered delicacies. I have limited experience outside of China and America, but I suspect that preferences across the world vary widely, resulting in trade. 

To the extent that there may be information frictions between countries, arbitrage opportunities based on heterogenous preferences may exist.  As the saying goes, one man's trash is another man's treasure.

Notes:

* David Ricardo's Wikipedia

My Favorite Superhero

A couple of years ago, on a rainy Saturday evening, Sophie suggested that we watch a movie.  Somewhat serendipitously, she chose a film called Big Hero 6. At first, I was hesitating.  While superhero movies are often exciting and well funded, they also tend to be predictable and their characters one-dimensional. The last thing I expected on that rainy Saturday night was that I was about to meet my favorite superhero.  

Baymax 2.jpg

If you haven’t already seen the film, I suggest you stop reading to avoid spoilers.

Big Hero 6 is set in the fictional city of San Fransokyo in the near future.  In particular, robot technology has advanced substantially, and university students are hard at work trying to develop prototypes.  Big Hero 6’s lead protagonist is Hiro Hamada, a teenage physics and robotics prodigy admitted to university at 14.  Hiro is a complex character who is coping with his older brother, Tadashi Hamada’s, unexpected death in a fire. Before his death, Tadashi, also a physics prodigy, was working on a most remarkable project.

I have to admit; I liked Baymax from the moment I met him.  His gentle, curious, and informed personality are very different from the way most films portray robots.  Throughout the film, Baymax maintains his curiosity and an awareness of his limitations. When Baymax doesn’t understand how to care for Hiro who was going through an emotional crisis, Baymax began his research.

In addition to pursuing intellectual knowledge, Baymax can quickly learn martial knowledge as well. Hiro uses Karate movies as a training tool, and Baymax displays immediate competence.

Near the end of the film, Baymax and Hiro are battling with a terrorist and Baymax is forced to sacrifice himself to save Hiro.  The scene is remarkably emotional and I teared up.  While Baymax’s body is destroyed, Baymax cleverly manages to remove his personality chip.  Hiro then decides to rebuild Baymax's body, reinserts his personality chip, and Baymax is reincarnated. The film implies that in addition to Baymax’s reincarnation, Tadashi (who created Baymax) has also been reincarnated. The line between creator and creation is blurred.

The more I learn about robotics and advances in artificial intelligence, the more I believe that a creature like Baymax might become reality sooner than we think.  If our future robots are gentle, curious, and informed, then they are going to help a lot of people.

What about you, who is your favorite superhero?

Real estate: to own, or not to own

I was first exposed to the real estate business through my grandpa and grandma. While I was in my early teens, my grandparents both worked as real estate agents in Long Island, New York. They were locally known as “The Dream Team.” One day after school, my grandpa took me out for a slice of pizza and I asked him to explain his work as a real estate agent.

Grandpa Jerry explained, “A real estate agent helps people buy and sell homes. In exchange for their help, the real estate agent keeps a small percent of the transaction price when a home is bought or sold. To put this “small percentage” in perspective, imagine you receive a small slice of a normal sized pizza, you can eat for a day. But if you receive a slice of pizza the size of a house, you can eat for a year.” My grandpa and I both love to eat pizza, and his explanation stuck with me.

Pizza House.jpg

For the last eight years, I’ve participated in the residential real estate market as a renter in Shenzhen, New York, and Cambridge. When you agree to be a renter, you agree to pay a fixed amount of money each month to live on your landlord's property. In exchange, the landlord needs to provide the renter with selected amenities and agrees to cover any capital expenditures required to mitigate wear and tear.

From a theoretical perspective, paying rent is very similar to entering into an interest rate swap contract.  In this contract, as the renter, I agree to pay fixed, and my landlord receives floating.  The landlord collects a fixed rent, pays variable expenses, and most importantly receives a floating rate of return equal to the capital gains or losses that come from changes in the property's market value.  More recently, I've been re-thinking my decision to pay fixed and have started to think about taking the other side of the swap.

Of course, there is an academic answer to the rent/buy decision. The challenge is that the answer entirely depends on your assumptions.  While these assumptions are uncertain, they can be estimated with varying degrees of precision. My friend Ben Willinksy recently passed me a model that the NYT created that helps you easily evaluate the theoretical approach to the rent/buy decision.  The drawback to this tool is that it has 20 input assumptions.  Like all assumption driven valuation models, slight changes to some of these assumptions can lead to a wide dispersion of outcomes.

I’ve always felt this theoretical approach to answering the rent/buy decision to be unsatisfying. A more satisfying approach would help me answer questions like:

  • How good of an investment has buying a home been historically?
  • What is the relationship of housing investment returns to other asset returns (stocks, bonds, cash, etc.)?
  • What is the relationship between housing and inflation?

I wanted to approach the rent/buy decision empirically rather than theoretically.  Remarkably, there was little long term research on housing returns until quite recently. In November of 2017, a team of five economists working in Europe and the US published a paper that comes a long way to bringing an empirical perspective to the rent/buy decision.  The paper wonderfully titled, “The Rate of Return on Everything: 1870-2015” asks the question, what is the rate of return on the four core investible assets in the economy?* The researchers analyzed the real and nominal rates of return for Treasury Bills, Treasury Bonds, Public Equities, and for the first time, residential real estate for 16 countries from 1870 to 2015.  Collecting and cleaning this data alone was a huge achievement.

From this data, we can look at the historical returns, volatility, and correlations for each of the four core asset classes.  I extracted the charts below from the paper and they help to provide a sense of the shape of the return distribution for each of the four asset classes.  I pay special attention to housing below.

Real Estate Chart 1.png
Real Estate Chart 2b.png
Real Estate Chart 3.png
Real Estate Chart 4.png

As is clear from the charts above, the average public equity market total return for this period was about 7% real and the average housing return was also about 7% real.**  Even more intriguingly, housing returns appear to be lowly correlated with public equity markets and considerably less volatile. Housing also appears lowly correlated with inflation while equities are negatively correlated with inflation.  Modern portfolio theory suggests if there are two assets with similar returns but low correlation with one another, then it is a strong argument for owning both assets.

The critical risks which could cause total capital loss to a housing investment are tail events including political risks, local economic decline, natural disasters and a sudden need for liquidity at a time when there are few interested buyers. Assuming these risks do not materialize, my instinct is that over long periods of time you are likely to receive a real return comparable to the returns described above.

The real housing returns described above include both rental income and capital gains.  However, a landlord receives rental income only if they have a renter living on the property.  If a home is owner occupied, then the owner only receives the capital gain return and the rental income is instead enjoyed as the benefit of living in the home. The chart below details the nominal returns for housing, decomposing it into capital gain and rental income.  Looking only at the capital gain return gives us a good sense of what outcome we can expect should we become a landlord and live on our property.

Real Estate Chart 5.png
Real Estate Chart 6.png

So what should you expect as a homeowner? Nominal returns of 3.5% to 8.5% with an average of 5.7% over the sample period with half the volatility of equities. If the rest of your portfolio is composed of bills, bonds, or equities, these characteristics are even more intriguing.  If you have the desire to become a landlord and manage renters, your returns can be considerably higher and the rental income comes with a volatility profile considerably lower than treasury bills which are often described as a risk-free asset.

After reading this paper, I am reasonably confident that taking the floating side of the swap is the optimal long-term decision.

End Notes:

*The paper was written by Oscar Jorda (Federal Reserve Bank of San Francisco and the University of California Davis), Katharina Knoll (Deutsche Bundesbank), Dmitry Kuvshinov (University of Bonn), Moritz Schularick (University of Bonn), Alan Taylor (University of California Davis): Link to the paper is here

**For reference, real returns are defined as nominal returns minus inflation.

Twitter: My journey from MAU to DAU

When I first started using Twitter, I did not understand how to use it.  Not knowing who to follow, I went with Twitter's basic suggestions; friends from Facebook, major news outlets, @BarackObama, and @jack. After a few months, I decided to more carefully select who I followed.  As a result, Twitter became much more pleasing to use. 

My Twitter use is something of a compulsion. Twitter sits on my iPhone's home bar, directly next to my thumb.  Often, when I have a spare moment, I find myself reading through Twitter. Ever since they installed night mode, it has been much easier on my eyes.  

Background Twitter.jpg

Twitter's given me infinite reading content.  In many ways it is better than a library, which also provides abundant content.  Twitter users can enter into conversations with other users about anything. Hashtags # help to link ideas and provides a searchable context for those who want to see who is tweeting about a particular category of thought.   

Consider the following twitter scenario:
@jack, the CEO of Twitter, tweets that his team's added a new feature to Twitter. Users can tweet back to @jack saying "Thanks so much for your great work @jack!" (provided the tweet is less than 280 characters).  The coolest part of Twitter though is that @jack can tweet back to you. 

On Twitter, you can talk to anyone.  They may even respond to you.  Twitter is in some ways a core part of the democratic process on the internet.  @realDonaldTrump realized that online society is distinct and separate from offline society.  @realDonaldTrump campaigned just as frequently online as offline.  @realDonaldTrump is now @POTUS.

As for those who continue to criticize Twitter for not controlling the spread of fake news, I'd be happy to lend you my copy of a biography of Alexander Hamilton.  When you read it, you'll realize that:

  • fake news has been a component of American politics since the founding,
  • vitriol and scorn are the norm,
  • sex scandals were common too. 

I use Twitter because I want to follow all kinds of discussions and occasionally participate when I feel like I have something meaningful to contribute.  Recently, Twitter added the bookmark feature, so that we can save our favorite tweets and re-read them at our leisure. No more screenshots!

I'm going to keep using Twitter because I want to be part of the global conversation.  Even if I have a small role to play in the #twitterverse, my journey from Monthly Active User (MAU) to Daily Active User (DAU) is complete. 

@AcmeReporter

On the Housing Market in Suzhou

A few weeks ago, I was in Suzhou, China visiting my in-laws.  In addition to enjoying hairy crab and travel by high speed trains, I also enjoyed exploring the housing market in Suzhou. 

What is Suzhou?

Before I discuss the housing market, it's worth saying a few words on Suzhou.  Suzhou is an ancient city with more than 3,000 years of history.  Suzhou has long been one of the wealthier cities in China because of its skilled silk artisans and well-constructed canals.  Today, Suzhou's diversified economy is primarily based on precision manufacturing, including electronic equipment, iron, steel, silk textiles.  More recently, Suzhou's become a key city for biotechnology research and development as well as leading edge computer engineering, Apple, Huawei and Microsoft all have research and development centers.  These research centers are supported by several prominent local universities and other foreign universities are building branches here as well. Suzhou has a population of more than 11 million and continues to see strong population inflows. In addition to its population size, it also has the benefit of being 25 minutes from Shanghai by high speed train (¥39.5/$5.99 for a one way ticket).  Suzhou people familiar with the US often compare Suzhou to Boston and those familiar with Japan often compare Suzhou to Osaka.

Suzhou Housing Map

Housing Market Overview

Suzhou's economic development began with the Gusu District (#1, Purple Ring).  Gusu is housed within the ancient city and surrounded by a moat.  Gusu consists of homes built 15-25 years ago.  These apartments are older, generally lack elevators, heating systems, insulation and garden areas.  These homes were built during a period when China was less focused on quality of life and more focused on meeting essential needs.  The Gusu District has high population density, high walkability and has more of the old China feel.  Building height restrictions make it illegal to build buildings much taller than 6 stories.  There is no more greenfield land in Gusu and thus the city has expanded eastward. 

Gusu District

Gusu District

Suzhou University is located in East Gusu at location #2.  This area feels much newer and taller (height restrictions relaxed) but building areas lack the large enclosed gardens seen elsewhere in the city. This area has homes built 5-15 years ago and has modern high rise apartment buildings, high population density and walkability. The interiors of these homes tend to be comfortable and similar to US standards, though likely without granite countertops. 

As the city expanded eastward, we move to the Gongyeyuan District (#3 and #4, Orange Ring).  The Gongyeyuan District resembles the Boston financial District and was built 5-10 years ago. Suzhou's iconic sky scrapper popularly known as "The Big Pants Building" is located here (see below).  This area also houses the first built modern apartment gardens (tall apartment buildings surrounded by enclosed gardens).  The area is slightly less walkable than Gusu because it is less dense.  The area is popular with foreigners and houses many of Suzhou's bars, clubs, posh restaurants, the financial services industry and corporate headquarters.  

Suzhou's development continues in Gongyeyuan District to the south across locations 5 through 8 (Black Ring).  These housing developments are presently under construction.  Homes here are luxury to ultra-luxury by US standards and have large enclosed gardens and are surrounded by schools and hospitals.  These apartments have amenities ranging from heated floors to in-apartment elevator access.  Homes here remind me of the pre-2008 US suburb build out.  Going into a sales office at one of these complexes feels like going to a fine restaurant. Attractive young sales agents offering tea and coffee will guide you around immaculate grounds and model homes.  The only problem that I see with these homes is their locations.  While #5 through #8 are located on subway lines, they structurally lack walkability because they've been designed to be lower density areas.   These apartment complexes are surrounded by wide multi-lane highways and it seems unlikely that you could live here without constantly relying on a car. 

Home Prices

Based on what I've told you so far, if you had to rank the homes in these locations from most expensive to least expensive, how would you're rankings look? 

My guess: 3, 2, 4, 1, 5, 8, 6, 7

I based this guess on the hypothesis that the most important determinant in home price is location.  As the old saying goes, there are three rules of real estate, location, location, location.  In most global cities, the price per square foot tends to be higher in the most dense areas that tend to have the most amenities.  In general, as you move further from the city core, prices decline.  Nearly all of my guesses though were wrong. 

The chart below describes the real estate prices in both SQM and SQF for each of the eight locations.

* The minimum size home in this location was ~200 SQM. 

* The minimum size home in this location was ~200 SQM. 

My hypothesis, that location (high density and walkability) would be the primary determinant of home prices, appears to be false. 

In particular, locations 5 and 6 being more expensive than location 2 really surprised me.  The way I see it, parts of Suzhou that are currently greenfield and even when completed will be relatively suburban areas are currently trading for more than the high density, high convenience, fully developed city core… 

I discussed this pricing difference with my in-laws and they were less surprised than me.  They explained that Chinese people have a strong proclivity toward buying new homes and their desire to raise their kids in a more park like environment may explain some of this demand.  I countered to them that the "new" homes built in 2017 are not much newer than the homes that were built in 2009-2015 in locations 2, 3 or 4.  To their point, the desire to move into new homes likely explains why the significantly lower quality 15-25 year old homes in location 1 trade for less than their location might suggest. 

Overall, I worry that there are a lot of people buying large luxurious homes in lower density, suburban like areas that are probably expecting rapid home price appreciation.  We saw this story play out in the US prior to the crisis and a lot of people lost money.  Consider these videos from location 5 and ask yourself if this isn't a sign of real estate excess?

How could we make the basement to this property even more excessive?

While it is the case that the city core is older and less shiny than it once was, its location is unlikely to depreciate. If you can find a property with a source of endogenous demand, say near a financial center or a university, even better.  Unfortunately, I expect there to be a lot of disappointed suburbanites in Suzhou over the coming years.  Even if their real estate valuations appreciate significantly, is it worth sitting in a traffic jam every day on your way to work? 

One sentence summary: in Suzhou, density may be under-appreciated and under-priced. 

 

On Learning Chinese Online

I started formal Chinese study three months ago.  Rather than finding a local private tutor or a group class in the Boston area, I used Baidu.  After a bit of bumbling, I found an outstanding online only school called eChineseLearning. eChineseLearning ("ECL") has been around for more than ten years and has impressive scale.  Currently, ECL employs 200 teachers working in either Wuhan or Xian.  ECL teachers work with students one on one over Skype.  Today eChineseLearning has approximately 2,000 students in 100 countries. 

Once you sign up for a trial lesson you'll first take a brief language assessment.  After learning Chinese mostly through osmosis rather than formal study over the last seven years; I was placed into an intermediate-advanced level class.  My teacher and I decided to primarily study Chinese in a business context.  My teacher's name is Lydia (韩琛). She is from Xian and lives there today with her husband who works in tech.  She's been working at ECL for several years.  From her perspective, ECL is a job with compelling benefits and reasonable remuneration.  She gets to work entirely from home, doesn't have to spend time marketing/finding students and is compensated based on the number of classes she teaches (work more, earn more). 

My favorite part about Lydia is her ability to teach at a level just slightly above my current level.  In the beginning of class we'll often talk about our day and then she smoothly transitions to working through the textbook.  It is very helpful to practice listening and speaking through Skype rather than in talking in person.  Whenever I don't understand something, which is constant in our relationship, she can quickly explain it to me through text.  Lydia is also patient with me when I'm struggling to think in Chinese after working a full day.  She also encourages me to keep working at Chinese and reminds me frequently reminds that at my level progress is much slower and requires dedication. 

After class, I add all the new words learned to my word list.  From there, I use flash cards to review what I've learned.  The best flashcard app that I've found is trainchinese and I try to use this app to study on days when I don't have class.  

ECL's pricing is highly competitive. A one-year Chinese language class package costs $2,600 annually.  This package allows me to take three one-hour Chinese lessons per week.  Usually I space each lesson out with a day in-between to give me time to complete my homework.  Learning Chinese, one on one with an excellent teacher for less than $20 per lesson is a very good deal.  In person lessons in the Boston area will easily cost double that before transaction costs. 

After three months, I am pleased to report that I've made some progress, though I have years of study still ahead!  

好好学习,天天向上

(Study hard and make progress every day)

 

 

On communal living and Star Trek

My good friend Ben Asch asked me the following questions on Facebook last week:

Facebook BA-BC

As an optimist, I tend to view most changes in human social institutions as positive. While it is the case that the rise of “shared living arrangements” (“SLA”) will likely result in a class of adults that cannot cook or clean, they will also have additional time to develop new skill sets or deepen those they already possess.  As you suggest, SLAs will further human specialization.

I suspect however, that cooking (and even cleaning) skills will not be lost permanently.  I tend to view most changes in human social institutions as cyclical rather than uni-directional.  As fewer folks cook, more specialized cooks will emerge, some will work at WeLive, other SLAs or as we deregulate the restaurant industry perhaps food trucks, hawker stalls, as well as traditional restaurant concepts.  

As robots and replicators further develop and the need for people to engage in cooking and cleaning diminishes, I suspect that people will want to cook.  Cooking might end up more like sport fishing, a group of dedicated hobbyists keep the tradition alive, but the will to catch fish rather than farm raise them is a desire rather necessity.  The transition from necessity to desire is one that I’ve observed across the labor and product space throughout the economy and tends to be cyclical.

One way of looking at SLA might be to reflect on the life of DS9’s Captain Benjamin Sisko.  Ben Sisko grew up New Orleans, Louisiana in the year 2332.  His father ran a restaurant, “Sisko’s Creole Kitchen,” by this point in history, people had eliminated food scarcity.  The invention of the replicator saw to this.  In 2332, restaurants run by humans are no longer necessary, nonetheless they were still places that people enjoyed visiting to socialize with friends or gossip the proprietor.    

For those that retain rare skills, you’ll always have the benefit of looking cute.

As far as whether we should or shouldn’t fiddle with the tax code, I don’t know.  I’m not sure we should encourage or discourage group living relative to any other living method. Speculating a bit, given that modern society can in some ways be isolating, a good argument could be made for encouraging SLAs to lessen loneliness (especially as we age).  For many in the internet age, human contact offline may be limited.  SLAs can provide people with a stronger sense of community. Community has been a driving force throughout history.  I’m confident that the desire to eat with other folks that you like will continue to be part of our future too.  If some of us are spending less time in the kitchen, and more time in the music production room, art studio, co-working spaces, starships or laboratories and are furthering their passions, I’m for it.

Economics Review: The Founder (2017)

How's a milkshake salesman build a fast food empire with an annual revenue of $700 million? Persistence -Ray Kroc

I recently had the pleasure of watching The Founder, a film that portrays the story of how McDonald’s expanded from a few burger stands to the largest restaurant business in the world. While there are more than 100 critical reviews for this film found on Rotten Tomatoes, in this post I’m going to review a selection of the economic lessons that this film taught me.

--Spoiler Alert--

Process innovation

  • Dick and Mac McDonald had countless ideas that are best described as a process innovations.
  • Developed the Speedy System, a process that gets the patron her food within 30 seconds of ordering or less.  Compared to the previous wait time at burger joints of 30 minutes, this was a 50x to 100x shorter wait time than their competitors.
  • Placement of kitchen stations. Burgers move from the grill clockwise to each station, bun, garnish, bun, wrapping, down a chute to the register.  Check out the video below for a far more beautiful description.
  • Optimize each individual cooking station’s location in the kitchen and techniques used at each station using the scientific method.  The two brothers would take a stopwatch to each station and attempt to shave 5 to 10 seconds off each station's "time to completion" though additional process improvement tests.  All improvements were recorded and the brothers would discuss results after closing.  Their discussions would be framed in the following language, “doing X instead of doing Q saves Y seconds, at only a Z% reduction/improvement in quality.”
  • Limit menu, focus on on the few items that are perennial best sellers (burgers, fries, shakes) only and get those few items to customers quickly and reliably delicious. They understood the “80/20” rule many years before their competitors.
  • Patrons wait in queue rather than in their cars to order their food. This reduces staff costs (no girls on roller skates) and increases the probability that your order is correct.

Technical innovation

  • Serve food in a paper bag and not on plates. Wrap food in a wax paper wrapper for faster consumption (no need to clean plates and cutlery).  Reduce costs by not having dishes to brake.  At the time Kroc first sees a McDonald's burger served in paper bags, he’s unsure of how to eat it.  The film implies this is the first time he’s seen food not served on a plate at a restaurant. A book could be written about this innovation alone.
  • Invented a device that dispenses ketchup and mustard in the correct quantities reliably and quickly.

The challenges of expansion

  • The brothers attempt to franchise McDonald’s, but they were willing to expand at a rate in which they could guarantee quality.  Their expansion was therefore slow.
  • Kroc realized that the brothers focus on maximizing quality per unit of time would result in lower margins. For example, Kroc and his associates realized that if McDonald’s served milkshakes made from powdered milk rather than real milk, they would be able to save on refrigeration costs, improving gross margins.
  • The film helped me better appreciate the inverse relationship between quality and scale.  

The importance of real estate

  • McDonald’s corporation launched a real estate company.  The firm, would purchase land, and lease it back to the franchise, giving them both control and an additional source of revenue aside from franchise fees.
  • Being a large land owner likely gave them access to future loans more easily given bankers' historic love of land as collateral.

Financing risk

  • At first, Kroc had a lot of trouble seeking financing for his firm.  He had a reputation as a sleazy salesman and many bankers were unwilling to provide him with a loan.  As such, Kroc was forced to mortgage his own home to sustain McDonald’s growth.
  • It seemed odd that Kroc wouldn’t have thought to seek private equity backers, but having recently read Shoe Dog (story of Nike’s founding) which took place around the same time as The Founder, Kroc’s decision is less odd.  At the time, there was no private equity industry making growth equity investments and businessmen were forced to finance new businesses with debt.  

Equity valuation

  • There were several moments in the story where Kroc refused to give equity to others.  In his divorce, Kroc gave his wife all assets: home, cash and car, but refused to give her even one share of McDonald's.
  • During a dispute with the brothers, Kroc promises them 1% of all future royalties, but only on the condition that the deal is a "hand shake" agreement and not in the form of written contract.  The brothers agreed and Ray refuses to pay them.  I found this plot twist to be incredible, how the brothers lawyers failed them! 

Authenticity

  • I’ll let Ray Kroc explain:

Is Boulder, Colorado the best place in the US to visit right now?

I've been living in an Airbnb in Boulder, Colorado for a week.  Having never visited Colorado before, I didn't know what to expect. I was delighted to wake up to the sunrise below.

Boulder Sunrise

I was pleasantly surprised to realize that Boulder is the best city in the US to visit right now. I've detailed a few facts about Boulder below:

  1. People are friendly.  People in Boulder are more friendly than anywhere else that I've visited in the United States.  From store clerks, Uber drivers, security guards, park rangers, waiters and fellow restaurant patrons, the overwhelming kindness is remarkable.  Acts of kindness are non-random and frequent.
  2. Everyone exercises. People in Boulder are in great shape.  There appears to be a much lower prevalence of obesity.  Many of the rolling expanses of road have bike lanes. Dedicated bike paths are common throughout the city.  Public spaces, including parks and amphitheaters are heavily frequented for exercise. 
  3. High speed driving.  I've never liked driving, but early morning drives around the roads encircling Boulder provide an opportunity for high speed fun.  Street signs read "Speed Limit 75, Minimum 50."  For a Northeastern boy, this was a real treat.
  4. Foothills of the Rockies. The Rocky Mountains are phenomenally beautiful all the time but sunrise is particularly stunning.  The hiking, skiing and views available a short distance from Boulder are world class.
  5. Boulder is a mountain town. In Boulder there is no dress code, people wear whatever they feel will make them comfortable. Whether their shirt is Polo or Tie Die, no one judges.
  6. Technological superiority. Recently, there has been a tech boom in Boulder/Denver area.  Google is constructing a large campus in the area along with a variety of other technology companies in sub-sectors ranging from internet services to cryptocurrency. 
  7. Deregulation of alcohol.  Colorado has long been at the forefront of the home brew movement.  There are more microbreweries in Colorado than any other state.  Roughly 10% of total US breweries are in Colorado, though it has only 2% of the US population.  Microbreweries are also beginning to partner with the craft whiskey community to create new product/business combinations.  The atmosphere makes for a highly competitive beer market and great diversity of taste.
  8. Rational marijuana policies.  Colorado has been at the forefront of rational policy regarding the consumption and sale of marijuana.  Post-legalization, responsible consumption seems like the norm and tax revenue has been a huge benefit to state finances.  Quality of product is assured and people no longer need to interact with the black market.
  9. Cultural preservation and green belt.  There exists a large green belt around the city of Boulder.  This green belt helps to preserve the area around boulder so that everyone can have a view of the mountains.  New structures cannot be built more than four stories tall so as not to impede the view of other citizens.  This will likely have an inflationary effect on home prices.
  10. Traffic patterns are changing.  We've heard that traffic around the Denver area has gotten much worse since marijuana legalization in 2012.
  11. Economic resilience, Colorado residents call the great financial crisis the great pause (indicating the recession didn't hit them too hard) and the boom that's happened since 2012 has been enormous. 

There are many great places to visit in the US, but none with Boulders combination of attributes.  A special journey is well worth the expense. 

On Electronic Music

Music is as ancient a part of human culture as cooking, mating and running.  According to Wikipedia,

Music is found in every known culture, past and present, varying widely between times and places. Since all people of the world, including the most isolated tribal groups, have a form of music, it may be concluded that music is likely to have been present in the ancestral population prior to the dispersal of humans around the world. Consequently, music may have been in existence for at least 55,000 years and the first music may have been invented in Africa and then evolved to become a fundamental constituent of human life.
— Wikipedia

I think it could be well argued that music isn't a distinctly human form of entertainment.  Animals from birds to whales seem to sing as well.

Over the millennia we've managed to create music with a wide array of simple tools from sticks and animal hide to complex instruments like piano and violins.  In general, the more complex the instrument, the more training is required to become skilled.  Additionally, the more complex the instrument is, the more expensive. Music was created and produced by a small percentage of the population and the rest of us had to enjoy it as a spectator.

Like most other aspects of our lives, over the last few decade, software has dramatically decreased the cost of making music.  Today, we can create studio quality electronic music on any computer using a variety of software packages that range from a few hundred dollars to free.  The cost of learning this software is also close to free through YouTube and other sites.  As we've seen the cost of making electronic music fall, we've also seen more electronic music created.

Electronic music festivals are popular all over the world, millennials from every dozens of countries can be found at music festivals.  The spirit of international inclusion and promotion of diversity across phenotypical traits is relatively rare in music.  I continue to find attending large festivals inspiring.  Seeing hundreds of thousands of people partying together, enjoying music created using software by DJs young and old, mixing together thousands of songs (and crediting the original authors) is an awe inspiring experience. 

Donating to Scientists

There are so many scientists using their time to increase our knowledge about the world.  Much of science tries to make incremental improvements in knowledge.  Taking a strand of the literature and increasing it just slightly. Yet, some scientists like Professor Vera Gorbunova (University of Rochester) dare to attack a problem in a completely distinct manner.  A manner which asks not “what could we do to fruit flies to make them live longer?” but instead she asks, “what animals in nature do we observe with the longest lifespans in general as well as relative to their closest cousins.  Professor Gorbunova studies aging, by observing and understanding naked mole rats (not fruit flies).

How can we support creative scientists? We can ask our politicians to raise taxes or borrow more money (grow the national debt) to give to scientists as grants, or we can make private donations to the scientists that we think are working hard, being creative, care about humanity, teach effectively and are personally inspiring to you.

For the reasons above, I donate to Professor Gorbunova’s lab and hope to do so for as long as she continues working.  Some years, perhaps I will give a larger percentage of my net income.  Other years a smaller percentage, but none the less I really like the idea of helping to further her work. 

While I know my contributions are very small, I do hope and suspect that the Professor Gorbunova would put it to better use than me who would probably spend it on something with a lower theoretical ROI.

I strongly encourage you to find a scientist whom you truly respect and support their work.  Even a $50 check can move the needle over time.

Dating Advice

Key facts about dating:

  • If you are single, you have two options: 1. ask your crush out or 2. don't ask your crush out. 
  • If you ask them out, they might say yes or no.
  • If they say yes, your situation will improve.  
  • If they say no, you are no worse off. 
  • If you don't ask them out, then your situation will not improve. 
  • Any trade with upside and no downside is a good trade.
  • Good luck

Book Review: A Man for All Markets

I first learned about Edward O. Thorp while reading "Fortune's Formula" (Poundstone 2006).  In FF, Thorp is portrayed as a brilliant mathematician who decided to focus his attention on games of chance (roulette) and games of probability (blackjack) to gamble against Las Vegas casinos with an edge.  Poundstone wrote a fine book, but much of Ed's humanity, personality and research approach are not well explained. Published just a few months ago, Ed tells his life story from growing up poor during the great depression, to becoming a gambler, mathematics professor, investor and ultimately a philanthropist

Thorp's story begins in the 1930s, his family felt the ravages of the depression and they were often short on money.  From an early age, a number of unusual personality traits and mental abilities became clear. He enjoyed reading and had an outstanding memory.  For example, he was once challenged by a passerby who noticed that Ed was holding a tome on British history that looked much too complicated for him, and asked Ed if he knew anything about the British monarchy.  To his adversary's surprise, Thorp went on to name all British monarchs from Alfred the Great to George VI.  In addition to reading comprehension, Thorp's interest in experimentation was evident from his younger years as well. He enjoyed building radios, model airplanes and using tools to improve his surroundings. This theme would become a defining characteristic of Thorp's life.

From an investment perspective, Thorp's book contains a wealth of wisdom. Common consensus on roulette was that it was a game of pure probability, and given the house's slight edge, unbeatable.  Thorp, knew full well that in theory roulette might be unbeatable, but he wanted to explore it for himself to see if the path of the ball was random as theory suggests or if there might be some patterns/path dependency present on the table.  Thorp decided to tackle the roulette wheel by approaching the problem as an experimentalist.

Thorp bought a few old roulette wheels and began exploring for patterns recording where the ball ended up after a normal spin.  He then learned Fortran to run computer simulations on the data he obtained.  These experiments implied that there were patterns to the balls, but he'd need a computer to help him identify them.  This finding resulted in Thorp inventing the world's first known wearable computer which helped him make real-time calculations and gave him an edge betting at the roulette table.  Thorp developed new techniques and equipment as needed to recognize patterns in data and used theory to codify his results into a betting strategy that could be carried out in real casino conditions.  This involved practicing with his friends and in casinos with small amounts of money to see if he could execute his strategy in a risk controlled manner.  Once satisfied with his results, he slowly increased his bet size. 

Later, Thorp would apply an open minded experimentalist approach to investing in securities, commodities and other financial products on Wall Street.  The prevailing wisdom among academic economists and financial theorists at the time was that market prices were efficient, that is to say, that all prices were right.  One of the implications of this theory of securities prices was that there are no patterns in securities prices which could lead to sustained arbitrage profit. As Thorp admits, this is a fine theory, but to test it you need to examine the data and see if there are in fact any patterns.  Thorp shows again and again throughout his story that this theory is false.  From investing in closed-end funds trading at a discount, statistical and fundamental arbitrage techniques and other well-known techniques in the vein of Benjamin Graham are tradable and produce a positive return.  Thorp's several decades of success should give any proponent of the efficient market hypothesis pause.  Thorp's success inspired many other mathematician run investment partnerships that were able to invest in systematically mispriced securities.  Several of these groups were likely trading on the so-called "Black-Scholes" model for more than a decade before Black and Scholes published their result.

In addition to investing on his own, he was one of the first to run a fund of funds.  He invested with many others including Warren Buffett (early in Buffett's career), believing that detecting skill in pricing securities is ex-ante observable, but requires extensive due diligence.  When contemplating an investment in another investor's partnership, Thorp would visit the fund's office and in some cases ask the investor to work from his office for several months.  His process for reviewing an investment manager included reviewing trade ideas in detail and assessing their thinking for rigor and creativity.  This kind of due diligence approach led him to recognize Bernie Madoff as a Ponzi scheme decades prior to the scheme's collapse.

Thorp's book ends with some thoughts on the importance of science.  One of Thorp's central concerns is that the US may be losing its future edge in science, mathematics, and technology because of a pattern he's observed in labor markets. Thorp notes that America which during the 20th century was viewed as the place which caused brain-drain in other parts of the world, such that brilliant people would leave their home countries and go to America to seek their fortune.  Thorp notes that today, the opportunities for brilliant scientists (given the US-visa system and lack of funding) may be better in China than the US.  He's observed a concerning pattern where many top talents are being educated in the US and then returning to their home countries.  Ultimately, this lost potential could result in the decline of America's role in the economy as a leading innovator.  Thorp notes that while Rome was not built in a day and did not fall in a day, a slow decline due to reverse brain-drain is deeply concerning.

In summary, I'd strongly recommend Ed's book if you are interested in games of chance, strategy, investing, seeing applications of the scientific method to human problems and spend time with a man who cares deeply about education and acting morally.  Thank you for taking the time to write "A Man For All Markets" Ed, your experimental approach rooted in your tendency to not believe what others tell you unless you check it for yourself is inspiring to me. Perhaps this is why Seth Klarman named his horse "Read the Footnotes."

Please pick up a copy of Ed's book today.