Capital Markets and Economic Regulation

Tim Brown's, head of Infratil's "Capital Markets and Economic Regulation" area, thought provoking article in the Dominion Post's 24 October 2012 got me thinking about economic investment.  Tim's thesis was New Zealand companies reinvest too little of their current profit, to the detriment of theirs - and ultimately New Zealand's - long term success and opportunities.  The legacy of low New Zealand investment was low company capital growth, manifesting in low average returns from the New Zealand share market measured over an 18 year period. 

Lets:

• Accept Tim's statistics and metrics and forget about which is "the correct" start and end points to measure international and inter-temporal average return rates;
• Accept Tim's analysis that low investment "caused" lower average returns to the New Zealand share market;
• Extend Tim's analysis, what else might be occurring?

 

Investment / Dividend Decision Making in Choice Economics

At a micro-economic level - the individual's decision-maker's perspective - existing companies choose to reinvest or return profit to their shareholders according to the options they face and the consequences of their choice.  But the value of the reinvested profit generates only a likelihood or a probability that it increased profitability will result.  No current investment is certain of generating a future profit.  The expected, probable, "could be" or "may be likely" future profit increase (not the profit level) from reinvestment is the only benefit that could support a business reinvesting its now, known and certain current profit level. 

Against that "benefit", is the opportunity cost of reinvestment - the cost of not doing the next valuable alternative use of the profit, which is - in this instance - returning the profit to the shareholders.  On the New Zealand share market, a market traded internationally, where the company competes with others for the attention of financial investors, the cost of not paying a dividend is high.  The share price falls, the credibility of management is undermined, and investor attention shifts to alternative investment opportunities, all of which generate current and future issues for the company.

So Tim is absolutely right.  From the companies perspective it probably does make sense for it to return current profit to existing shareholders and reduce the current and future impact on its share price. as opposed to reinvest the same money for a potential, maybe / could be increase in future profits.  

An Alternative Thesis:  Sharemarket Trading Peverse Incentives

But let me suggest an alternative thesis: the low investment behaviour is the result of the public dog-eat-dog short term nature of the share market itself.  Where companies DON'T trade on the share market, then the need to return a dividend as high as your neighbouring stock exchange company isn't so great.  The expected net benefit from the could-be/may-be marginal profit from the reinvested returns less the opportunity cost of not paying a dividend is much more comparatively large.   

Consequently, with less downside to reinvestment, and a higher relative upside to reinvestment, then economic theory would suggest companies which DON'T trade on the share market might have a higher rate of reinvestment.  And if they did, than all of Tim's points follow: they have higher average rates of return, and they generate more economic value for their shareholders and New Zealand over time.

To illustrate my point, I've used Statistics New Zealand's Institutional Sector Accounts (ISA) from here. The ISA distinguish between "Private non-corporate producer enterprises" which I've labelled as "Small" and assume are not regularly traded on the stock exchange, and "Private corporate producer enterprises and producer boards" which are "Big" companies who either are, or are similar to traded share market companies.

Graph 1: Returns to Factors of Production - Large/Small Companies

From Graph 1, large companies pay more of their productive surplus to their employees than they retain in profits.  Over time, they have been paying comparatively more to employees, and comparatively less to business owners.  From Graph 2 below, large business have also not fundamentally changed their Total Income to Value Added rates.  If they were reinvesting, then they would be increasing the amount of income they receive from all of their investment relative to their value added.  And from Graph 2, they have not significantly altered the level of their total income to value added between 1999 - 2009.

All of this is entirely consistent with Tim's analysis.

Graph 2:Total Income - including Investment Income to Value Added - Large/Small Companies

The bit that differs from Tim's analysis is the comparative behaviour and investment outcomes of the Private non-corporate producers.  From Graph 1, a significantly higher proportion of economic surplus is returned to owners than is paid to employed labour.  From Graph 2, significantly more of that retained surplus has been reinvested, and led to high and increasing rates of total income to value added.

Small companies tend to perceive higher relative benefits of reinvesting and face lower opportunity costs of reinvestment compared to larger companies. And, from Graph 2, they are generating exactly the investment/wealth behaviour Tim wished for stock market traded companies.

Maybe share markets are not great investment-enhancing economic vehicles?

Television and Duopoly Economics

I love duopolies: two or more companies fighting it out in an economic arena.  There's a couple of different models out there to describe the outcome of duopoly behaviour.  

One theory (Cournot duopolies) says that the companies will fight it out, matching business models and competing until both or all are "the same".  At the end of the day, each competitor winds up with about equal market share.  So if there's two companies, each will fight with each the other and wind up with half.  For example, Vodaphone and Telecom, before 2 Degrees, had simliar-ish market shares in the mobile phone market (~2.0 - 2.4 mill users), but have lost some market share to new entrant 2 Degrees.  They both share a similar business model, they are both "the same".  And, for 2 Degrees, mimicking both Telecom and Vodaphone will be a successful strategy - if nothing else changes it could reasonably be expected to secure 33% of the mobile telecommunication market.  Not too bad as a business proposition..

But then there's another theory (Stackleberg duopolies) that says one company will become dominant over the other.  Its does this through moving quickly and decisively into a dominately market position which seizes the lions share of a industry sales.  Faced with such a dominate competitor, any other firm looking to enter the market is dissuaded from actively and aggressively competing to steal market share.  Instead, they chooses to operate at a significantly lower level of size of operation, happy in niche areas, not competing for the others business. Its just easier that way:  the dominant firm is so much bigger, and the competitive fight to steal their business is MUCH harder. 

Television Industry
Take Sky TV for example.  Ever seen its balance sheet?  Compare and contrast it with TVNZ. I've reproduced the salient numbers below, together with inter-year comparisons, which I'll use to talk about the interesting bits below:

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	Sky TV				TVNZ
	2012	2011	Growth		2012	2011	Growth
Residential satellite subscriptions	682,348	641,337	6.4%		-	-
Television advertising revenue	67,235	62,691	7.2%		313,687	304,666	3.0%
Other Revenue	93,491	92,920	0.6%		33,079	35,750	-7.5%
Total Revenue	843,074	796,948	5.8%		346,766	340,416	1.9%
Subscribers	846,931	829,421	2.1%
Programme rights	216,131	209,008	3.4%		199,596	193,440	3.2%
Depreciation and amortisation	134,119	124,954	7.3%		22,964	21,277	7.9%
Other Expenses	290,921	266,265	9.3%		131,353	131,368	0.0%
Total Expenses	641,171	600,227	6.8%		353,913	346,085	2.3%
Tax	48,847	51,706	-5.5%		5,242	8,898	-41.1%
Profit after tax	122,787	120,326	2.0%		14,207	2,080	583.0%
Profit as a Percentage of Revenue	14.6%	15.1%			4.1%	0.6%
	Sky TV				TVNZ
Balance Sheet	2012	2011	Growth		2012	2011	Growth
Property, plant and equipment	364,335	364,335	0.0%		83,484	100,383	-16.8%
Goodwill	1,424,494	1,424,494	0.0%		-	-
Other Assets	173,638	151,731	14.4%		159,897	128,307	24.6%
Total assets	1,962,467	1,940,560	1.1%		243,381	228,690	6.4%
Total Equity	1,253,864	1,297,544	-3.4%		154,635	154,281	0.2%

Points to Note:

1. Although not immediately apparent, draw your eye to the $1.4 billion Goodwill figure in Sky's balance sheet.  Its main asset is goodwill which is approximately 3 times larger than its investment in physical property, plant and equipment.
    
2. Mull that number over for a bit: this is evidence of a super-normal profit.  Goodwill is an intangible figure... it represents the difference between physical assets and market value.
   
3. The next immediate difference is in revenue size - Sky is more than twice the revenue size of TVNZ and growing.  That's where the super-normal profit comes from.  Both companies increased their revenue, but in comparison with TVNZ, Sky is in a completely different league.  Its revenue grew 5.8% compared to TVNZ's paltry 1.9%
   
4. I haven't replicated TV3 revenue, owned by Canwest - a private company, because its annual report wasn't on its website.  The only numbers I found were old.  So we can't see the full television industry's Total Revenue for 2012 and 2011.  But even on the numbers we can see above, TVNZ has only 30% of the combined revenue, much lower than half and suggesting Stackleberg duopoly behaviour.
   
5. Sky managed to increase its subscribers by 2.1%, and its subscription  revenue by 6.4% - Sky viewers are paying Sky 4.3% more to view Sky TV in 2012 than in the previous year.
   
6. Sky more than doubled TVNZ's rate of growth in Advertising revenue.  So not only are consumers paying more to view Sky, advertisers also perceive the viewer benefit.  Advertisers back winners.
   
7. TVNZ and Sky paid similar programme licensing costs, but Sky's business model allowed it to capture more of the viewer's "consumers surplus"  - they were able to charge viewers a price related to the benefits the viewer received from the shows.  TVNZ, in contrast - with an advertising only business model - couldn't capture any of the viewer's benefit from viewing.  TVNZ makes money by an indirect advertising related method, compared to Sky's charging.
   
   
8. In comparison to TVNZ, the average amount of revenue it retains as profit is massive.  Approximately 15% of revenue earnt goes directly into net profit for Sky.  That's massive!  In contrast, TVNZ can only expect to pocket 4% of its revenue.  And last year, it couldn't even expect to pocket 1%.  This difference directly reflects the business models of the two companies, and Sky's able to capture consumer (viewer) surplus in its subscription model. 

So, if TVNZ is "losing" against Sky, why doesn't it change its business model, and seek to secure consumer surplus through subscriptions like Sky has achieved?  In part, the above results are the legacy of the TVNZ's Public Charter, which obliged it to focus on public service objectives and expectations, both of which are the antithesis of pay-for-view subscription.  

But also in part, comes the uphill battle associated with taking on the large market incumbent inherent in the thinking underlying the Stackleberg duopoly theory.  How else do you explain Igloo and Heartland Television which are examples of TVNZ co-operating with Sky within a commercial environment?

The Off Work Economist

Good Morning World!

My name's James Hogan, and I'm a practising Economist in a New Zealand Government department.   Importantly, I'm on holiday.  So, in between building websites, cleaning the house, and landscaping the section, I've got some time to read and keep abreast of the News of the Day.  And like all bloggers, I've got my two cents to add..


My background is in applied economics and economics statistics.  For me the "oh wow!" moment in economics occurred at Statistics New Zealand when I was looking at Retail Trade statistics. 

I was looking at sales statistics from around the country within different cities and commodities.  Hundreds of thousands of people were out there buying what ever it was that they wanted.  They weren't talking with each other, they weren't communicating or on the phone about the latest and greatest offering from retailer Y selling brand X.  But what they were all doing was acting "the same".  Sales of durables increased and decreased in unison between the cities.  Changes in petrol sales were moving similarly between the different geographical areas. 

No one was co-ordinating the decision making of the hundreds of thousands of customers, telling them what to buy, and them all abiding by that common decision.  These separate, independent peoples were unconsciously acting in unison, to coin an oft-used phrase, as if all were being moved by an invisible hand...

Economics is real.  People act (or not act) in economic ways.  They respond to their economic opportunities in a way that both shapes their decision making and which, in turn, shakes the economic environment.  They are not aware (normally) of the impact their relatively minor impact has on aggregate change.  Seeing that actual aggregate economic behaviour was a powerful message for me.

In this blog, I hope to start pulling out real life examples of where these forces of change are occurring and what they mean using real life examples of what I'm seeing in publicly available statistics, the media and as implications from economic theory.  In between cleaning, and landscaping, and probably - if my partner has her way - painting the house.

I am employed by the New Zealand Government, so these represent my personal views only, and nothing which I reflect can be attributed in any way to the views of my employer.


Thanks for reading :)

James Hogan