Wednesday, 31 August 2011

Has the nature of investment in the economy changed?

I may have more to say about this in the next few weeks, but this New York Times article about industrial policy reminds me of a question I asked on twitter the other day:
...hedge funds and venture capitalists are geared toward investing in financial instruments and software companies. In such endeavors, even modest investments can yield extraordinarily quick and large returns. Financing brick-and-mortar factories, by contrast, is expensive and painstaking and offers far less potential for speedy returns.
This might not just be a change in investors' preferences. (Although if they have decided they prefer fast returns over slow ones, I don't know that I'd criticise them for that.)

What if something deeper has happened. In the late 1940s and early 50s, macroeconomic trends were fairly clear: Europe was on the verge of a major recovery, and American growth was likely to continue. In conjunction with this, we could predict with some confidence what people would want to spend the proceeds of that growth on. Most people would want cars, houses, refrigerators and TVs.

Therefore it was fairly clear that you could make decent money by investing in factories to build cars, refrigerators, TVs - or on land in Western Europe where houses would be built. Which is fortunate, because those are long-term investments. It takes several years to build a car factory and longer to build all the related distribution infrastructure - but that investment would keep paying back into the 1970s and even 80s - thirty years out.

Today, the macroeconomic trends are still fairly clear - China and India will get much richer over the next twenty years, while the Western economies and Japan will grow more slowly, though there will still be plenty of consumer demand there.

But it looks like consumer preferences are changing much faster than fifty years ago. The thirty-year predictions we could make in the fifties would be crazy to make now. I have no clue what consumer goods or services people will want to buy in 2041.

Of course there will still be cars and fridges on sale. But those will earn lower margins than in the 1970s, and if you don't already run Toyota or LG, it's almost impossible to invest profitably in that market. Anything that takes ten years to build, when we have no idea what consumers will want in ten years, is a losing investment.

So is it any surprise that investors turn to software - which, although it is also kind of unpredictable, at least turns around quickly. You will know in 18 months whether your bet has paid off. And if it pays off, it pays off big - the returns are quick, high, and disappear in a few years.

Presumably there are some long-term physical investments that look sensible - the car battery plants in the NYT article seem to be one example - but will the current investors be able to capture the returns, or will they be competed away as employees move around and patents expire?

Maybe this is what investment looks like now - short-term, individually risky but diversified via venture capital portfolios - instead of long-term and (relatively) low-risk via stockmarket holdings. You can make a long-term investment out of lots of short-term VC stakes, rolling them over when they mature; but that's a model that most investors are probably not willing to get involved in, except via shareholdings in the occasional company like Google which can afford to operate that kind of product development model in-house. Perhaps those who want to invest for the long term have no real choice but to buy government bonds.

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