SOPHISTICATED FINANCE

A Refresher on the Fundamentals of Capitalism

I am very fond of asking my students to define the words they use. For example, I have yet to find a student that has a good definition of marketing, despite the popularity of marketing courses in business schools. Suppose I asked you to define capitalism, the intellectual and practical foundation for business. What would you say? Drum roll....

Capitalism is "the free allocation of capital by individuals in the service of their individual ends (within the framework of a fully competitive market)". (paraphrase of Milton Friedman) 

This definition comes from a new working paper at HBS by Rebecca Henderson and Karthik Ramanna titled "Managers and Market Capitalism". The paper argues that businesses have a moral responsibility beyond Milton Friedman's dictum to maximize shareholder returns. The authors argue that businesses have a moral obligation to serve society by preserving free markets and capitalism, which is in their self-interest, and not just satisfy the self-interest of shareholders. Essentially without capitalsim and free markets the shareholders would most likely be harmed. Therefore, egregious behavior, such as the 2008 financial crisis, undermines the integrity of free markets and is therefore immoral.

The authors provide a moral framework around the writings of Milton Friedman through a very insightful discussion of the history of the economic principles that underpin his thinking. Friedman's thinking was in large part based on the original liberal thinking of Hobbes and Locke and further advanced by Friedrich Hayek. The economic history lesson alone makes the article worthwhile for anyone who needs a refresher in the fundamentals of capitalism.

I also think the article is the best development of a moral framework for capitalism that I have read. The power of the argument is that the authors derive the requirement for moral behavior from classic economics writings alone with no reliance on another discipline. Putting Friedman in a compelling moral framework is long overdue. 

The article is here  Download SSRN-id2231526. Simply a brilliant article.

Another perspective on capitalism from another group of HBS professors is here. "Capitalism at Risk", despite the title, presents views consistent with Henderson and Ramanna albeit derived from a totally different approach . Not as rigorous an approach but equally insightful.

 

 

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The Real Reason Google Should Not Cancel Google Reader

Much has been written about Google's decision to cancel Google Reader, their RSS feed reader. This decision troubled me for several reasons, not the least of which was that I had been using this free product for several years. However, something else troubled me about this as a strategic decision by Google but I could not figure out what it was. This morning Fast Company provided the answer in an article "The Danger of Free Google Software".

Google is one of the best examples of what Clayton Christensen calls disruptive innovation. Christensen correctly argues that a more limited feature set product at a lower price point can disrupt an incumbent market leader. For example, Gmail disrupted Microsoft Outlook. The power of Google's disruption strategy is in part that they have lowered the price to zero or free.

Google has used the same strategy with the new Google Drive, which is their competing product for online storage and backup. A certain amount of storage for free, which is perhaps a better price than market leader Dropbox, might encourage people to leave Dropbox...until now. Who wants to backup their whole life on Google Drive and in 3-5 years find out that Google is canceling the product like they did Google Reader.

For Google to make a decision that potentially undermines their whole disruptive innovation strategy strikes me as a very poor decision. No matter how bad the profitability of Google Reader, such a prominent product should not be cancelled when it it risks customer confidence in Google's other free products.

 

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Philosophy and Physics

George Polya, the famous Stanford math professor, once quipped " I am too good for philosophy and not good enough for physics. Mathematics is in between". Amongst the many implications of this quote, Polya implies that there is a relationship between philosophy and physics.

The intersection of philosophy and physics is an admittedly escoteric subject but a great example of interdisciplinary thought. However, as physics advances and becomes increasingly complex, the challenge is for the philosophers to understand the physics and identify the philosophical questions that must be considered. The discipline that addresses such issues is the philosophy of science.

The philosophy of science deals with "what science is, how it works, and the logic through which we build scientific knowledge". Building scientific knowledge requires a theory of epistemology, albeit a somewhat specialized epistemology or theory of knowledge. Philosophers were doing a good job of keeping up with the physicists until recently.

The Guardian newspaper has a great article on the three possible roles for the philosophy of science, as physics and perhaps all science gets increasingly complex. The three possible roles, as defined by Peter Godfrey-Smith, are:

1. an integrative role, whereby philosophy can assess and connect various fields with an emphasis on generic categories and perspectives; 
2. an incubator role, where philosophy develops new ideas in a broad and speculative form, which are then pursued in a more focussed and specific way within an individual science; 
3. an educative role, where philosophy teaches various general skills, including critical and abstract thinking

I will leave it to to your own deliberate thinking to decide which role you believe is the right course for the philosophy of science to pursue, although the Guardian writer argues for one particular role.

Now you may be wondering why I wrote this post on a subject for which the term "esoteric" might be an understatement. My three reasons are:

1. To demonstrate that philosophy is still relevant in the modern world
2. To show that the complexity of science has many implications, to which I think we are paying insufficient attention
3. To highlight a great example of interdisciplinary thought--the philosophy of science

I also think the Guardian should be commended for writing on such a learned subject. Other posts on public intellectualism are here, here and here.

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The Reversed Classroom

Much has been written about the "upside down classroom", where students access online lectures at night and work on problems in class with the teacher. Yesterday I tried something new and had the students do the lecture and I just made comments--the reversed classroom. 

I have been wanting to try this technique ever since I discovered that children learn to teach before they learn to read. The brain develops the ability to teach before it develops the ability to read. So naturally we are all teachers. However, this natural ability is not used frequently in classrooms, except hopefully by the teacher or the professor.

Yesterday two students independently presented Michael Porter's Competitive Strategy, probably the best book ever written on business strategy. The first student elected to focus on the concepts in the book, and except for one small omission did a good job. The second student presented on the details of using the "5 Forces" and extracting value and probably did a better lecture than I do. My role in both presentations was as the play-by-play commentator in football broadcasts, interjecting comments to more fully develop an idea or to make a related point outside the scope of Porter.

The class was one of the best classes in eight years of teaching. The students were more involved than usual, asking more questions and offering more of their own ideas. Not having the burden to follow a lecture plan, I was able to expand the discussion into a wider range of related topics which made the class more interesting to the students.

At the risk of drawing more conclusions than one event warrants, my observations on why the class worked so well are as follows:

1. New presenters were a change of pace that prompted the students to pay more attention
2. Students were less intimidated to ask questions of fellow student presenters, which lead to a larger number of participants in class discussion
3. The presenters did additional research beyond reading the book, which lead then to find some excellent new presentation materials
4. The students had just returned from spring break, so they were more rested and engaged in class than normal (maybe we need more breaks during the semester)

Next week one of the students is going to present an HBS case. That will be more challenging than a book lecture. If that goes well I will keep going with this experiment of the reversed classroom.

Much has been written about how schooling diminishes the natural talents of children to be curious, passionate explorers of all things new. The natural ability of children to teach as a learning method has been almost totally overlooked. This is despite the fact that every good teacher comments on how much they themselves learn by teaching.

 

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Dropbox Buys Mailbox?

Many have reported that Dropbox bought Mailbox. Mailbox is a new iOS email app that has gotten a lot of press. Plans are to move Mailbox to other operating systems. Question one should ask is: why did Dropbox need to buy Mailbox?

On the surface Dropbox appears to be one of the most successful apps in recent years, right behind FB and Twitter. However, a great app does not make a successful company that can sustain double digit growth for several years after an IPO. Dropbox has added new features recently but those features look to me to be more related to competition and less related to growing revenue.

My view is that Dropbox needed an additional product to maintain attractive revenue growth rates. Adding another product is one way to move toward being a company and not just an app.

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Urbanization's Effect on the Environment

Only a person living on Mars for the last twenty years is not concerned by the deterioration in the environment. Many concerned people focus their efforts on forestation, farmlands, endangered species and alternative fuels. All are logical areas for research, investment and innovative solutions. However, I read little about the effect of urbanization on the environment.

In this post from 2011 I pointed out that over 700 million people will move into cities in the next 20 years. Managing the effects of this scale of migration on the environment represents an issue that needs much more attention. I anticipate that many cities will not have the transportation infrastructure to support the supply of daily necessities and the effects of hydrocarbon fuel burning vehicles will bring air pollution issues to a new level. Unless personal vehicles are banned in cities (which is not likely), the only alternative I see is to bring farming inside the cities. Of course, with so many additional people in the cities, the only way to incorporate farming is to think in cubic terms and large vertical structures.

Fortunately, some architects are already addressing the issue, as reported in this article from io9. Very cool drawings of farm buildings in cities. I particularly like the metropolitan pig farm rendering. Perhaps the pig waste will move through underground piping similar to current water systems to the tomato farms. Could have some profound effects on the nature of food exports. Wonder if the Chileans will develop and license metropolitan salmon farming technology.

Image credit: informedfarmer.com

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Presenting Financial Information

Suppose your boss asks you to send him the year-to-date six month P&L. What would you send? There are probably three alternatives:

1. Send the cumulative six month results
2. Send quarters 1 and 2 summed to a six month total
3. Send each of six months individually summed to a six month total

The proper answer is number 3. This approach has several benefits:

1. Makes it easier for the recipient to spot check accuracy by looking at values for six individual months
2. Makes it possible to do trend analysis over six months of data
3. Allows any seasonality to be obvious

Note: Unless you are a publicly traded company, I can see no reason to ever report financial information by quarter.

 

 

8 Reasons Why You Missed SXSWedu

The writers at Edudemic were nice enough to present their take on the 10 themes at SXSWedu, the edtech spinoff of the popular SXSW event. Eight themes look really boring such as BYOD, big data, MOOCS and classroom in the cloud (read the article for the other boring themes). These themes are boring to me because anyone seriously interested in education should have already figured out these issues about 2-3 years ago. However, Clayton Christensen believes that the challenge of MOOCs has not been adequately addressed by universities.

The two interesting themes from the conference are:

1. Personalized learning (incorporating personalized data into the student learning process)
2. Blended learning (redefining the role of the teacher in a technology rich educational environment)

These issues are interesting because they focus on new ways for children to learn through the use of technology. Developing new ways for children to learn should be the real focus of technology in education.

Student learning is usally a secondary issue in education today, as everyone focuses on improving school administration and teacher productivity in the classroom through technology. Administration and teacher productivity improvement are such popular topics because school district budgets represent a large market for suppliers. Also, the technology sellers have 30 years of experience in positioning their products for administrative and productivity improvement.

In fairness to SXSWedu, perhaps the writers at Edudemics missed other interesting themes at the event.

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Edudemic has a great post today on entrepreneurship by university, captured in this infographic. Maybe there is something to this studying entrepreneurship in universities. Note the information is only for six universities and overlooks all the other college educated entrepreneurs.

More on Disruptive Innovation

In a recent video interview with Mark Suster here, Clayton Christensen, the renowned HBS professor, presented some additional thinking on his theory of disruptive innovation. What was new for me was Christensen's position that disruptive innovation only applies in industries with a technology core. What Christensen means is that if an industry/product is using technology and that technology is critical to the customer experience and value creation (for the customer), then there is the possibility for disruption.

Certain industries lack such a technology core. Christensen sites the hotel industry as an example. The hotel industry cannot be disrupted. A hotel chain can only emulate a competitotr with a richer feature set for the customer. Disruption through technology is not possible. Other "old" industries such as restaurants and construction probably are in the same situation as hotels.

Another group of industries which lack a technology core are probably heavily regulated industries such as healthcare and education. Until very recently neither industry used technology for a better customer experience and only relied on technology for improved administration or staff productivity (doctors). 

Of course, the absence of a technology core does not prevent outsiders from introducing customer facing technology to "disrupt" the industry. Coursera, the online university, would be an example.

Christensen has a very gloomy outlook for the future of HBS and universities in general. He asks us to pray for HBS. If we are praying for HBS then we need constant prayer vigils for some other universities.

Christensen also believes that university education must be more focused on teaching the practical skills required by employers. For business and engineering schools I would agree. However, some of the best disciplines to develop critical thinking are philosophy, economics and history. Not sure that any of these disciplines would meet Christensen's standards for practical training.

One of many other posts referencing Christensen's thinking is here. The post references his theory of how to size a market.

General Unified Theory (GUT) of Country Economic Growth

L. Pritchett and E. Werker from the Harvard Kennedy School have released a working paper titled "Developing the guts of a GUT (Grand Unified Theory): elite commitment and inclusive growth". The paper deals with why some countries are able to generate periods of high economic growth and why some countries are able to sustain economic growth over long periods of time. Ultimately, the writers hope to provide a theory that explains both the good and bad economic performers.

Interesting points from the paper include:

1. "Nearly all of the currently rich countries are rich because they grew at a modest pace for more than a hundred years. The GDP per capita in OECD countries typically grew at around 2 percent per annum from 1870 to today.This is roughly the average pace of growth of all countries since 1960."  Steady positive growth produces better results than boom-bust sequences of growth.
2. "Countries with boom and bust have episodes of both rapid growth but also of collapse." Such unsteady growth characterizes many of the poorest countries. "One key fact that differentiates the growth performance of the “developed” countries from the “developing” countries is that developing countries are more likely to have negative shocks to growth and suffer serious reversals in those negative shocks... when developing countries are growing they grow considerably faster than developed countries—about 1.5 ppa faster (5.37 versus 3.88). But during periods of negative growth the growth is much slower—2.3 ppa slower (-4.61 versus -2.33)—and the slowness when slower is slower than fastness when fast".
3. "Countries may have the same average growth rate but very different dynamics." The UK and Ghana illustrate this point in Exhibit 1 below.
4. There is by now a large body of empirical literature suggesting that “institutions” are important to long-run economic prosperity. Institutions are both public and private sector organizations. "There is often a very strong connection between levels of prosperity and levels of the quality of “institutions” but the connection between the initial level of the quality of institutions and subsequent growth or between economic growth and changes in institutions is often very weak. What “weak institutions” mainly predict is a high variance of growth rates. 
5. "The main difference in the data in the growth rates of those countries which currently have electoral democracy and “autocracies” is that “autocracies” have a higher variance of growth rates. The highest and lowest economic growth rates tend to be in the “autocratic” category".
6. There is a tight link between per capita GDP and quality of government, which is defined as a) rule of law, b) quality of bureaucracy and c) control of corruption. 
7. For countries to create steady growth states both the political and economic institutions must be inclusive. When either type of institution is not inclusive growth is unsteady. This conclusion supports my belief that education and social inclusion are the basis of individual empowerment, which leads to the individual taking control of their economic and social well being.

The interesting case is, of course, Taiwan, Korea and Singapore, who have each gone from near poverty to sustainable growth in per capita GDP for a 50+ year period. All three are characterized by economic inclusiveness and perhaps Singapore establishes the minimum condition for political inclusiveness. Establishing the minimum level of political inclusiveness, given that economic inclusiveness appears to have been established, is perhaps the real challenge in China if they wish to establish long term, steady economic growth.

Exhibit 1

 

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TSL Education

Kara Swisher at All Things D had an interesting article on TSL Education. TSL's primary service is to allow teachers to exchange lesson plans through TES Connect. To quote from their website, TES Connect is:

"With over 2.3 million members spread across 270 countries and territories, TES Connect is the largest network of teachers in the world. www.tesconnect.com has over 2.8 million downloads a week and is home to more than 550,000 individually crafted teaching resources developed by teachers for teachers. This massive collection helps to inspire and inform teachers when they are preparing their lessons."

While many are focused on improving teacher productivity through technology (in the classroom), perhaps more attention and investment should be directed toward making traditional tools available through the technology. 

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