Investing Caffeine

Margin Surplus Retake

June 10, 2010 at 11:27 pm 4 comments

Like a B-rated horror movie using the same old cliques (i.e., girl home alone with serial killer on the loose or a concealed intruder hidden in the back seat of a car), one of the financial cliques that persists today is the belief that the United States trade deficit will result in financial ruin for our economy. The recent widening of the trade deficit to $40.3 billion makes this economic issue a topical discussion. Enter Andy Kessler, former hedge fund manager and author of Running Money. He believes the stale, exploding trade deficit arguments are hogwash, primarily due to his “margin surplus” theory articulated in his book and Wall Street Journal article entitled, We Think, They Sweat.

Profiting from Trade Deficits

The absolute numbers used by Kessler in his Toshiba laptop example might have changed since his book was first published in 2004, but this margin surplus theory example is just as relevant today as it was back then. Here is an excerpt from his book:

“Let’s open up that Toshiba laptop. With a $300 Intel chip (which has at least $250 in profit for Intel) and a $50 Windows license ($49.95 margin to Microsoft), the laptop is then sold by Toshiba back into the U.S. for $1,000. Toshiba and every other supplier are lucky if they make $50 profit, combined, on the deal.”

In this illustration, government statistics would recognize a $1,000 contribution to our bloating trade deficit figures, even though nearly 90% of the laptop profits would be flowing (“surplus-ing”) back to the U.S. Hmmm, maybe this trade deficit thing isn’t as evil as it is portrayed in the popular media, or perhaps we are measuring it incorrectly? Kessler makes the case that Gross Domestic Product (GDP) is not the most important economic gauge, but rather the real crucial GDP metric is actually Gross Domestic PROFIT. He adds the best indicator for economic profits is the stock market, and as foreigners seek more productive returns on their cash beyond the 3% Treasury yields, they will eventually filter back their dollar currency reserves into stocks and other more productive asset classes.

Brain Driven Economy

You don’t have to be a brain surgeon to realize our roots as an industrial economy have shifted to an intellectual property economy. So while we may be exporting low-skilled labor jobs to China and other low-cost regions, our country is also creating higher-skilled, higher-paying jobs at innovative growing companies such as Google Inc. (GOOG) and Apple Inc. (AAPL). Case in point, flip an Apple iPod over and read the fine print on the back – it reads, “Assembled in China…Designed by Apple in California.” Once again, the commoditized aspects of slapping together a widget have been outsourced to workers in far-off lands for a small fraction of what American workers earn. If improving the standard of living is our goal, then transferring low paying jobs to foreigners should not be a concern. According to Kessler, $70 in iPod profits (versus $4 for the Chinese assemblers) from this unique, differentiated device has generated millions in profits, which in turn can be used for the creation of desirable, high-paying jobs here in the U.S.  

Selling the Farm

Warren Buffets has a different view about our trade deficits and the directional value of the U.S. dollar. He perceives our economy as a fixed size farm that is selling $2 billion pieces of the farm to foreigners on a daily basis.  Buffet adds:

“We’re like a very rich family; we own a farm the size of Texas but want to consume more. If you force-feed $2 billion a day to the rest of the world, they get somewhat less enthusiastic over time – and the dollar is worth less.”

Over time, Buffett believes future generations will resent paying for the gluttony of consumption by prior generations and foreigners will demand a higher interest rate for their loans. What I believe Buffet fails to consider is that the farm is not static. As we sell off $2 billion chunks of the farm, portions of those proceeds are being used to adjoin additions, buy new farms, build adjacent wind turbines, and/or incorporate other productive uses. Now if the proceeds were used to solely purchase bon-bons and doughnuts, then indeed we would be in trouble. Ultimately, the financial markets will be the true arbiter of how efficiently the foreign capital is being invested and will dictate the level of rates paid on the loans. From a pure cash management standpoint, stretching out payables (net imports) is a sound practice (i.e., it’s desirable to collect early and pay late).

The flip side of the argument explains how the farm sale proceeds from our asset sales to foreigners (such as our real estate, our Treasuries, and our stocks) can be employed in a productive manner. The Buffett argument states that our farm will eventually be completely sold to foreigners or they will hold a gun to our head asking for higher interest rates to fund our deficits. The problem with that argument is that the money received from the farm sales (Treasuries, stocks, real estate, etc.) can be (and is) used to build new farms. And that is the key question…are all these deficit building dollars being used to create new, innovative, job creating companies like Google and Apple, or are these dollars being redeployed into unproductive uses (e.g., worthless t-shirts and lead-filled toys from China, or funding of bailouts and cash-for-clunkers waste) ?

At the end of the day, money goes where it is treated best – meaning global capital seeks the royal treatment in markets where profits reign supreme. So rather than relying on rusty, obsolete statistics measuring the balance of trade (i.e., trade deficits and GDP), investors would be better served by taking a page from Andy Kessler’s book. Following the principles of “margin surplus” will increase the probabilities of profiting from global capital flows.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, Treasury securities, GOOG, and AAPL, but at the time of publishing SCM had no direct positions in Toshiba, INTC, BRKA/B or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Entry filed under: economy, Financial Markets. Tags: Andy Kessler, economics, margin surplus, Running Money, trade deficit, Warren Buffett, We Think They Sweat.