Monday, July 28, 2014
Gogerty, The Nature of Value
The framework might be familiar, but The Nature of Value: How to Invest in the Adaptive Economy (Columbia University Press, 2014) takes the reader into unexplored and underexplored territory. The book moves seamlessly between theory and practice and adds substantially to our understanding of both.
It might seem obvious that price is not value, but ordinary investors as well as financial modelers tend to forget this. For instance, many asset valuation estimates rely on models like Black-Scholes or the efficient market theory that use flawed inputs such as historical prices. They assume that economic risk is measured by price volatility. (No, says Gogerty, economic risk is “the chance that you permanently lose the capacity to generate or receive future economic value.” [p. 11]) They justify a firm’s stock price using dubious metrics to compare it to a competitor’s stock price. (“If firm X is priced at 120 times revenue, then seemingly similar firm Y must be a bargain when priced at 80 times revenue. This dangerous analytical shortcut—in essence, using a price-based model to compare apples to oranges—was popular during the Internet bubble of 1997-2000. In that case, both the apple and orange turned out to be rotten pieces of fruit. Being less rotten doesn’t make something more edible.” [pp. 12-13])
If investors are inclined to reduce value to price, many economists incorrectly reduce what is inherently an adaptive process to a mechanistic one. Keynes was one of the greatest offenders. He anticipated that within two or three generations the economy would plateau and reach equilibrium, which he described as “bliss.” But, Gogerty argues, “the only economic systems found today that are truly at or close to equilibrium are nearly dead economies. A cow that achieves equilibrium is called a steak, and the economy closest to achieving equilibrium today is probably North Korea.” (pp. 21-22)
Gogerty’s model of the economy as an adaptive, networked system begins with its fundamental building block, the ino (informational unit of innovation). Inos, which are analogous to genes, are expressed as capabilities, giving organizations the potential to deliver value if they are properly nurtured. These inos need not be original; “more often, big ino-enabled chunks of functional knowledge and capabilities are borrowed, shared, and mixed.” (p. 61)
Companies create value by having multiple advantaged capabilities. Gogerty cites the work of The Doblin Group, which identified ten categories of business innovation capabilities, and gives examples of firms that excelled in this regard and those that fell short. He contends that “the more types of unique capabilities a firm’s goods and services offer, the longer it may dominate competitors. To use a biological metaphor, it is one thing to be the fastest frog in the pond. It’s another to be the fastest, healthiest, best-looking, strongest, most fertile, and most metabolically efficient frog in the pond. Ideally, a firm should have long-term advantages in each of the ten innovation capability categories, with each capability impossible to replicate by competitors for the foreseeable future.” (p. 90)
At the next level of the economic hierarchy are clusters, competitive spaces in which firms fight for “the scarce resource of customer value flow.” (p. 102) Gogerty does a masterful job of describing four broad types of clusters (Lollapolooza, cash cow, lottery, and Red Queen) and their life cycles. ETF investors would do well to pay special attention to this section of the book. As Gogerty later explains, “people forget that a sector ETF allocation is actually a bet on the distribution of value capture among competitors in a cluster. Anticipated revenue growth means increased value will flow through the cluster—but does not guarantee sustained profits for any single firm, much less the aggregate cluster of firms. Competition and cluster instability can limit the cluster’s retained profits and the sector’s ability to retain value or build wealth.” (p. 307)
Followers of Warren Buffet know about the value of moats, but Gogerty goes deeper into the weeds and devotes an entire part of the book (three chapters) to this topic.
Finally, Gogerty analyzes the nature of various kinds of economies, those that are investable and those that are better left alone. He also discusses monetary shocks and their implications for the allocator, a term he prefers to ‘investor’.
The Nature of Value is a well-reasoned, thought-provoking book that belongs in the library of every investor, professional and retail, value and growth.
*The Santa Fe Institute has some free online courses starting in September—introduction to complexity (a re-offering), mathematics for complex systems, and nonlinear dynamics. For those relatively new to the field, I can recommend the introduction to complexity course as well as Scott Page’s MOOC on Coursera, Model Thinking.