Short Circuited Feedback Loops
Finding and filling gaps in the market is one avenue for entrepreneurial success. Obviously, the first to tap into an unmet consumer demand can unlock massive profits. But unless there’s some comparative advantage, competition will quickly commoditize the market and profit margins will decline to just above breakeven.
Example of a “commoditized” market – hard-drive storage costs per GB. This is actually the essence of economic progress; this price decline has benefited consumers immensely and vastly enriched their lives. This makes it all the more baffling that central bankers insist we absolutely need price inflation in order to have economic growth (in fact, it actually demonstrates what dangerous lunatics they are). – click to enlarge.
Unfortunately, finding and filling gaps in the market is much easier said than done. Even the most successful serial entrepreneurs fail more often than they succeed. What’s more, success in one endeavor doesn’t guarantee success in another.
Anyone who has ever developed and marketed a new product from concept through sale knows how difficult it is to achieve profitability. For every good idea there must be a hundred bad ones. Yet the only way to really know the difference between a profit generating idea and a cash hemorrhaging fiasco is through trial and error.
Success and failure provide real feedback. They deliver information – at a profit or loss – to businessmen and investors. What’s working? What isn’t? What adjustments can be made to help eke out a profit? These are the types of information that only the market can provide.
But what happens when the feedback loop is short circuited and a potential gap in the market is not really a gap after all? What if fraud and folderol turns a desert wasteland into a tropical oasis mirage? What happens is that otherwise intelligent investors are duped into throwing good money after bad.
Swindle and Speculation
In his perennial classic Manias, Panics and Crashes, author Charles Kindleberger includes an entire chapter on the Emergence of Swindles. One of Kindleberger’s insights is that speculative booms, often resulting from the cheap credit provided by loose monetary policy, sow seeds of white collar crime and subsequent financial distress. Here we turn to Kindleberger for edification:
“Commercial and financial crises are intimately bound up with transactions that overstep the confines of law and morality, shadowy those confines may be. The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom. Crash and panic, with their motto of sauve qui peut, induce still more to cheat in order to save themselves. And the signal for panic is often the revelation of some swindle, theft, embezzlement, or fraud.”
Charles Kindleberger’s famous tome on manias and crashes. The phenomenon that manias are as a rule accompanied by massive fraudulent activity that is only uncovered after their demise could be observed again and again, throughout history.
No doubt, sleight of hand, smoke and mirrors, trick plays, and the like, add a certain lighthearted delight to life. The fumblerooski. The melon drop. The kid that throws mud at your car half a block before his brother’s car wash.
Cons and scams like these sharpen our wits. They prepare us for people and situations that aren’t quite as upright as they first appear. Specifically, they help protect our pocketbook from encounters with mutual fund brokers, Dan Rather, and charity fundraisers.
Of course, large scale operations to separate fools from their money are no joke. The consequences can be ruinous. Victims may never recover.
The Great Stock Market Swindle
Last week, a Bloomberg report (via Zerohedge) crossed our desk which exquisitely captures the symbiotic disharmony of swindle and speculation described by Kindleberger. Here’s a partial extract:
“Call it the perfect pyramid scheme for the ‘new normal.’
“In the latest example of the venture capital euphoria that has dominated the US in recent years, not to mention potential fraud, Bloomberg reports that vegan food start-up Hampton Creek, had a novel idea of how to spend the venture funding it had raised: by buying up its own product. To wit:
‘“In late 2014, fledgling entrepreneur Josh Tetrick persuaded investors to plow $90 million into his vegan food startup Hampton Creek Inc. Tetrick had impressed leading Silicon Valley venture capital firms by getting his eggless Just Mayo product into Walmart, Kroger, Safeway, and other top U.S. supermarkets within about three years of starting his company.
‘“What Tetrick and his team neglected to mention is that the startup undertook a large-scale operation to buy back its own mayo, which made the product appear more popular than it really was. At least eight months before the funding round closed, Hampton Creek executives quietly launched a campaign to purchase mass quantities of Just Mayo from stores, according to five former workers and more than 250 receipts, expense reports, cash advances and e-mails reviewed by Bloomberg….’
“Wait is that legal? Well, technically it is not illegal, although it is extremely unethical (imagine if, gasp, Facebook was using click-farms to fabricate users – it’s the same concept) however it underscores the money printing culture permeating the VC community, which through its generosity may be implicitly enabling fraud. Case in point: Theranos, and now Hampton Creek.”
Bloomberg video on the (allleged) Hampton Creek mayo buy-up scam
Indeed, one of the reigning hallmarks of our time is the abundance of deceptions that presently pass for standard practice. For example, not long ago, dividend recapitalization – using debt to pay stock dividends – was the sort of dubious practice reserved for private equity firms.
These days, thanks to the incentive of the Fed’s ultra-low interest rates, using borrowed money to buy back shares or pay stock dividends is a practice commonly executed by many S&P 500 companies.
Perhaps this is one reason why stock prices have gone up in the face of 15 months of declining earnings. Make of it what you will. From our vantage point it appears the entire stock market has turned into a great swindle.
Caveat emptor – let the buyer beware.
Sometimes they don’t come back: A few famous market manias and crashes – only one of them (the DJIA) actually recovered from its losses, but it took 25 years and only one or two of the components of the average at the time of the crash are still part of it today. Many investors never lived to see the day when they would have theoretically reached breakeven in nominal terms – and very few of them saw the day when it finally recovered in real terms sometime in the mid 1980s.