The Death of Capitalism

One of the most dramatic events of the Transformation is 'The Death of Capitalism.'  This does not mean the death of free enterprise or robust equity markets or entrepreneurship or the triumph of socialism, globalism or any of the several technocratic 'moneyless society' theories floating about the Internet.  Specifically, it means that the share of equity in earnings and net assets that is apportioned to those who provide financial resources will fall to relative insignificance as most of the equity will be apportioned to those who provide knowledge, human, relationship and entrepreneurial capital.  This death of the rules of financial capitalism and the rise of the new rules of knowledge capitalism will completely reshape the financial markets, in fact, of society as a whole. 

Consider the chart below.  Because many companies are retaining cash, cash equivalents and short term investments that are large enough to distort the financial ratios, they  have been removed from the equity and from the market value and Net Income has been reduced by 4% to reflect an imputed after tax return on the removed current assets.  Financial Analysts who fail to adjust for this non-employed capital will likely miss just how dramatic the current events are.

BV/Share
EPS
ROI
Market  to Book
Industrial Age Companies




General Electric
3.48
0.63
18.10%
3.1
Exxon
26.33
5.55
21.10%
2.7
Walmart
15.31
3.92
25.60%
3.3
   Average
15.04
3.37
22.38%
3.0





Information Age Companies




MicroSoft
0.42
2.12
504.20%
54.5
Cisco
0.99
1.08
109.00%
13.6
Apple
24.24
14.03
57.90%
12.3
Google
31.22
20.44
65.50%
15.9
  Average
14.22
9.42
66.24%
24.1
*Data taken from audited financial statements and market statistics as of 12/09/2011

The dramatic difference in performance between the Industrial Age and Information enterprises is in no way a fluke.  In fact a theoretical consideration of the factors involved leads to almost identical results.  Below I show the traditional Industrial Age Balance Sheet based upon the preferred financial ratios, say, of around 1980.  Return on Sales is 5% and the Financial Ratios were taken mostly from here.  Next to it are the new, generally accepted Information Age expectations.




Per Million $ of Earnings

Industrial
Information

Accounts Receivable

$3,333,333

$1,000,000

Inventory

2,000,000

200,000

PPE and Other LT Assets

6,000,000

2,500,000

Total Assets

11,333,333

3,700,000




Current Liabilities

2,666,660

600,000

Long Term Liabilities

4,333,340

1,500,000

Total Liabilities

7,000,000

2,200,000




Net Book Value

$4,333,333

$1,500,000

Return on Book Value

23%

67%

When this is properly understood, this information is Earth shaking.  IT is dramatic and it changes everything.  This fundamental change will cascade throughout all financial markets, both debt and equity, both public and private, leaving nothing remotely like it was before.

Consider a new Industrial Age start up, with a capital infusion of $1,000,000 that grows for ten years at its equity constrained rate of 23% and at the end, has a Market to Book Ratio of 3:1.  It will, at the end of the ten years have a market value of $1,000,000 X 1.23^10 X 3 =$23,777,838.  Now consider an Information Age company with the same initial $1,000,000 but it instead grows at its equity constrained rate of 67% and at the end has a Market to Book Ratio of 12:1.  Its ending Market Value will be $1,000,000 X 1.67^10 X 12 =$506,157,838!

Now let's look at it the other way around.  Suppose there is a ten year old Industrial Age company that currently has a Market Value of $1,000,000,000.  With the same equity constrained growth rate and Market to Book Value ratio, its initial equity would have needed to be $1,000,000,000 / (3 X 1.23^10) = $42,055,968.  Now consider the Information Age enterprise above.  Its initial equity would need to have been $1,000,000,000/(12X 1.67^10) = $493,917.  The first is a major Venture Capital event.  The second can be funded by small investors through a Reg D.

Now, as an entrepreneur or investor or just a person who intends to live in the future, this should blow you away.  If it doesn't, you don't quite understand it yet.  You may want to take a few minutes and review what you have read.
As rates of return for PPO's increase, as they will, the number that become available will increase dramatically, as well.  Over the next thirty years, household incomes will explode and the additional purchasing power will be spent primarily in design value added, content and other forms of Information Age GDP.  In other words, little of the growth in GDP will go to Industrial Age enterprises.  Rather, it will create an explosive growth in Information Age enterprise formation.  

It will also precipitate a profound and tumultuous reformation of the equity and debt markets.  A few of the more significant events will be:
  • As investors recognize the substantially higher sustainable growth rates and ROI's that are now characteristic of Information Age enterprises, investment dollars will flood to the start-up and early round private equity market.  The expectation for young, aggressive investors will be that they can turn $10,000 into $10,000,000 in 10 years or less.  As widely reported, muralist David Choe, by accepting facebook stock in lieu of payment turned $60,000 into $200,000,000.  While the value of facebook stock is proving to be very volatile, Mr. Choe is staying well above the target of 10K à 10M in 10 yrs.  The establishment will, understandably, launch a dissuasion campaign.  In fact, it is already doing so against the recent startu-up enabling JOBS legislation.  However, in the face of many success stories, it will be largely unsuccessful and we will experience a kind of 'Private Equity Gold Rush.' 
  • As markets continue to fragment and experience accelerating change, rigid and hierarchical corporations will not be able to adapt and will be replaced by networks of smaller, more autonomous enterprises that share markets and some resources but are individually financed and operated.  Anyone who as ever gone through a mega-corporation reorganization, knows just how disruptive they are.  They often take years to pay for themselves, but as the Transformation continues, they will increasingly be outdated before they are completed.  Consequently, many of the existing mega-corporations, responding to these pressures, will undertake massive divestiture or 'spin-off' programs in order to transform themselves into the more adaptive Enterprise Networks.  This rapidly increasing supply of success prone, small, newer businesses will significantly increase the supply of quality PPO's for investors.
  • While the number of PPO deals will increase rapidly, the amount of funds chasing them will grow even faster.  Funds will leave the public secondary markets, from the debt market and from the commodity markets.  Also, rather than concentrating on 'exit strategies', which will simply require reentry into the ever more competitive private equity primary offerings market, private equity investors will choose to stick with the 60%+ dividend streams of their current investments.  The buy and hold strategy will come to dominate and the primary efforts will be put into finding quality investment opportunities for the smaller, but still very significant, dividend stream of these mature enterprises.
  • The publicly traded secondary equity markets will enter into a very long term bear market.  This will be caused by a simple demand shortage as investment dollars preferentially chase private equity positions.  However, it will also be caused by falling P/E ratios as total shareholder return will need to increase in order to compete with the very high returns characteristic of the private equity markets.  401(k) pension funds and their counterparts in other countries will find that annual contributions are taken up entirely with replenishing capital losses.
  • As the capital required to create a start-up or to fund its growth continues to fall, the emphasis in the ventures industry will shift from its supply of financial capital to the value of its knowledge base.  The equity requirements are small and readily available.  The value-added will be in identifying and assisting quality start-ups.  We will move from an era of Venture Capital to one of consultative 'investment angels.'  Many fund managers will migrate toward fulfilling the Treasury function within an Enterprise Network.
  • Because, compared to today, the demand for early round private equity investment opportunities will far exceed the supply, quality entrepreneurs residing within success prone Enterprise Networks will be in the stronger bargaining position.  When, as in the Industrial Age, it required $42 million to fund a start-up that will be worth $1.0 billion ten years later, the investors could demand a significant portion of the equity.  When, in the Information Age, the same company only requires a $500 thousand of equity infusion, the entrepreneur can demand a significant portion of the equity. This will translate into private equity investors bidding up the share value of start-ups and early round PPO's.
  • With the advent of crowdfunding, $10,000 or less can get a person into a start-up, the number of people playing in the PPO markets will increase dramatically.  401(k)'s will be rolled over into PPO IRA's.  Pressure will be placed upon employers to have PPO options in their 401(k).  However, reacting to the very high rates of return of the Information Age enterprises, very quickly literally millions of people will build million dollar plus portfolios.
  • The Income Explosion created by the explosion in new Information Age start-up ventures will be highly deflationary, requiring central banks to engage in aggressive quantitative easing policies.  As it becomes clear that ‘printing money’ is required just to stay even, world gold prices will collapse as, again, funds will migrate from the precious metals markets to the PPO's.
  • With the supply and demand function so heavily favoring the entrepreneur, the 'gold rush' will lead to an Private Equity bubble as investors become more forgiving of entrepreneurs who lack capital, experience or have a problematical business model.  As during the housing bubble, when almost anyone could get a mortgage, almost any start-up will be fundable.
  • The central banks, faced with persistent deflation will need to keep discount rates very low and also engage in other QE strategies that may include the purchase of not just government bonds but also corporate bonds.  By doing so, they will lower the yield on debt instruments and make them relatively unattractive to the private investor.  As happened during the housing bubble, banks will borrow money specifically to invest in debt markets as the spread remains high.  This is very subtle, but very important.  In essence, the debt markets will be socialized.
  • All of this liquidity at low cost will stimulate the implementation of productivity enhancing  technologies.  This will increase profits, but also speed up the Transformation and intensify the Industrial Age Apocalypse.
From a somewhat more theoretical perspective, what we are seeing is the death of capitalism, defined as the concept that equity in net assets and earnings accrue to those who contributed the financial capital.  Accounting principles and practices as interpreted by FASB and IFRS, are built around this assumption.  However, if an Information Age enterprise has a Market to Book Ratio of 12:1, it means that only 8.3% of Market Value resides in financial capital.  The remaining 91.7% resides in non-financial value, ideas, knowledge, relationships, etc.

Even today, the aspiring entrepreneur with a head full of good ideas but a thin wallet often feels that the Venture Capitalist or Investment Angel is bringing the primary value-added with their investment.  Frankly, many investors still share that attitude.  So today, we have a disconnect between the attitudes of investors and the realities of the markets.  Over time, and not that much time at that, the attitude will necessarily change.  Aspiring entrepreneurs will unabashedly come to the table with the sense that they have substantial equity with which to bargain.  As we will explore later, a Klout ‘reach’ may have a specific value based upon the more detailed ‘scoring’ that Klout now provides and will like improve over time. 

In the very near future, investors and entrepreneurs will come to the table within an Enterprise Network.  An Enterprise Network is defined as a private and bounded, opportunity rich and success prone productive environment and during the Transformation will, for the most part, replace the hierarchical, publicly traded corporation as the dominant enterprise structure.  To restate and emphasize, Corporations will not protect you from the Industrial Age Apocalypse.  In fact, they will often be ground zero.  Indemnification is to be found in an Enterprise Network. 

Most Enterprise Networks will be created to capitalize upon a specific market, technology or industry.  For example, rather than an Industrial Age News Corp, an Internet News and Entertainment Enterprise Network will create an enabling, success prone enterprise environment for independent projects and offerings. Most will be niche or demographically defined.  Entrepreneurs who join these Enterprise Networks will have ready access to investors, advisers, collaborators and, most importantly, customers.  Of course, no enterprise environment, no matter how success enabling it may be, can make a bad idea succeed.  However, this structure removes most of the impediments that can cause good ideas to fail.

This completely changes the dynamic in several ways.  By creating a bounded productive environment created to capitalize upon specific characteristics of the Transformaiton, investors will be generally knowledgeable on the factors that influence success.  The aspiring entrepreneur will need to convince the investors of the quality of the business model, however, they will not need to educate the investor on the anticipated changes in the market, technology or industry upon which the plan is based.

The investor understands and accepts these premises or they wouldn't be there.  Additionally, in a market that is pushing the limit on start-ups, the success prone nature of the Enterprise Networks will help satisfy the investors' risk concerns.  The same is true of potential collaborators, advisers and customers.  So rather than being a constant uphill battle, enterprise formation is facilitated.

While Enterprise Networks will facilitate and improve enterprise success, they are far from a guarantee.  Each business model still must be assessed based upon the cultural, social, political and economic future within which it will operate.  Clearly, the challenge for both the Information Age entrepreneur and investor is to properly assess the likely course of the Transformation and its likely impact on specific enterprises.  The opportunity that looks wonderful today can easily be overtaken by events and be completely non-viable a few years later.  Other enterprises that do not look very attractive today can play right into the Transformation and be world beaters a few years later.

Nobody can decrease the very substantial risk of an uncertain future to zero.  Such crystal balls simply don't exist.  However, all knowledge of futurity is not equal.  To say otherwise would be to say that because nobody can know for certain the result of tonight's game, that the professional sports handicapper's odds of being correct are no better than the guy down the street.  Of course that is untrue.  It is not perfect knowledge of the future, but it is superior knowledge of futurity.



3 comments:

  1. Michael, I think you have whacked some of the things going on in the economies of the world right on the head. We are in a fundamental restructuring and rethinking of the Global Economic Paradigm---and we are going to get to see it play out in our lifetimes. This is going to be interesting. The Age of the "Dinosaurs" is ending. This will be interesting ideed.

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  2. It astonishes me that even those in the industry seem to be missing just how profound this is going to be. I think that when you have spent your whole career thinking inside the box it is hard to even see outside of the box, much less think there.

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  3. I imagine the world like a packed opera theater on fire. There are four named exits. Work, play, education and exploration. The only door that operates within our system right now is work, but that door is barely serviceable anymore and only fits one person at a time. The other three are blocked from the other side by mountains of debt, red tape and weapons. On the upper level of the theater, there is a fireproof balcony where world leaders, politicians and aristocracies argue loudly over whose pile is bigger, whose God is more righteous, whose weapons are the deadliest or which imaginary line on the theater floor was stepped on by whom. Instead of lowering the ladders and tossing down fire extinguishers, they would rather continue arguing and let the people crush themselves trying to escape. Because of the internet, all the people on the bottom can now see this behavior and are doing searches to find out how to grow their own ladders and make their own wings and build their own fire extinguishers. If the owners of the balcony don't start helping out, they're going to start getting their proverbial teeth kicked in by some really pissed off people wearing homemade wings.

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