This is the once-a-week free edition of The Diff, the newsletter about inflections in finance and technology. The free edition goes out to 8,221 subscribers, up 211 week-over-week. This week’s subscribers-only posts:
- The UK as a Science Hub is an update on Boris Johnson’s plan (or, if you prefer, Dominic Cumming’s scheme) to make Britain a scientific powerhouse. The outlines of the plan aren’t new, but the opportunity is.
- The Equity Risk Premium at 0% Interest looks at the implications of low real rates for tech companies. In equilibrium, low rates are good for equities because they raise the present value of future cash flows. But another way of saying this is that, in financial terms, low rates mean the future happens all at once.
- Globalization: A Toy Story) is a prequel to today’s note, discussing the history of Hong Kong’s toy industry. Hong Kong’s toy industry was basically nonexistent in 1945, the biggest in the world by 1972, and consistently lost share to China from the 80s onward. It’s a case study in how globalization works.
- The Depressing Bull Thesis for Rocket Mortgage is a writeup of Rocket, the largest mortgage originator in the US, which recently filed to go public. Fewer red flags than expected, but it’s partly driven by a dire financial bet.
In this issue:
- Why Are Toys Such a Bad Business?
- V-Shaped Recovery is here… just not evenly distributed.
- Tech Sees Like a State: Indonesia Edition
- Clever Currency Games
- Treasuries: Bad Deal, No Alternatives
- China Equities Update
- Video Games and Pricing Power
Why Are Toys Such a Bad Business?
Early-stage investors sometimes use the heuristic that if a product gets derided as a toy, it’s worth investing in. That model would have gotten you into PCs in the 70s, the Internet in the early 90s, social networks when the good ones were privately-held, cryptocurrencies, and drones. The risk is investing in actual toy companies, which is usually a terrible decision. Hasbro stock hasn’t done anything for half a decade, and Mattel trades where it did in the early 90s. JAKKS Pacific has destroyed most of its shareholders' wealth, and Funko is working on the same.
This is not a new phenomenon, either. The biggest toy company in the US in the 50s was Louis Marx & Company, whose founder made the cover of Time. Sales declined slightly over the next decade, and faster after that; the company was bankrupt in 1980. Coleco rode the Cabbage Patch Kids trend in the mid-80s—in 1985, they had the highest return on equity of any company in the Fortune 500—but they were bankrupt by 1988.
The record is no better for retailers. Toys R Us is bankrupt, of course, and they followed FAO Shwarz, KB Toys, Right Start, and Zany Brainy.
The toy industry has not been kind to investors, at any level.
There are a few reasons, and a few relevant lessons.
First, the toy business operates on an annual cycle. Historically, about 40% of toy sales happen during the holiday season, and about half of those were in the two weeks before Christmas. (That’s a dated statistic, from about twenty years ago. Discretionary retail sales in general have gotten spikier, since more shoppers are used to fast, free shipping. With Amazon Prime, the Christmas shopping season starts on December 22nd or so.) 84% of US toy sales come from China, transported by a mix of ships and air freight, so they need to be ordered months in advance.
And they have to be marketed: while cheap toys can compete on price, the higher-margin ones only get sold when there’s an effective ad campaign. Mattel created this model (and overturned Louis Marx’s price-first approach) when they spent their entire net worth on a one-year sponsorship of The Mickey Mouse Club in 1955.
TV ad campaigns, too, tend to be purchased in advance. About half of TV ad spending is allocated to the upfronts—booked March through May to be delivered by the end of the year.
This locks toy companies into a challenging bet. Every year, they have to a) predict trends, b) invent them, and c) commit capital to them. All without knowing how the rest of the year will turn out. Since toy trends exist, but don’t last for very long, they have to invent new products every year—but the technological state of the art doesn’t advance very fast. It has all the volatility of tech, without the progress.
A handful of companies have made serious money in toys, or, rather, in toy-like or toy-adjacent businesses. The video game industry has generally done well. Disney turns a profit. And Games Workshop has a nice little business. (I wrote up in The Diff in April—note that I’ve since sold the stock, just for valuation reasons) . Lego, too, is a great business, worth an estimated $15bn.
What these companies have in common is that they escape the demographic trap that toy manufacturers are locked into. Every year, there’s a new cohort of six-year-olds, and they need something that a) didn’t exist last year, but b) appeals to timeless six-year-old sensibilities. They don’t have much brand loyalty, because a year later the same toy is a toy for little kids. Each of these successful companies beats that in a different way:
- Video games' average age has trended older over time, so instead of marketing to more trend-sensitive young people, they’re marketing to more dollar-insensitive not-so-young people.
- Disney has a generational loop, of which toys are a small part. Movies and streaming video get kids hooked on Disney characters, which can be monetized at much higher dollar values through their parks. (See my writeup here for much more.)
- Games Workshop and Lego have a very healthy product dynamic: the ones you already own are an economic complement to the ones you buy. And Lego clearly designs their marketing around hitting two generations, too: at the Lego Store, $30 Rise of Skywalker-themed Lego sets are at a kids' eye level. The $800 set based on the original trilogy is positioned at an adult’s eye level.
These companies have something else in common: they own their core intellectual property. Video game publishers do make games based on superheroes and sports leagues, and Lego certainly has branded sets, but the core of each business is IP owned by the company itself; the licensed products are a lucrative side business: it’s much easier for a video game company to re-skin characters than for a movie company to start a video game studio. As a case study, one popular game was originally intended to be set in the Game of Thrones universe, but ended up using in-house IP instead. Disney, of course, sells toys based on its own characters. And while some Lego sets are associated with outside brands at the point of purchase, they inevitably end up being fungible with other Legos.
Because it’s a hit-driven industry, toy companies that succeed can be immensely profitable for a while. The problem is that the difference between a cultural landmark and a fad is visible after a decade or so, while the decision of how much to order and how much to spend on marketing has to happen every year regardless. So toy companies with a hit product in year N tend to be bankrupt companies writing down the value of their inventory to ~$0 in year N+3 or N+5.
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V-Shaped Recovery is Here…
… just not evenly distributed. And not likely to last. In Japan, Uniqlo expects Japanese sales to be up 25% Y/Y in their August quarter, after a 15% decline last quarter. Their regional estimates are very much virus-driven, with optimism in China and pessimism in countries seeing a second wave, or, in the US’s case, a 1.5th wave. And worldwide PC shipments grew in Q2, mostly due to the one-time build-out of home offices and Zoom-based schools. In China, auto sales were up 10% in Q2 ($), and China’s copper smelting is also rising ($).
Inventory restocking used to be a significant driver of GDP growth: when the economy slowed, companies had too much inventory on hand, and had to cut jobs to work through the excess. Once they ran out, they had to rehire fast. Now, supply and demand for manufacturing are located in different places (with different policies), and companies are more averse to holding inventory for long periods, so this model isn’t as descriptive or predictive as it once was. When the people getting fired are the ones providing demand, it’s easy for a recession to feed on itself, and easy for a recovery to bootstrap itself, too. When those groups are in different countries, and when the swings in inventory are more muted, it’s less of a factor, leading to fewer recessions but much slower rebounds.
Tech Sees Like a State: Indonesia Edition
The Indonesion government is strapped for cash, and needs to spend heavily to mitigate the effects of Covid-19. But the government is not great at collecting taxes (taxes are 11-12% of GDP. For comparison, Mexico and the Netherlands have similar-sized economies, and collect 16% and 39%, respectively). But tech companies are great at collecting taxes on online commerce, and tend to charge close to the Laffer peak. So Indonesia is outsourcing taxation to them ($) by imposing a 10% value-added tax on large Internet companies. Google, Facebook, and Netflix have built their own “tax collection” apparatus, and are better at catching tax-evaders and charging the right amount. As it turns out, tax-farming wasn’t a terrible idea, just a few centuries early
In other tax news, Chinese mainlanders working in Hong Kong suddenly owe the mainland’s 45% tax rates rather than Hong Kong’s 15%. China seems to alternate—on a daily basis—between wanting Hong Kong to be a financial center they control and wanting to use their control to end Hong Kong’s status as a financial center.
Clever Currency Games
The dollar, by virtue of being the world’s most-used currency, is the currency that least represents how currencies work. Since it’s a reserve currency, dollars are demanded by people who don’t earn them or spend them, but who know they’ll need them, so the US has less control over the value of its money than any other place. To paraphrase John Connally, it’s everyone’s currency but America’s problem.
For example, there’s no way the US could get away with this ($):
Africa’s most populous nation has long maintained several exchange rates. In addition to the interbank and black-market rates, there are official rates for consumers wanting dollars for school and medical fees abroad, for Muslims making the pilgrimage to Saudi Arabia, and for people wishing to buy hard currency at exchange bureaux.
That’s a very clever setup. Smaller countries can use a tiered exchange-rate system to moderately encourage or discourage certain behaviors, or to dole out favors to particular groups. Dollars are so liquid, and used in so many places, that the US has to take a more binary approach, of allowing or banning transactions; taxes get routed around.
Treasuries: Bad Deal, No Alternatives
Alpha Architect has a negative view on treasuries, arguing that they’re not a good diversifier and that yields are too low to justify owning them. The piece goes into detail on how treasuries function as insurance (not always!), and how they’re mostly owned by price-insensitive buyers like regulated insurance companies and central banks. All true. But the most important line in the piece is: “Okay, Treasuries Aren’t Compelling: What Are My Alternatives? Answer: Nothing.” Investments are always expressed in relative terms. In an aging world, we shouldn’t expect anything to be cheap because there’s so much demand for savings.
China Equity Update
Chinese CSI 300 index dropped 1.8% in the last session, and it’s now up only 14% since late June. Bloomberg profiles the wild market, with plenty of pull quotes from new investors (“There’s no way I can lose,” sounds like a classic bull market line, but there’s a tinge of desperation there). One company, QuantumCTek, rose 1,000% in its IPO ($).
Video Games and Pricing Power
2K games is trying to push video game prices above the de facto ceiling of $60/copy. Video game prices have been declining in real terms, in part because of cheaper manufacturing and distribution. As the video game industry gets more mature, predicting sales for any given title gets easier, which encourages publishers to invest more in production. So cost deflation in one part of the market is offset by cost inflation in another.