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The Diff is a newsletter exploring the technologies, companies, and trends that are making the future high-variance. Posts range from in-depth company profiles, applied financial theory, strategy breakdowns and macroeconomics.
Should You Hedge It All?
One of the central insights of modern finance is that you should only take the risks you're being paid to take. Suppose you discover the world's most amazing, underrated CEO—a charismatic leader, an expert capital allocator, and someone you'd absolutely trust to multiply your money many times over, over an extended period of time. And this CEO happens to run a nickel mining company. So buying the stock is making two bets: your differentiated bet on the manager, and a generic bet on supply and demand for a particular metal. You could refine this by learning about the nickel market, figuring out what the long-term drivers of supply and demand are, and coming up with a differentiated view. But the other option is to just hedge that half of the bet, either by shorting other nickel miners or shorting nickel itself.
In financial markets, this is sometimes trivial to understand and often straightforward to implement. You're either calculating a correlation between asset prices to neutralize some unwanted exposure, or you're hedging something that directly correlates with the company's topline so your bet is on what's unique about the company. Capital markets make this convenient, because you can directly measure the correlation between what you're buying and what you're using to hedge. It's a popular approach, both because it's a cleaner way to express a thesis, and because stripping out extraneous variables makes it far easier to justify high pay. (See this book review of Advanced Portfolio Management for much more).
But we can easily extend this. For example, many people need to buy gas for their cars, and can't significantly vary their driving (though they have more room to do this than they used to). Very conveniently for them, there are companies out there that are entirely in the business of buying land with oil and gas in it, leasing out the usage of this land with what amounts to a revenue share, and paying all of that out as a dividend. Median US annual spending on gas is about $2,148, so for 20 to $50,000, you can (roughly!) hedge that out.
That headline number is a good start for explaining why most people don't do this: if $2,000 a year is not a worrisome expense for you, it's not worth the trouble; if it is, where are you going to find ten to twenty-five times that amount?
There are more capital-efficient hedges. But they're the wrong size; the standard oil futures contract represents 1,000 barrels, so you can hedge your lifetime consumption or none of it. You might try lower-leverage versions of this, like an ETF that tracks oil futures performance but comes in a more convenient size.
But it raises another problem: if you're making an illiquid trade—and there are no easy ways to trade a derivative based on your own future consumption of oil, beef, potatoes, or anything else—and if you hedge it with a liquid and levered asset, you can find yourself in a situation where you get margin-called on the unprofitable leg of an overall-profitable trade. This is one version of the story behind the collapse of Long-Term Capital Management. This also the proximate cause of 2022's nickel market excitement, when a huge trader got margin calls on short trades and, while he controlled enough physical nickel to make good on that eventually, did not have the ready cash available to meet those margin calls. (The nickel was mostly still in the ground.)
Hedging all that future consumption either means having an insanely high savings rate or taking on a lot of leverage, and it's simply embarrassing to get your brokerage account wiped out because you were shorting Hertz and Avis to hedge the fact that you bought a car.
There is one category where you can do this. You can lever up in order to hedge a large expense, and not have to worry about margin calls. Unfortunately, it's also a case where that's a relatively bad idea: buying a house is a way to control the risk that you'll get priced out of where you live; you're switching a floating obligation (rent) for a fixed one (a mortgage). But the local housing market is strongly influenced by local wages, so in that sense it's renting that's a hedge, especially if you live in a city with disproportionate reliance on a single industry. Houston real estate crashes when oil does; Manhattan condos are on sale when bonuses are down; Bay Area housing is a proxy for tech pay.
There's a related concept that does have some legs: using what you know about your industry to a) invest in the best companies, and b) hedge against your employer losing in some critical area. It's not crazy for someone who gets all of their money from one specific kind of economic activity to make bets that pay off if that part of the economy gets less lucrative. The good news is that this has been done before. The bad news is that the most prominent case was Enron ex-CEO Jeff Skilling, who shorted a competitor a few days after quitting his job as CEO. In general, "buy what you know" ends up being something close to "buy a revenue-weighted selection of companies that you're adjacent to in the supply chain." Shorting competitors adds to the bet that you're making on your own company. And it's coupled with another problem: especially for the outlier tech companies, there isn't a direct competitor who represents a clean bet on that outcome. Netflix is the purest bet on streaming, and shorting its competitors means betting against non-streaming video, or against cloud computing and online retail. Google is a big bet on search, but the other bets on search are small parts of other companies' product portfolios.
There are two broad models we're left with:
First, it's good to remember that for any given asset class, the global portfolio's exposure sums to 100% if it's cash, real assets, or equity, and to 0% if it's credit or a derivative. Stocks have to have an owner, so the world cannot be anything more than 100% net long the stock market. Loans have a borrower (who is effectively short the loan), and a derivative is a two-sided bet with winnings equal to losses. So, for any given kind of risk, somebody needs to bear it on their balance sheet. The people who own stocks, generally high-income net savers who are gunning for a better/earlier retirement but not seriously worried about being able to provide for themselves in the future, are the perfect demographic for warehousing this kind of risk. If the market's going to drop 20% at some point, it's ideal if the main real-world impact of this is that a large number of millionaires are millionaires by a slightly smaller margin.
The second upside from this is that concentrating your risk is, in part, the price you pay for participating in some high-upside jobs. Venture capital investors typically expect a fund's backers to put a meaningful check on themselves, but the median venture fund manager would do better if they put an equivalent amount in the S&P. There's signaling value, here, where they're demonstrating that they don't think they will be the ones underperforming other asset classes. Similarly, the pressure to buy a house past a certain point forces most people to eventually double down on whatever city they're in and buy something.
So we actually have a pretty convenient financial system. For someone who absolutely insists on hedging their risk, there are opportunities to do so; if you're worried about the price of eggs, Cal-Maine stock is right there, and not onerous to borrow. But for the most part, if you're saving responsibly the hedge is not worth the effort, and it's better to take advantage of the fact that your retirement savings can withstand the inevitable volatility of higher-return asset classes. And, in the event that you do the truly irresponsible thing—put all of your wealth into the company that also supplies you with a job, and to which your reputation is tied, too—know that while you risk losing it all, at least you haven't hedged your way out of the possibility of serious wealth.
Elsewhere
Apple Car
Apple wound down its autonomous electric car project after at least a decade of effort. One reason: it's hard to compete with Tesla. Apple's biggest successes have been in categories where there are already products, but there's room to make something visibly better than the incumbents at a profitable price point. That criterion is in some ways easier to achieve in hardware than elsewhere, because the industry has prudent risk-aversion and a tendency to target measurable year-to-year improvements over the prior model, rather than expensive leaps. That's a particularly tough contraint in hardware that's a complement to software—and, if you define software broadly enough to include media, it applies particularly well to the iPod—where the new product needs to complement some existing category and can't get too far ahead of it.
In that sense, it really does make sense to blame Tesla, since Tesla essentially adapted the Apple approach of launching a product that was clearly superior on most measurable criteria and that added a new product trait it automatically monopolized. Teslas, as individual products, are hit-or-miss; they are a testament to the tradeoff between scaling production and achieving consistent quality. But as a brand, they occupied the exact spot an Apple Car would have.
State-Directed Investment
A group of British asset managers have asked the government to require ISAs (tax-advantaged retirement accounts) to have their investments restricted to UK-based firms. From a pure efficiency standpoint, this is a bad idea, both in the backward-looking sense that the UK market hasn't done all that well in recent years and because geographic diversification typically pays off. On the other hand, it's an interesting act of market timing, because British equities are fairly cheap right now, and sometimes markets go through self-fulfilling cycles where a large amount of capital chasing a limited set of companies leads more companies to go public and more companies to go for growth. Arguably, an economy performing below its optimum should make this kind of tweak to the tax code; if you limit people's freedom to invest in a country with a better economy, they have a (costly) new incentive to improve their own.
Flywheels and Bubbles
Here's a fun piece whose intermediate-term conclusions are easier to endorse than its longer-term ones: MicroStrategy is a levered Bitcoin investment vehicle that tends to trade at a premium to the value of the Bitcoin it owns (there is also a mostly-irrelevant operating business). As long as that premium continues, it can issue stock, use it to buy Bitcoin, and simultaneously push up the value of its main investment, which, depending on the contours of market sentiment, can be a perpetual motion machine for a while. Each iteration increases MicroStrategy's representation in index funds, making it less valuation-sensitive, and also increases its impact on the crypto market through sheer size. Historically, there are very few such financial feedback loops that last indefinitely or end well; a more common outcome is to learn that there are limits to these processes.
(Disclosure: I’m short a small amount of MicroStrategy. A very small amount, since it’s easier to imagine the stock doubling than dropping to zero in the short term.)
Inflation Impacts
The WSJ has a good piece on how much independent restaurants are suffering from higher prices right now. They're getting squeezed in two directions, both of which come down to utilization:
The shift from dine-in to pickup and delivery has meant that they're bearing extra costs for packaging, while they aren't recouping as much of their rent as more tables stay empty. They could adjust prices to encourage dining in, but they're already having a hard time turning a profit. Meanwhile, if they skimp on kitchen staff, they can end up being understaffed when the peak does happen.
The big source of cost increases is labor, and the big driver of that is rising pay for gig workers. So the restaurant pays for UberEats twice, first because of Uber's cut and second because Uber's existence forces them to pay more for the workers they get.
Larger restaurants face exactly the same pressures, but have more tools to insulate themselves. They can do dynamic pricing (as long as they don't call it surge pricing, and as long as they focus on the fact that off-peak prices are lower rather than that peak prices are higher). And they have better data to determine exactly who should come in for a given shift. That's part of the broad theme of larger companies having an easier time adjusting to inflation than smaller ones.
Vertical Integration
In 2005, Boeing spun off some of its aircraft assembly assets into a new company, Spirit Aerosystems, which continued to work with Boeing but also did business with Airbus. Now, after multiple safety issues, they're thinking of buying them back. This is a good illustration of the unhedged short position theory of strategic mergers: Spirit's independent existence is, arguably, a liability for Boeing at this point, because Spirit pays the cost of more careful assembly while Boeing, as a more recognizable brand, faces the cost of an insufficiently thorough process.