Don’t be an underpants gnome

What is magical thinking?

Economists have a term for hoping that the future will be different from the past – “magical thinking”. President-elect Trump’s infrastructure and tax plan is a great example of magical thinking. He has proposed spending up to $1,000,000,000,000 (yes, that’s $1 TRILLION) dollars on infrastructure repairs and upgrades. He has not proposed tax increases or other spending cuts to pay for this infrastructure spending. Rather, he is projecting that the infrastructure spending will increase US GDP growth from the current 2-2.5% to 4% per year, and the increased tax revenue created by higher growth will pay for the spending. Every single economist I’ve read says there’s no basis for this.

In short, Trump’s plan depends on hoping something will happen that’s never happened before. Hope is not a strategy.

Magical thinking in investing

Magical thinking also comes into play when analyzing potential investments. Let’s take Amazon as an example. Amazon has enormous sales yet is barely profitable. Despite being unable to prove that it can convert huge sales into even reasonable profits, Amazon is selling at ~175x earnings. Why?

Magical thinking.

Investors are hoping that at some point in the future something at Amazon will magically change.

Amazon has such enormous sales in large part because they have low prices. If Amazon believed they could raise prices and still have the same volume of sales, don’t you think they would have done it by now? The only logical conclusion is that Amazon believes the current pricing scheme maximizes profits and raising prices will decrease profits.

Some people will point out that Amazon is making more money on their “core” business of selling and shipping product and the numbers look worse because of their various R&D investments, their build out of distribution centers, etc. They claim that if you remove the “one time” costs Amazon’s numbers look better. The problem is that when “one time” costs happen year after year they cease to become one-time costs and start to become normal expenses.  Amazon makes these continual R&D investments because they believe they need to do so to protect their current and future business.

Amazon does roughly $120B in sales per year and in 2015 had a profit margin of .56%. They already benefit from massive economy of scale and yet barely turn a profit. Why should we expect that to change in the future? If their sales double I don’t think it’s reasonable to expect their profits to go up by 10x. That would require magical thinking.

Other examples

Magical thinking is what the entire dot-com bubble was built on.  Somehow investors believed that money-losing Internet companies be able to turn “eyeballs” into profits. How? Nobody was quite sure, but they knew that profits were just around the corner.

South Park had a great example of this kind of thinking from their underpants gnome episode.

The underwear gnomes aren’t making money today, and they aren’t exactly sure how they will make money, but they are sure that if they just keep doing what they are doing then profits will somehow come eventually.

Or take Pets.com. They were losing money on every sale, but they hoped to become profitable by making more sales.  It reminds me of this Saturday Night Live skit:

SNL BANK OF CHANGE.

Conclusion

You just can’t analyze a company (or, by extension, an investment) if you can’t project future profits with some reasonable degree of certainty. And once your projections require something magical to happen you’ve crossed the line from investment to speculation.

I prefer to invest in companies where no magical thinking is required. Coca-Cola already makes money on every 12 oz can of soda they sell. Nothing needs to be different in the future for Coke to make money. Ditto with Visa or Nike – they make money every time somebody swipes a credit card or buys a workout shirt. Visa and Nike can just continue doing what they are doing on an ever larger scale to make ever larger profits. Nothing needs to magically change in the future.

Investing in a company and needing something magical to happen before profits appear is not a good strategy for building long-term wealth.

 

 

 

 

6 thoughts on “Don’t be an underpants gnome

    1. Yes, Amazon makes huge margins on AWS, but I’m not sure what their competitive advantage in that space is. They are competing with other deep-pocketed tech companies like Google, Amazon, and IBM.

      The numbers I’ve seen show that AWS made $861M in profits in 2016 Q3. That’s roughly $2.5B annualized. Their other operations LOST $541M.

      So you’re right that AWS is clearly the profit engine at Amazon. The question is then if Amazon should get rid of their existing chronically unprofitable retail division, which is what people think of when they think of Amazon.

  1. Does it mean that people with imaginative and magical thinking will not find investors for their ventures? I doubt. People have always tried to maximise their return even at the risk of making investment in imaginative ventures. Otherwise there would not have been any Amazon or Flipkart in this world.

    1. Sure – there will always be people willing to invest in very early stage and unproven ventures. However, I think you’re confusing early-stage companies with companies that require magical thinking to become successful. For example, Microsoft got its start by writing a BASIC interpreter for the Altair microcomputer. Bill Gates and Paul Allen wrote the interpreter in just 8 WEEKS and then licensed it to Altair. From that point on the company was profitable. Although they were small it was clear how they were going to make tons of money – they just needed to do more of what they were already doing.

      Compare that to a company like Amazon that for the last 20 years has made a grand total of approximately $0 in profits.

      Maybe they’ll find a way to make billions of glorious profits in the future, but that will clearly require major changes to their current business model. They can’t just keep doing more of what they are already doing. That is inherently more risky.

      My point is this – leave the risky stuff to other people and take the easy money.

  2. How does your framework fit to analyse some of the old companies that will need to keep up else end up holding a Xerox or a Kodak, even though they made “money” and were well understood. A new magical scenario “email / digital” or “apple iphones” just killed them off.

    1. Well, the best companies won’t face any sort of existential threat the way that Xerox and Kodak did. This means companies like Coke or Hershey’s that sell products that haven’t changed in 100 years and won’t need to change in the next 100 years. Nothing is going to come along to make these products obsolete.

      I tend to shy away from technology companies for the very reason you mention – they must continually reinvent themselves in order to stay relevant and profitable. Apple and Microsoft and IBM must continually work onto next big thing. How much money is Apple making today on products that are just 5 years old? I’m guessing it’s right around $0. How much money is Coke making on the exact same formula of soda from 100 years ago? Billions.

      And all companies, regardless of industry, face the prospect of bankruptcy if they aren’t continually improving. Kodak lost a huge opportunity to turn their dominance in film photography into a dominance in digital photography. Xerox was a tech company that didn’t continue to innovate and eventually got left behind.

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