Thursday, May 3, 2012

Hussman on Growth

At the end of this week's Hussman essay is the best thing I have ever read on growth.

Consider a very large, untapped market for some product. We can model the growth process in terms of how quickly that product is adopted by new users, whether there are any "network" effects where new buyers are attracted to the product because other people already use it, how frequently existing users replace their products, whether late-adopters come in more slowly than early-adopters because of budget constraints, how quickly the untapped market grows, and a variety of other factors.

Whether you do this sort of modeling with a spreadsheet or with differential equations, you'll get essentially the same results. Specifically, growth rates are always a declining function of market penetration. Most strikingly, the growth rates begin to come down hard even at the point that a company hits 20-30% market penetration. Network effects accelerate the early growth, but also cause growth to hit the wall more abruptly. Replacement helps to accelerate the early growth rates too, but ultimately has much more effect on the sustainable level of sales than it has on long-term growth. In fact, if the replacement rate (the percentage of existing users that replace their product each year) is less than the adoption rate (the percentage of untapped prospects that are converted to new users), it's very hard to keep the growth rate of sales from falling below the rate of economic growth.

[T]he key feature is that growth rates are a rapidly decreasing function of market penetration.

Apple is now valued at 4% of U.S. GDP, but then, Cisco and Microsoft were each valued at 6% of GDP at the 2000 bubble peak.
This really reveals the silicon valley VCs as a bunch of hacks and hucksters. Isn't it telling that they cash out when they IPO the companies? Is this a country of such rubes that they don't realize that companies without significant demands for capital are just listing on the public markets in order to hang paper on suckers?

Also, the short AAPL / long natural gas (aka the "Gundlach") is sounding more and more awesome. We are going to start tracking this trade on the blog. However, rather than spot natural gas or one of the awful natural gas ETFs, we will use CHK as our proxy because it's so undervalued.


Taylor Conant said...

Isn't it telling that they cash out when they IPO the companies? Is this a country of such rubes that they don't realize that companies without significant demands for capital are just listing on the public markets in order to hang paper on suckers?

Thanks. That is what I could never understand is why these companies were going public when they have no need for the capital.

Taylor Conant said...

Btw, one question I had when I was researching DWA was why it ever IPOed. If you had a lucrative film franchise, why would you want to give outside rubes a piece of that pie?

The answer has to do with Paul Allen, MSFT fortune dingbat investor, who originally seeded DreamWorks (the parent company), essentially because he wanted to buy his way in to the glitz and glamour of Hollywood.

Paul Allen strikes me as the consummate lucky moron billionaire. He was at the right place at the right time with the right skill set (MSFT) but everything he's done since he got so wealthy, partly by happenstance, has been pretty unimpressive.

He put all this money into DreamWorks and then, when he either got bored of being a part of Hollywood, or antsy about short-term volatility of his various investments, or both, demanded a cash out. So, they decided to spin off the animation division (which was really the part of the studio showing the most promise and which was least dysfunctional, ironically) and take it public. The company got about $130M~ in new capital from the IPO, poured the requisite millions in fees into the ibanker trough so the syndicate pigs could all be fed and the rest went to Paul Allen to cash him out of his shares. Then, they did a secondary offering shortly thereafter to cash Paul Allen out of the rest of it.

Now, the OBVIOUS reason to IPO in that situation was to cash out Paul Allen and leave a bunch of suckers in the public holding the bag. And at the time, and at the price DWA IPOd at, this was probably exactly what happened (the prospectus explicitly laid out that if you bought shares in the IPO you'd instantly be diluted and overpay for the actual value of the company by some 80% or so).

But in the end, I think the joke might be on the illustrious Mr. Paul Allen. He bailed out to lick his (many) wounds and in the process gave up his stake in what I believe to be a valuable growth enterprise. Which would be an especially fitting end to a story that began with an uneconomic, ego-driven initial investment by a clueless accidental billionaire.

I suppose if I am wrong, though, then that just makes me dumber than Paul Allen. Which is entirely possible.

CP said...

It's always impressive when people are successful, or at the top of their field, in multiple areas. That's a sign that their first success wasn't just luck. One of the other Microsoft dudes, Myhrvold, seems like he is actually sharp. He is doing original interesting work in culinary science for example.

Paul Allen had cancer in 1982 and it sounds like Ballmer and Microsoft pushed him out of management.

Some of the project he has done since seem worthwhile.