Mean Reversion and Creative Destruction

Tuesday, April 05, 2011

With the risk on trade in so many things partying on, TMM are always wondering what could make the music stop not just for the markets at a whole but in particular what can really change the dynamics in individual markets and especially commodities. Tim Wu's excellent The Master Switch is mostly about information empires - AT&T, Microsoft, Google and others - but applies equally well to really disruptive change in other non-information based industries - like autos. Wu notes something oddly true about what drives changes in industries beyond the ebb and flow of GDP:

History also shows that whatever has been closed too long is ripe for ingenuity’s assault: in time a closed industry can be opened anew, giving way to all sorts of technical possibilities and expressive uses for the medium before the effort to close the system likewise begins again. This oscillation of information industries between open and closed is so typical a phenomenon that I have given it a name: “the Cycle.”

TMM think that this idea of information being a natural monopoly can equally well apply to other industries where network externalities are big - it is hard to be an auto company and require use of highly specialized parts without losing cost competitiveness. Ultimately if you are a small part of a big supply chain it is hard to stray too far from the template. As a result, Wu notes that the big shocks in IT come from people who kind of know what the existing platform is but have no vested interest in it:

Another advantage of the outside inventor is less a matter of the imagination than of his being a disinterested party. Distance creates a freedom to develop inventions that might challenge or even destroy the business model of the dominant industry. The outsider is often the only one who can afford to scuttle a perfectly sound ship, to propose an industry that might challenge the business establishment or suggest a whole new business model. Those closer to - often at the trough of - existing industries face a remarkably constant pressure not to invent things that will ruin their employer. The outsider has nothing to lose.

Disruptive industries tend to be a conundrum for the macro investor because macro primarily deals in cycles and existing paradigms - rewriting the rules is something venture capitalists think about all the time and which entrepreneurs claim they are always doing but it happens much less often than one might think. So, as a disinterested macro investor how does one determine when something might be changing in a big way? How do you tell the Steve Jobs from the whack jobs?

When it comes to equities chasing momentum can be messy - corporate profits are cyclical for most industries and great success breeds great competition over the medium term. Jeremy Grantham's unshakeable belief in mean reversion is no article of faith given GMO's track record. However, occasionally strong trending behavior is telling you something, especially in tech. To that end, look at Apple, Baidu, or others - value guys who get altitude sickness at >30x trailing PE ratios missed the boat on these names, bigtime. Things that trend this far and trade this rich do so because people slowly but surely realize that there is a paradigm shift going on - if there isn't, it is time to think about shorting. To that end, TMM have been noting some very strong trending behavior in the lithium space for some time: FMC,  Rockwood, and others its time to ask - is this it? Are electric cars ready for prime time and how is this likely to play out?

The documentary "Who Killed the Electric Car" asserted that GM basically killed the electric car to defend its existing business. While the jury is out on this they certainly dropped a promising program way too early to focus on bigger SUVs with fatter margins. There were barriers to adoption before which were as below:

1) People need to be able to adequate range on a charge.
2) They need to be able to recharge quickly.
3) The EV has to be competitive on cost on a "total cost of ownership" basis - ie, NPV 10 years of driving costs and use sensible discount rate to work out what the breakeven EV premium is.

On all these counts the old EV1 with NiMH batteries didn't really stack up - charging time was hours not minutes, range was short, and the costs were high.

However, look at the Tesla Model S and some recent changes in battery technology.

- Lithium charging in minutes not hours.
- 300 mile range.
- Cost of ownership breakeven slightly under $100 crude depending on whose numbers you are using.

One major difference between what Tesla is doing and what others like Nissan's leaf, GM's Volt and others are doing is rebuilding the car from scratch. Induction motors which don't use rare earth metals and are easier to cool are used in preference of direct drive, there is no backup power generation which obviates the need for any engine or fuel tank and most other parts are largely off the rack - the design IP is in battery management and aesthetics more than anything else which makes for a very simple and easy to service design. Compare that to the various halfway house options being offered by other manufacturers - they are too invested in their existing infrastructure and designs to break cleanly. Similarly, look at the mind blowing stupidity of Chinese auto companies which are now getting cheap loans to make lead acid battery powered cars with a range even worse than the EV1. Until TMM had seen websites like this one from Baoya Auto we couldn't reconcile the fundamental outlook on lead with current spot - now we just know its another way in which China is creating GDP out of utterly pointless investment. Absolutely every single established player in the industry cannot bring itself to make the jump and it looks like the disinterested outsider is going to have to shake things up.

Tesla seems to be doing a lot of clever things right now and may remake the auto industry - if only because all the majors cannot bring themselves to start off with a clean sheet of paper. For slightly more low beta way to play this theme it is probably better to just catch the trend in lithium miners and chemical producers as there is probably going to be a lot of competition between battery chemistries and the intermediate parts of the industry. One thing is for sure though - if this is the way it goes the whole internal combustion supply chain is going to get gutted faster than Blockbuster was by Netflix and Apple TV. TMM have one thing to say about the future of Lear and Magna if they continue as a "business as usual" proposition:
And on lead, TMM think that the bigger they are the harder they fall - every $ rise in LME lead pushes more E-bike users in China to lithium ion which is lower cost on total cost of ownership even at a 25% discount rate. We are sticking with this one - given high silver prices are inducing so much lead production in China and the pending technological shift that will kill demand, this is more likely than not going to play out like whale oil prices.

Posted by Nemo Incognito at 10:05 AM  

14 comments:

re Magna - Stronach, aside from recent leaving the management of the company, has cashed out to the tune of 860 mn by renouncing his multiple voting shares. Among his reasons was his interest in supervising the development of Magna E-Car Systems of which he is personally part owner.

Frankie agrees.

Charles Butler said...
11:16 AM  

Difficulty is, as electric vehicle technology advances, so does technology for hydrocarbon extraction and processing advance as well.

Deep offshore (Brazil) and ultra-heavy/tar (Canada, Venezuela) oil which has been heretofore uneconomical is rapidly becoming viable, and in Canada's case actually making its way onto the market.

Too many proponents of electric cars are driven by bogus ideology, be it Climate Change (formerly known as global warning) or Peak Oil; both of which have truly no basis in reality.

Anonymous said...
1:49 PM  

great post.. a little different from the normal macro man, but I like it even more...very much PM style.

though I cant agree on shorting lead. it looks like every other commodity right now.. its not really over extended at all

i will have to look into rockwood, and fmc... any other interesting stocks? battery makers (A123) have been a dud. Seems to me that battery cars and smart grid plays all to have very percise electrical equipment and I have been looking at a play on speciality electrical makers, more so than EMR or something like that

abee crombie said...
1:52 PM  

Abee Crombie I think the value in this switch is going to be in lithium, choke points in the supply chain (AC Propulsion) and winning brands (Tesla, others TBD). Batteries etc are just going to look like semiconductors unless a company can produce a truly exceptional and differentiated product which has not happened to date.

Nemo Incognito said...
2:45 PM  

Re: Tim Wu: http://techliberation.com/ongoing-series/problems-with-the-lessig-zittrain-wu-thesis/

Electric vehicles do seem to make sense for urban driving, especially fleets, (just like natural gas makes sense for freight). But didn't Top Gear rip the Tesla for many things including the range? And doesn't the distance to charge decline precipitously in cold weather? Who knows, what are the Lithium plays we can follow?

Yossarian said...
4:59 PM  

I think the Top Gear episode is pretty dated and the battery tech is a moving target right now. Other lithium plays get pretty small/mid cappy: ORE AU, TLH CN, etc. I'd avoid any spodumene / hard rock guys ex Talison - their cash cost estimates don't stack up and I doubt Galaxy Resources ever gets built.

Nemo Incognito said...
5:26 PM  

Off topic...

Our favorite Nobel laureate once again makes the elementary appear complex and provides, ex post facto, an explanation for why equities rallied:

http://krugman.blogs.nytimes.com/2011/04/04/the-transmission-mechanism-for-quantitative-easing-wonkish/?smid=tw-NytimesKrugman&seid=auto

Brilliance such as this only come along once in a lifetime, thank goodness.....

Leftback said...
6:08 PM  

LB - A certain degree of artfulness is required to make simplicity reveal anything new. Lacking this, the result is invariably mediocre, aka Krugman.

Charles Butler said...
6:58 PM  

nemo i agree completely about the disruption in the supply chian.. I just would rather play it on the long side vs short. But very true the major car companies have thier head in the sand...with ford's sync you can now get facebook updates... wow i wonder who got a promotion for that amazing idea

as for my interest in specialty electrical components, seems to me they will have a far larger use than just car, smart grid

and even the semi's (battery) had a good run in the 90's before ppl realized competition would be a killer... (no one seems to care with netflix either ).

much better risk reward from the long side.. hop on the ride for a 10 bagger

abee crombie said...
6:59 PM  

Electrovaya (EFL CN) is a small Canadian Li-ion battery developer that might be worth a look for this theme:

"
Electrovaya Inc. designs, develops, and manufactures proprietary Lithium Ion batteries, battery systems, and battery-related products. The Company develops its products for the clean transportation, smart grid power, consumer and healthcare markets. Electrovaya Inc. has production facilities in Canada and the United States, and customers globally.
"

jaguaracer said...
7:18 PM  

Tesla is suing the BBC over their portrayal claiming that the show was scripted before they drove the cars (http://www.crunchgear.com/2011/03/30/tesla-vs-top-gear/). I am moderately inclined to believe them.

As an unrelated aside, clearly you have never read a good book by the light of a whale-oil lantern. A substantially more enjoyable experience than anything I've had out here in California since the incandescent light bulb was banned. Plus, you get to imagine all those whalers stopping in the Hawaiian island on their way to Alaska to track a few sperm whales. A truly romantic experience.

BRM said...
9:45 PM  

Those geisha girls don't like you , TMM.

FX said...
12:37 AM  

You nver hear of Chinise compnay that take phlogiston out of lead make silver?
You gonna be eating your shorts TMM!

Anonymous said...
12:43 AM  

Anon 12.43

u r kidding right? .. it is AU not Ag, long time since I even thought of "dephlogisticated" substance in its "true" calx form...

On AUD though ... if Oz is the only sure bet to increase returns for the carry trade I would hate to bet against it ...

Anonymous said...
3:29 AM  

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