QBR
MON•IPO•LY
Overly exuberant investors may not be the sole cause of the IPO jump.
Monopoly sellers charge a price above intrinsic value. p.20
The Queen’s Business Review
FEBRUARY 2014
ISSUE NO. 1
LETTER FROM THE EDITOR
TABLE OF CONTENTS
Real Estate
World
Business
Economics
Finance
4 8 14 18 21
Foreword:
Letter from the Editor
3
Is Brazil Ready for its
Largest Celebration?
12
IPOs as a Monopoly:
How Issuers Profit
Canada Needs an Exit
Strategy for CMHC
Big Box vs. Culture:
Kensington Conundrum
4
Is My Social Network Worth
$180,000?
6
Fashion Stagnation:
A Look that’s Here to Stay
16
14
Equity Risk Premium:
A Misleading Indicator
At the Top of its Class:
On Teachers’ Private Capital
Queen’s Global Markets:
Predictions for 2014
8
Canadian Food Retail:
A Cramped Space
17
All that Mines Gold
is Not Gold
Dollar Troubles:
The CAD in 2014
10
Intellectual Rent:
The Knowledge Economy
18
I
21
22
-2-
24
Editor-in-Chief.
David Kong
and layabouts have all been thrust—ready or
not—into a frothy, turbulent environment of
perpetual change. All of us must adapt our way
of thinking on a daily basis, gathering vital new
data minute-by-minute, or risk being left behind. Into this maelstrom, we boldly venture.
This is the inaugural issue of The Queen’s
Business Review (Or QBR, for short. Around
here, there’s not often time to say our own
name in full.) It is brought to you by a team
of undergraduate business students at Queen’s
University in Kingston, Ontario, Canada. Although our home is a lovely small city beside a
lake, our perspective is anything but provincial.
At this writing, many of us are currently living
and studying in locations around the globe,
from France to Hong Kong to Australia and
several points in-between. From my window, I
look out across the rooftops of Paris, with the
happy hubbub of the street echoing up to me
from below, the sounds of clicking heels on
cobblestones carrying distant echoes of Samuel
Morse’s urgent dots and dashes. If you listen
and pay attention, everything communicates.
The Queen’s Business Review exists to illuminate, inform, advise and educate our engaged readers by sharing our collective voice,
with its global point of view. Our first issue explores how firms and industries are reshaped
by accelerating change. In “At The Top Of Its
Class,” we look at how a private equity fund
executed a contrarian strategy to become a
national leader in direct investing. In “A Look
That’s Here To Stay,” we analyse whether the
high-fashion industry has stalled, as copycats
emerge in the information age. We ask, “Is My
Social Network Worth $180,000?” We look at
what takes it to distinguish yourself from your
peers in today’s business world in “Brand Yourself.” There’s more.
We go beyond analysis to propose new ideas. In our cover story “IPOs as a Monopoly”,
we present an economic theory on how issuers
can earn supernormal profit. In “Intellectual
Rent,” we show how value accrues to knowledge even when it isn’t used. We present an
exit strategy for CMHC and a business strategy
for RioCan.
QBR’s purview encompasses business,
economics, finance, investing, real estate, entrepreneurship, and technology. Together with
our readers, we face the mysteries of the future
with confidence: our impetus is the power of
“Collective Intelligence, Intelligently Applied”.
We hope you enjoy reading this inaugural issue
as much as we enjoyed producing it.
-Tom Kewley
2013-2014 QBR Team.
Christine Bancroft
Kyle Butler
Paul DeSadeleer
Chris Haliburton
Michael Karp
Tusaani Kumaravadivel
Chester Lau
James Lee
Yingxi Liao
Yang Liu
Keenan Murray
David Murray
William Upans
Riley Webb
Fraser Wells
David Wilson
Josh Wine
LETTERS
SUBMISSIONS
Write for QBR
HIRING
Work for QBR
Please email comments on articles to
letters@qbreview.org. There will be a
letters section in our next issue.
Set your ideas in print. Send your article
for publication in our next issue to
submissions@qbreview.org. Deadline for
our next issue is March 1st, 2014.
Join the 2014-2015 executive team.
Positions span funcions in graphics,
writing, IT, layout, art, sales, linguistics
and more.
Email executive@qbreview.org.
Applications will be posted on our
website soon.
n 1844, Samuel Morse convinced the United States Congress to give him the modern
equivalent of $1,000,000 to build an experimental telegraph line between Washington and
Baltimore. Morse’s scheme was thought to be
foolish and impossible. But he persevered and
lo and behold, his telegraph worked. Once decoded, the dots and dashes of its first transmission read: “What Hath God Wrought?” It was
the world’s first ‘text message’, and from that
day forward, information moved faster than
ever. Today, 170 years later, the Internet contains over one trillion unique links, accessible
from a small, portable device that fits in your
pocket. On those all-too-frequent overly-busy
days, it almost makes one want to send an SOS.
Thank you, Mr. Morse.
Yes, we inhabit an interconnected world,
which means we live on a high speed, complex
merry-go-round. Heads of state, business leaders, academics, students, citizens, busy-bodies
TOGETHER WITH
OUR READERS, WE
FACE THE MYSTERIES
OF THE FUTURE WITH
CONFIDENCE
Director.
Tom Kewley
Linguistic Editor.
Lauren Coles
Art.
Emily Gong
Sara MacLellan
Editor.
Jonathan Claxton
Adviser.
Lance Fraser
Online.
Alex Lam
Graphics.
Yuting Pan
Endword:
Brand Yourself
Write to QBR
20
CONTRIBUTORS
26
-3-
February 2014, The Queen’s Business Review
over the past ten years, no aspect of CMHC’s
business model requires it to question this secular updraft in real estate prices. Because macro prudential oversight is not part of CMHC
mandate, it is under no obligation to consider
the effect of its conduct upon the economy as a
whole. Notwithstanding that its mortgage guarantee programs facilitate assumption of ever increasing residential mortgage debt by Canadian
households, CMHC is not required to weigh
the destabilizing effects which the rising levels
such mortgage debt impose upon the economy.
As a result, it has acted as a pro cyclical agent,
automatically responding to each increase in
prices with increased levels of mortgage insurance. Incentivized by the proportionately larger
fee and interest revenues associated with larger
loans and insured against any risk of default,
mortgage lenders have also had little reason to
question the sustainability of rising real estate
prices. The combined effect of this partnership between the government, CMHC and the
Canada Needs an Exit
Strategy for CMHC
Conceived as an instrument for making housing
affordable to ordinary Canadians, Canada
Mortgage and Housing Corporation (CMHC)
has evolved into a significant contributor to
housing price inflation and a source of social
and economic dysfunction.
WILLIAM UPANS
W
ith Canadian household debt exceeding 165% of disposable income and housing prices which are
among the most overvalued in the world, the
need to reform federal housing policy has become compelling. The Federal Government is
a major player in the housing market. Through
the CMHC, it guarantees the principal and interest on $560 billion in residential mortgages,
amounting to 31.5% of all outstanding Canadian residential mortgage debt. Although private
sector owned Canada Guaranty and Genworth
Financial Canada also offer mortgage insurance
in Canada, CMHC dominates the field, with an
estimated 75% - 80% market share.
CMHC extends mortgage insurance to
borrowers who would not otherwise qualify for
housing loans. Because CMHC’s obligations
are 100% guaranteed by the federal government, lenders perceive CMHC-insured mortgages to be virtually risk-free. Not only are they
prepared to lend to sub-prime borrowers who
have CMHC backing, they are prepared to do
so at effectively subsidized rates which do not
reflect any risk of default. The first theorem
of welfare economics states that competitive
markets lead to Pareto optimal allocations of
resources. Pareto optimality is attained when
it is impossible to make one person better off
without making at least one person less well off.
It is a classical measure of economic efficiency.
Parliament created CMHC in 1946 for the express purpose of overriding the market forces
which would otherwise govern the behaviour of
the residential mortgage industry. In so doing,
Parliament implicitly accepted that CMHC’s
activities would produce a less than Pareto
optimal allocation of credit within Canada.
The intended payoff for this distortion of the
free market was an increase in the availability
of affordable homes for ordinary Canadians,
particularly World War II veterans and their
extended families.
CMHC’s Pro-Cyclical Effect on Housing Prices
For the first half-century of its existence,
CMHC delivered on its progressive mandate
without serious ill effect. However, an inflection
point occurred around 2003, when the worldwide boom in real estate prices began to gather force. In the ten years following this point,
nominal average Canadian house prices approximately doubled, significantly outstripping
increases in nominal wages. In the same period,
CMHC’s mortgage guarantees more than doubled, from $230 to $560 billion. Despite the
irrational exuberance of Canadian homebuyers
THE MOST PLAUSIBLE
TRIGGER FOR A
REAL ESTATE CRASH
IN CANADA IS A
RISE IN INTEREST
RATES ABOVE THEIR
PRESENT HISTORIC
LOWS
mortgage lending industry is the creation of
an efficient pipeline which seamlessly delivers
credit to the residential real estate market at
historically low interest rates and in apparently
unlimited amounts, all fully guaranteed by Canadian taxpayers.
Economic Disequilibria
This system has created a range of unintended
economic disequilibria. As the IMF recently
pointed out in its country report on Canada,
the availability of risk-free CMHC backed res-
Household Debt to GDP
Household Debt to GDP at its highest yet
120%
100%
80%
60%
40%
20%
0%
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
Statistics Canada
-4-
CMHC Mortgage Insurance in Force
CMHC has slowly crept higher
700
600
500
400
300
200
100
0
1996
1998
2000
2002
2004
2006
2008
2010
2012
CMHC
idential mortgages has prompted lenders to
prefer residential mortgage lending to business
lending. As the IMF points out, in the long run
loans to businesses tend to have a more positive effect on increasing GDP per capita than
investments in residential real estate. By putting businesses at a relative disadvantage in the
competition for credit, the CMHC’s mortgage
insurance operations effectively divert capital
from more productive uses to comparatively
unproductive investments in real estate.
Another criticism by the IMF is that while
federal insurance of home loans insulates Canadian banks from mortgage lending losses, it
also subjects the Government of Canada to substantial contingent liability in the event of a catastrophic real estate crash and is consequently
a source of financial instability. At $560 billion,
the massive scale of this contingent liability rivals net federal debt, which is $671 billion. The
bailouts of the banking systems of the United
States, Iceland, Ireland and Spain following
real estate crashes clearly demonstrate the long
term economic costs of socializing the real estate losses of the financial sector.
CMHC IS NOW FAR
TOO LARGE TO BE
SOLD TO ANY SINGLE
BUYER
Currently, the most plausible trigger for a
real estate crash in Canada is a rise in interest
rates above their present historic lows. In the
event of even a 2-3% upward movement, many
households burdened by substantial mortgage
debt will be forced to sharply reduce consumption, with potentially substantial adverse effects
upon aggregate demand and negative knockon effects on tax revenues and employment.
Among the households most at risk would be
those with high-ratio CMHC backed loans, because their relatively high interest expense to
income ratios would leave them with little room
to maneuver.
Looking beyond personal and public finances, CMHC’s insurance programmes have
also promoted a degree of distortion within the
Canadian labour force. In December 2012, the
construction industry employed 7.2% of the labour force. This can be compared to 4.2% of
the non-farm labour force in the United States
within the same period. With its source of subsidized capital, Canada’s construction industry
is larger than it otherwise would have been, and
when the perpetually predicted real estate crash
occurs, crippling job losses in this sector will
surely follow.
Social Inequities
Because of the role it has played in propelling
housing prices higher than they would otherwise have been, CMHC shares responsibility
for a series of social inequities. The first social
group which has been aggrieved by the inflation
of housing prices is lower income households.
With the prices of even modest homes now
beyond the reach of lower income earners in
many of Canada’s urban centers, CMHC has
ironically played a role in increasing economic polarization rather than reducing it, as it was
originally intended to do. The second group
whose interests have not been well served is
young households. First time buyers are generally younger than existing homeowners. As a
result, the advent of steeply rising house prices
has contributed to already alarming intergenerational wealth transfers. (The saddling of
younger generations with rising levels of public
debt and unfunded pension and health care liabilities are other examples of such intergenerational wealth transfers.) While downsizing baby
boomers have been cashing out of their homes
at inflated prices, the young families who are so
often on the other side of the sale transactions
have been driven to assuming enormous mortgages to finance their purchases. A third group
which may yet fall victim to the current system
is renters. If a massive real estate crash were
ever to occur, all taxpayers would bear the burden of covering CMHC’s losses, including the
30% of households which are not homeowners.
Wind Down the Mortgage Insurance Business
It is evident that Finance Minister Flaherty is increasingly restive about the massive size of CMHC’s mortgage insurance portfolio. In a recent
speech, he told listeners: “Regrettably, CMHC
became something rather more grand I think
than it was intended to be. We’ll see over time
-5-
what that role should be.” Clearly, significant
changes to CMHC’s mandate are now within
the realm of contemplation. We would suggest
that those changes should be profound and
that their implementation should be pursued
as a matter of priority. CMHC was conceived
in the immediate post-war era, when massive
state intervention in the economy was still fashionable among liberal Western democracies.
Enthusiastically supported by bankers, realtors,
builders and others benefiting directly from the
market distortions caused by its mortgage insurance programs, CMHC continued to grow tremendously in size during decades littered with
the failure of other state-owned enterprises. It
is now a dinosaur in an age in which the most
successful democracies confine government’s
role in the economy to regulation rather than
direct participation.
CMHC is now far too large to be sold to
any single buyer. In any event, it would be undesirable to transfer CMHC’s market dominant
position to private hands. Preferably, CMHC’s
mortgage guarantee business would be gradually wound down. Existing clients would be
allowed to keep their CMHC coverage, while
new clients would be channeled in the direction
of the corporation’s existing two private sector
competitors and towards new mortgage insurers who would be encouraged to enter the Canadian market. The first line of business to be
terminated should be the bulk insurance which
CMHC provides to banks to enable them to
convert pools of mortgages into marketable
securities. The termination of CMHC’s retail
mortgage insurance should come next, but
should be spread over time, enabling private
insurers to develop the capacity to handle the
new volumes of insurance they would be called
upon to underwrite. Government guarantees
of the liabilities of privately owned mortgage
insurers should also be eliminated over time.
Approaches along these lines were used with
success by the Government of Australia when
it withdrew from the mortgage insurance market in 1997. Because of their complexity, size
and importance, the winding-down of CMHC’s
mortgage insurance programs should be gradual. However, in light of the scale of the housing
bubble which now exists in Canada, it is vital
that the government begin its withdrawal from
the mortgage insurance business without delay
and by doing so put an end to the economic
and social dislocations which its long involvement in that business has caused. After all,
there is nothing truly unique about the mortgage insurance business that requires it to be in
the hands of the government. Accordingly, the
optimal approach to this business is the same as
to almost any other: leave it to the free market.
http://research.stlouisfed.org/fred2/series/USCONS
http://business.financialpost.com/2013/12/06/flaherty-cmhc-mortgages/
http://www.imf.org/external/country/CAN/
http://www.fin.gc.ca/frt-trf/2013/frt-trf-1303-eng.asp#tbl15
http://www.statcan.gc.ca/tables-tableaux/sum-som/l01/cst01/econ40eng.htm
February 2014, The Queen’s Business Review
Player B (Other
Consumers)
Shop at
Shift to
Kensington Walmart
Prisoner's Dilemma
Wal-Mart and Kensington should co-exist
Player A (Any Individual
Consumer)
Shop at Kensington
4,4
4,7
Shift to Walmart
7,4
3,3
1 Payoff is achieved utility; numbers are arbitrary but demonstrate the overall dilemma
2 The payoff is highest for consumers when they shift purchases but others do not, allowing for
both establishments to exist simultaneously
3 The payoff is lower when both players shift purchases to Wal-Mart as Kensington Market
becomes degraded and provides less utility
4 It is assumed that a world with only Kensington Market is slightly better than a world with WalMart and a degraded Kensington Market
Big Box vs. Culture
How Should RioCan Approach its Kensington
Conundrum?
ELLIOT SEETNER
W
hether they like it or not, real estate developers are in the business
of building communities. If a project is deemed threatening to a community, unprofitable conflict can occur. RioCan became
very intimate with such conflict earlier this year
when the company proposed a three-story retail development on Bathurst Street just blocks
away from Toronto’s cherished Kensington
Market. The development’s major tenant was
planned to be Wal-Mart, the arch-enemy of
many small business owners. While complaints
from locals can easily be dismissed as hippie
hogwash, a deeper examination of the situation
can uncover a fundamental and legitimate market failure.
RioCan’t
For Torontonians, Kensington Market is a cultural icon. Beginning as a settlement for Jewish
immigrants, the neighbourhood has become
home to a wide diversity of foreigners, and is
currently packed with eclectic clothing stores,
specialty groceries, cult-following restaurants,
and other unique retailers. Most notably, the
area has vibrant ‘Pedestrian Sundays’ every
weekend during the summer months, with musicians, artists, food stalls, and more, which always draw a large crowd. Aside from locals, the
area attracts some 500,000 “pleasure” tourists
every year (Toronto Visitor Market Report);
accounting for business and other visitors, the
total number is likely much higher.
In May of 2013, real estate giant RioCan
released plans for a development that includ-
Kensington Market Failure
So, if the locals do not like Wal-Mart, why
does the development pose a threat to them?
Politics aside, one can see a paradox in the activists’ claims. On the one hand, if Wal-Mart
actually served a need in the area, its presence
would promise only improvements to the relative standard of living and utility of the locals.
On the other hand, if 89,000+ residents truly
despised Wal-Mart as much as they claim, the
store would become unprofitable and pose no
threat to Kensington Market; few would choose
the new store over the Market!
REAL ESTATE DEVELOPMENT IS THE
BUSINESS OF BUILDING COMMUNITIES
ed a two-story Wal-Mart unit and underground
parking. In response, local residents have
voiced great concern and an activist group,
Friends of Kensington, has gathered more than
89,000 signatures petitioning against the proposal. The highly publicized ordeal led Toronto City Council to pass an interim control bylaw
and freeze the development for a year.
Needless to say, the Financial Post’s Outstanding CEO of the year, Ed Sonshine, was
not happy with this decision. While he and his
company wait on the outcome of their appeal to
the Ontario Municipal Board, it is worthwhile
to examine the root of the problem. This may
help RioCan and other real estate developers
avoid future conflict and foster positive relations with the communities that they operate in.
-6-
This, of course, is not true and the problem
lies in the Market’s value as a public good and
its vulnerability to the issues of collective action.
The individual shops of the area provide unique
offerings, but more than that, they together contribute to a culturally rich environment; in few
other areas can consumers encounter artisan
breads, live reggae music, street dancers, and
flea-market goodies all at once.
While this environment provides utility to
consumers, a Wal-Mart would undoubtedly
provide additional utility in the form of convenience and low prices. A significant portion
of Kensington Market’s consumer base (especially the locals) would likely shift a portion of
their shopping to the new big-box store. While
they will likely continue activities such as eating
meals and drinking coffee in the Market, cloth-
ing and grocery purchases may become WalMart-sourced.
This then leads to a Prisoner’s Dilemma;
each consumer maximizes utility when both
Kensington Market and Wal-Mart exist, but the
collective shift of consumer dollars to the new
store threatens many small shop owners (see
matrix). While certain, committed individuals
will renounce Wal-Mart shopping in protection
of the Market, the latent nature of the consumer
base in question and the increased payoff from
shifting at least some purchases to the new store
will lead to overall significant changes in the
small shops’ demand. Due to high rent and an
overall large fixed proportion of their costs, this
decrease in demand will likely force many small
shops into illiquidity and insolvency. Without
the ability to lower their costs quickly and compensate for this decrease in demand, the overall
Market will see shutdowns and degradation. As
a result, consumers will be left with Wal-Mart,
a decaying or completely non-existent Kensington Market, and an overall lower level of utility.
Not Hogwash at All
Clearly then, with this possible and maybe even
likely outcome, the activists and City Council
have rational concerns. From the latter group’s
point of view, in addition to threatening over-
EVEN SHOPPERS
DRUG MART OR
LOBLAWS WOULD
CAUSE LESS
CONTENTION
all citizen utility, a threat to Kensington Market
threatens tourism and its associated additions
to tax revenue. Moreover, protecting this neighbourhood is a key step in bolstering Toronto’s
brand and self-esteem, which has been made
only more important amid the downpour of
Rob Ford-driven negative publicity.
Make Friends, Not Enemies
From the REIT’s perspective, community support cannot be seen as just an important but
a critical factor of success. RioCan’s business
model is fundamentally reliant on development
projects and taking in rent; any hindrance to
these activities will cause the company to have
issues in profitably employing its assets and paying fat dividends to shareholders. With a stock
price currently down more than $3.50 (12%)
since the beginning of this ordeal, the company
is under pressure to overcome such hindrances, restore stable returns and brace for an approaching increase in interest rates (the stock
depression is likely unrelated to the Kensington
Market challenge but further compels action
from RioCan in this realm).
The Kensington Market situation is not the
first and will not be the last time the compa-
THE COMPANY CAN
BE MORE SELECTIVE
OF ITS TENANTS
AND COGNIZANT
OF POTENTIAL
NON-MARKET
BACKLASHES
ny’s objectives come into conflict with that of
a community. To manage such conflicts in the
future, it and other real estate companies must
consider the market failure that arises; most
consumers would appreciate and benefit from
a Wal-Mart development on its own. However,
the threat of losing a cultural community diminishes this appreciation and can and will cause
lengthy and costly delays.
To solve the apparent problem, RioCan
could do several things. First, the company can
be more selective of its tenants and cognizant
of potential non-market backlashes that may
arise in response to them. Wal-Mart directly
competes with the small businesses in the Market, has operational advantages which cannot
be matched by them, and holds an extremely
negative stigma; proposing a Wal-Mart was
proposing the market failure described earlier
and provoking public outcry. By choosing less
controversial tenants, the company would be
able to more easily complete its development
and still earn high returns - even Shoppers Drug
Mart or Loblaws would cause less contention
-7-
(higher price points and their positions as less
direct competitors would evoke a less significant shift of demand).
Second, RioCan can position itself as a
community partner, rather than exploiter, by
supporting the neighbourhood and culture. For
instance, sponsoring Pedestrian Sundays and
other Kensington Market events would help
sustain the area’s vibrancy and financial success,
while also improving the company’s public image. Even if some consumer dollars shift to the
new development, such funding can compensate. If this shift is predicted to be substantial
and still threaten the neighbourhood, RioCan
can push Toronto City Council to provide re-
RIOCAN CAN
POSITION ITSELF
AS A COMMUNITY
PARTNER, RATHER
THAN AN EXPLOITER
lief; tax breaks for the small businesses would
help them manage their finances with the new
competition and sustain the historical and cultural landmark.
Eternal Sonshine
Together, these actions would mitigate or eliminate an evolving market failure. Torontonians would benefit from both establishments,
achieving higher utility than would be achieved
with only one. City Council would save the
important area and foster the improvement of
Toronto’s brand. Finally, RioCan would avoid
constraining regulation and further advance its
business model.
While an argument can be made that
bankrupting cultural neighbourhoods is a part
of efficient economic development, it is not a
strong one and it is not one that the public will
accept. By appealing City Council’s decision
and taking no steps to satisfy the community’s
interests, Sonshine is implicitly supporting this
unacceptable argument. If he is to successfully
navigate through the Kensington Market ordeal and reinforce his well-earned title as a top
CEO, he will need to change his perspective.
Although the recommendations proposed will
subject RioCan to some additional expenses
and investments, it will drive public approval
and serve the company well going forward. If
RioCan and other real estate companies are to
continue building communities, they must join
them first.
Toronto Visitor Market Report 2011. Rep. Tourism Toronto,
2011. Web. Jan. 2014. <http://www.seetorontonow.com/getattachment/7de27a85-eb45-44b3-af29-70dafc9875a1/Market-report-(full).
pdf.aspx>.
February 2014, The Queen’s Business Review
Queen’s Global Markets
Predictions for 2014
Venezuela will devalue its
exchange rate by at least 20%.
Canada & USA
By the end of 2014, the US will have
announced at least two more rounds of
tapering, although the stimulus program as
a whole will remain over $30B.
The labour market is expected to improve
in 2014 but the participation rate is still
disappointing and reflects continued
economic
problems.
Improving
unemployment rate means it is almost
certain that another couple rounds of
tapering will be announced. The first two
round of QE were used to help the US
balance out its economic troubles after the
toxic asset crisis and housing bubble in
2007/2008. QE III has had a limited effect
on the economy, and so tapering will not
have as drastic effects on the economy as
thought by some economists. The Fed
will be cautious about moving forward
and likely will not end the program until
the “magical” 6.5% unemployment rate is
actually achieved, at minimum.
The US trade deficit will decrease to below
$32 billion by the end of 2014.
The US has made gains in energy
production, a significant factor to lowering
the trade deficit, with a 5.6% increase in
petroleum exports in November 2013. The
value of oil imports has also decreased, in
part because of weaker foreign oil prices.
With a stronger dollar and international
supply forecasted to increase, imports
will likely continue to decrease over the
year. Oil exports will continue to increase,
following the 2013 trend - exports were up
10.8% over the first 11 months compared
to those in 2012. Exports of industrial and
capital goods and autos also increased in
late 2013, a trend that should continue
into 2014 as consumer spending increases.
There will be a slower than anticipated
GDP growth in France, at approximately
0.55%, due to higher than expected
unemployment rates and widening export
losses. For the past few years much
attention has been given to the economic
plight of Southern European countries.
However, many of these nations have made
economic reforms and are now on positive
growth trajectories. For instance Spain,
Portugal, and Italy have all have forecasted
GDP growth rates between 0.3% - 0.8% for
this year. official
In January of 2011, the tiered exchange
rate system merged to become one
fixed currency pegged to USD at 4.3
USDVEF. The currency was massively
overvalued and February 2013 saw
devaluation to 6.3 USDVEF. This was
catalyzed by lower than expected GDP
growth (only 1.5% in first half of 2013),
lack of sufficient internal production,
and restricted access to foreign goods
due to an overvalued currency and
other government factors. All matters
considered, the previous currency
devaluations and policies will not have
enough of the desired economic effects,
and 2014 will see further devaluation.
Latin America
Dilma Rouseff will win the 2014 Brazilian
Presidential Election.
The incumbent president of Brazil,
Dilma Rousseff, has presided over a
tumultuous time for her country since
being elected in 2011, and the country’s
economic growth has slowed since
her election. Brazil continues to be
plagued by corruption at all levels of
government, and this has been brought
to the forefront with large street protests
throughout 2013. Despite all of these
challenges, no credible threat has
emerged amongst Rousseff’s competitors
who have announced their candidacy,
and the opposition parties are all divided.
Recent polls show Rousseff leading with
47% support, compared to 19% for her
closest competitor. -8-
Much of the economic fear for 2014
will shift from peripheral nations to core
European nations.
Egypt’s EGX30 will reach 7500 by the end
of the year.
Japan will restart majority (>50%) of
nuclear reactors.
China’s 2014 GDP growth will be between
7.1-7.6 percent.
Egypt’s main stock index, the EGX30,
will reach 7500. The rationale behind
this figure is based on an assumption of
inherent political stability in Egypt this year.
It is nearly without contention that General
Abdel Fattah al-Sisi will run for president,
and he faces no obvious challenger for the
post. With the EGX30 index currently
trading at 13.78 P/E, valuations are by no
means lofty. Since 90% of trading on The
Egyptian Exchange is conducted by local
Egyptians, a favorable internal political
climate and a year of peace will permeate
through to higher valuations.
Since the 2012 Fukishima nuclear crisis,
the majority of Japan’s nuclear plants
have been offline and waiting for a
restart clearance. With a huge portion of
nuclear energy plants being shut down by
regulators, utility companies have turned
to replacements such as coal, heating oil,
and natural gas. However, importing these
energy resources is more expensive than
using nuclear energy and has contributed
to Japan’s large and rising trade deficit. China’s GDP will continue to grow, but at
a lower rate than in 2013. China’s GDP
growth in 2014 will be between 7.1 and 7.6
percent as it shifts its focus to long-term,
sustainable growth. Although China is
expected to undergo a variety of regulatory
changes in government and local economics
in 2014, which should improve certain,
key issues that are currently being faced,
a number of important factors remain to
be considered. Xi Jinping’s leadership has
made it clear that China is willing to accept
an overall slower growth rate, as long as this
allows for consumer-driven, sustainable
growth into the future.
Asia Pacific
China
Europe
Israel will not declare war on Iran this year.
Although the sanctions recently put into
place on Iran’s nuclear program are not
in the best interests of Israel’s security,
Israel will likely not attack Iran this year.
The international community will closely
monitor the nuclear program, and, if Iran
steps out of line, the United States may
potentially be the first to declare an attack.
Iranian President, Hassan Rouhani, seems
more open to negotiations with Israel
and the international community than his
predecessor Mahmoud Ahmadinejad.
The EU will continue to face mediocre
economic growth in 2014, running the
possible risk of deflation.
Fragile recovery will continue in the EU
as it faces mediocre economic growth in
2014. The GDP had already shrunk by
about 0.4% in 2013, of which 28 countries
had demonstrated an average of zero
growth. In 2014, it is predicted that the
EU’s GDP will merely grow by 1.1%. This
slow economic growth can be particularly
attributed to Cyprus and Slovenia, the two
worst performing countries expected in
2014. Cyprus is predicted to face further a
GDP reduction of 3.9%, while Slovenia’s
GDP will fall by 1% from 2013. Midterm Elections in France will give the
UMP more seats than the Socialist Party in
both houses.
Francois Hollande has been the latest in a
line of controversial French Presidents. The
policies of his party, the left sided Socialist
group, have struck up global debate as to
its effectiveness for France’s economic
and social state. Since his election in 2012,
France has not seen significant enough
growth, and Hollade’s popularity has
plummeted. Unless there is a significant
turnaround in France, expect the French
to voice their displeasure with how the
Socialist party has run the country in its
first two years. This will be demonstrated in
the midterm elections: both in the Upper
and Lower Houses, the Union pour un
Movement Populaire, will take more seats
than their Socialist counterparts.
Middle East & Africa
The current Egyptian government will
legitimize its claim to power by initiating an
election process scheduled for 2015.
The current Egyptian government will
receive the support of western powers
like the United States. They will initiate
improvements in education (current
literacy rate 73.9%) and look to improve
the economic environment with a focus
on international trade. The Muslim
Brotherhood will continue to subtly build
its forces and resort to violence at times
throughout 2014. However, the Muslim
Brotherhood will not rule Egypt because
the current government will receive support
from western powers and its military forces.
Hang Seng Index will reach 27,000.
The Yen will fall at least 15% against USD
in 2014.
Continued monetary stimulus by the Bank
of Japan will exert downward pressure on the
yen throughout the year. Investor demand
for yen will fall along with the Nikkei once
currency risk is priced in. A disappointing
‘third arrow’ will do little on the supply side.
Increasing commodity prices (resulting
from a weaker yen) will push inflation
beyond the 2% target, initiating a negative
feedback loop that will further weaken the
yen, while simultaneously risking escalating
inflation. This could threaten the low
interest rates that support Japan’s massive
public debt. President Goodluck Jonathan will resign.
For
Nigeria’s
current
President,
Goodluck Jonathan, the days of Nigerian
optimism and support for his People’s
Democratic Party (the party to which his
two aforementioned predecessors also
belonged) certainly seem distant. Mr.
Jonathan will ultimately resign because he
wants to ensure the longevity of his party.
He knows that a handoff of power to the
Vice President, and the appointment of a
new party leader long before a contentious
election year, is the best chance he and his
party have of maintaining power. Narendra Modi will become India’s next
prime minister.
India is in serious need of reform from its
financial sector, to its labour market, to its
infrastructure and power grid. Narendra
Modi is a proven reformist and is what
India needs to get back on track in order
to command the growth it should be
experiencing given its labour mobilisation.
Despite his bloody past, Modi will remain
committed to change, evidenced by his
recent tenure and actions in Gujarat.
-9-
The economic reforms that the Chinese
government announced recently will help
transition from an investment-fueled
economy to one that relies more on
consumption. The effect of these reforms
will be felt in the market in the coming year
and the Hang Seng Index will see substantial
growth as a result. These economic reforms
will help sustain the growth rates shown by
the Chinese economy, which should entice
investors into putting money into Chinese
stocks and securities. Queen’s Global Markets (QGM)
has a mandate to monitor
the economic variables of the
important economies in the world
and offer ideas and actions that
direct policy-makers. QGM is a
premier undergraduate economic
think-tank that considers the
forces that make the world turn.
Here, QGM members make
predictions on their region of
expertise for issues that will be
resolved by the end of 2014.
February 2014, The Queen’s Business Review
The Canadian Dollar
in 2014: A Diamond
in the Rough or
a Landmine for
Investors?
Commodity prices, Bank of Canada monetary
policy, and tapering of US quantitative easing
are just some of the many factors that will
substantially depreciate the Canadian dollar
this year. However, Canadian investors can
not only hedge against these risks in 2014, but
profit from them.
ALEXANDER CARBONE
T
he Canadian dollar (CAD) is widely regarded as a fairly stable currency, and
Canadian investors have become accustomed in the years following the 2008 financial
crisis to a CAD/USD exchange rate hovering
in the $0.95 - $1.00 range. At the beginning
of 2014, a suite of economic forces seemed to
align perfectly to lead to the depreciation of the
Canadian dollar. Gone are the days of a Loonie at par with the USD, and it would not be
surprising if Canadians saw a Loonie of ~$0.88
- $0.89 against the greenback by mid-2014. Despite these turbulent times for Canadian dollar
depositors, the Loonie’s impending depreciation will create many new investment opportunities in different sectors of the economy. This
article will reveal these opportunities and their
implications for investors.
2014 did not start off exceptionally well
for the CAD. In fact, in early January, the
Canadian dollar reached a 3-year low against
the USD. The first of many catalysts driving this
devaluation was the Federal Reserve’s decision
on December 18th, 2013 to taper quantitative
easing by $10 billion per month. The news may
have come as a surprise at the time; however the
idea of QE tapering has been widely discussed
by economists and media sources for quite
some time. Although there is much support
in the academic and professional community
for the first two rounds of quantitative easing,
a consensus exists amongst some economic
commentators that QE III, the third round of
bond-buying initiated by the Federal Reserve,
has largely failed to have an impact comparable
to the previous two rounds, and is inherently
excessive. However, the effect of the decision
was a rally for the USD, as investors quickly
discounted the news. The ensuing decline in
the Canadian dollar was likely driven by equity
investors flocking to the FX markets to collect
USD in order to purchase American securities.
The threat of continued QE tapering will
have a magnanimous impact on the Canadian
exchange rate, pushing the dollar down, as
investor sentiment regarding US GDP growth
and equity market performance brightens.
Of course, the effect of quantitative
easing on the Canadian dollar is an obvious
analytical conclusion for any investor with a
basic knowledge of monetary policy and its
effect on the FX market. Now, we can turn
the discussion to less conventional sources
of CAD depreciation in 2014. Rumour is
rampant that the Bank of Canada may continue
to lower interest rates in 2014, with Governor
Stephen Poloz claiming that the tool would
be available and is not out of the question.
There are several concerns that may warrant
a rate decrease. However, upon surveying the
existing information available, it is clear that the
most significant is continuing low inflation in
the Canadian economy. Some inflation places
healthy pressure on wages and consumer
spending to grow, and disinflation or deflation
are certainly not symptoms of a healthy
economy. Lower interest rates would further
deter foreign investors from the Canadian
- 10 -
bond market and a variety of Canadian-held
assets out of fear of insufficient returns. This
would exasperate the effects that tapering
would have on the dollar, causing investors
to exchange their CAD for USD in a firesale style. These low rates would also provide
incentive for Canadians to fund the purchase
of expensive, durable goods. With a cheap
dollar, however, imports would not be the
economical option. Therefore, we may actually
see growth in durable goods manufacturing
sectors in Canada, as imported goods become
unfavourable due to lower interest rates (or
even continued low interest rates), and the
CAD remains at a disappointingly low level.
THE CANADIAN
LABOUR MARKET
IS EXPECTED
TO PERFORM
DISAPPOINTINGLY IN
2014
This presents the first potential opportunity
for investors looking to get their “feet wet” in
the Canadian market – manufacturing. With
Canadian goods perceived as ‘cheap’ on the
markets and for the domestic demand reasons
specified above, the manufacturing sector may
actually be positioned to see an increase in
output later in 2014.
Unlike its southern neighbour, the
Canadian labour market is expected to
perform disappointingly in 2014, with the
unemployment rate rising from 6.9% to
7.2% as of a January 10th announcement.
The magnitude of this change was largely
unexpected, although a careful analysis shows
that the Canadian labour force participation
rate is at the lowest it has been, 66.4%, in nearly
48 months. This demonstrably justifies that
Canadians have increasingly been removing
themselves from the labour force, a testament to
the slow economic growth affecting the country.
Naturally, investors have chosen to exchange
Canadian currency in an effort to invest in
economies with better signs of growth, such
as the United States. Disappointing economic
indicators provide support for the conclusion
that the Canadian economy is not positioned
to demonstrate a growth trajectory equivalent
to that of the United States. Low productivity,
poor economic conditions in Eastern Canada,
and a trade and export deficit has positioned
Canada’s economy for slow growth and its
labour market for decline.
An interesting implication is the
effect of the labour market on Canadian
savings patterns. As consumers have less to
spend, and are faced with the possibility of
unemployment, savings accumulate, increasing
the funds available for investment and lending
activities by financial institutions. Out of this
prediction, another opportunity is born. As
unemployment increases Canadian savings,
investors will be drawn to US assets and
engage in a sell-off of CAD. In turn, this will
decrease Canadian purchasing power, and,
combined with unemployment, will increase
the savings rate in 2014. Furthermore, as banks
have greater capital available to them, they will
CAD/USD Exchange Rate
The CAD has exhibited continued strength until recently
1.2
1.1
1.0
0.9
0.8
0.7
0.6
2004
2005
2006
2007
2008
MANUFACTURING,
FINANCIAL
SERVICES, AND OIL
AND GAS PRESENT
SUBSTANTIAL
INVESTMENT
OPPORTUNITIES
Canada’s massive trade deficit is an
interesting point of discussion in reference to
currency. A deficit of nearly ~$940 million was
declared in early-January 2014, largely driven by
2010
2011
2012
2013
Bloomberg
reduced crude oil prices. Governor Poloz also
reported that the export sector may not recover
as expected this year, continuing the large trade
deficit to the dismay of economists. A declining
currency will have both an apparent and notso-apparent effect on this. A cheap dollar will
incentivize foreign companies to purchase
Canadian-manufactured goods, helping to
combat the trade deficit by boosting exportbased industries. However, the not-so-apparent
effect lies within what constitutes the Canadian
export industry. The outstanding issue is
commodities, with a particular emphasis on
oil prices. While economists and analysts have
different opinions, a prevailing one is that the
price of crude oil should fall in 2014, driven by
a variety of factors. One is simple economics
CANADIAN INVESTORS SHOULD NOT
DESPAIR OVER THE ENSUING DECLINE IN
THE CAD, BUT EMBRACE IT
be incentivized to increase lending activities,
offsetting the potential effect of an interest rate
decline and contributing to the relative health
of the financial services sector. Therefore, it is
plausible that Canadian banks will continue to
provide solid returns in 2014 despite the threat
of reduced net interest spreads.
2009
– some may argue that the time lapse in the
production of oil is expiring, and investors
are realizing that supply is increasing with
disproportionate changes in demand, especially
given the economic troubles that Europe and
other parts of the world continue to face. The
effect on Canada is interesting, for Canadian oil
prices are at a five-month high (as of January
2014), and, although conventional crude oil
prices (such as the West Texas Intermediate)
might see a decline, Canadian heavy crude
oil may outperform analyst expectations,
thus increasing the profitability of Canadian
oil sands producers. Subsequently, the trade
deficit gap may be positioned to close as a result
of increased demand for Canadian-produced
goods (fuelled by a favourable exchange rate for
foreign consumers) and higher oil prices.
An apparent opportunity would be to go
long on the Canadian oil sands. However, it
is important to transcend this simplicity and
present a deeper rationale for investing in
Canadian oil and gas. US economic growth
should increase the demand on the Canadian
economy for crude oil. This oil is refined in
the US and then distributed both within the
US itself and to international trade partners,
including Canada. US demand, a low CAD,
and a glut of Canadian heavy crude due to
favourable Canadian crude prices, will fuel a
positive feedback loop stimulating the Canadian
- 11 -
oil sands. Some skeptical readers may challenge
these premises, asserting that increased demand
for the Canadian export would help offset the
decline in CAD by increasing demand for CAD
to pay Canadian suppliers. However, one must
consider that Canadian distributors will likely
buy a significant portion of this refined oil back
in order to support their own domestic needs,
once again exchanging CAD for USD to pay
US refineries. In addition, pressure from the
sources noted previously in this article (ie. a
poor labour market and the continued threat
of QE tapering) will help to keep this offset
low. Some may inquire as to why the US would
choose to purchase Canadian oil if it is indeed
priced so favourably. The Western Select
Canadian Crude historically trades at a discount
to other popular crude streams, such as the
West Texas Intermediate, or WTI. These
factors will contribute to a productive and
profitable Canadian oil sands industry in 2014
and beyond, rendering Canadian extraction
companies a formidable investment.
The result of the above analysis is that
Canadian investors should not despair over the
ensuing decline in the CAD, but embrace it.
Manufacturing, financial services, and oil and
gas present substantial investment opportunities
to not only hedge against losses from Canadian
assets but ultimately turn a profit. In other
words, opportunities exist at large for investors
to expose themselves indirectly to FX risk
without engaging in the volatility of the FX
market. In conclusion, the CAD is not to be
feared, but to be embraced in 2014. The
shrewd investor should remember that, where
a short-sell opportunity exists, there is always an
opportunity to go long on an investment that
will react positively to the short opportunity.
The tenacity to find those opportunities is what
makes the difference between achieving the
market’s expected rate of return and an alpha
on the investor’s portfolio.
http://www.investopedia.com/university/forexmarket/forex4.asp
http://www.telegraph.co.uk/finance/economics/10526794/Federal-Reserve-begins-tapering-QE-what-the-analysts-say.html
http://www.google.ca/finance?q=CADUSD
http://www.bloomberg.com/news/2014-01-07/canadian-currency-fallsfor-second-day-as-trade-deficit-swells.html
http://www.vancouversun.com/business/Major+misses+employment+send+Canadian+dollar+tumbling+half+cent/9372060/story.html
http://www.thestar.com/business/2014/01/10/canada_hit_by_unexpected_rise_in_jobless_rate.html
http://www.huffingtonpost.ca/diane-francis/canadian-economy-2014-risks_b_4508675.html
http://business.financialpost.com/2013/08/26/canadians-savings-raterising-but-record-debt-will-remain-for-a-long-time-td/
http://business.financialpost.com/2014/01/07/canadas-trade-gap-widens-in-blow-to-recovery-hopes-as-u-s-trade-deficit-shrinks-to-4-year-low/
http://www.forbes.com/sites/billconerly/2013/05/01/oil-price-forecastfor-2013-2014-falling-prices/
http://www.theglobeandmail.com/report-on-business/economy/economy-lab/what-will-happen-to-commodity-prices/article16075906/
February 2014, The Queen’s Business Review
Is Brazil Ready for its
Largest Celebration?
What mounting tension in Brazil means for the
upcoming World Cup.
DAVID WILSON
O
ver the coming years, the eyes of the
world will be trained firmly on Brazil.
First, the country will be hosting the
2014 FIFA World Cup. Then, in 2016, its second largest city, Rio de Janeiro, will be hosting
the Olympics. Brazil is a nation that enjoys a
party; every February it is home to the world
famous Carnival. However, with ballooning
costs and an ambivalent population, many are
wondering whether Brazil will be ready for the
two largest parties of them all.
Ever since former Goldman Sachs Asset
Management chairman Jim O’Neil coined the
BRIC acronym in his 2001 report, “Building
Better Global Economic BRICs,” Brazil has
been a symbol for the growth of emerging economies in Latin America. However, tensions are
rising in the Portuguese-speaking nation. These
tensions have been magnified by the wave of
protests that have been occurring throughout
the country since June of 2013. The Brazilian
public’s frustration stems from the country’s
spending of vast amounts on sports projects, despite the little efforts that the government puts
forward to change its languishing social system.
Economic growth has slowed down remarkably
in the last two years, and social and political tensions are higher than they have been in a decade. Brazil’s ability to see any kind of benefit
from their hosting of both the World Cup and
Olympics is now in doubt.
A History of Disparity
Disparity has been woven into the fabric of
Brazil ever since the Portuguese colonized the
country in the 16th century. It has modernized
very quickly during the 20th century and, as
a result, various forms of inequality have become more visible. There were a few reasons
for this; however, the most important was the
weakness of Brazil’s education system, a trend
that is seen in many other third-world countries.
This problem holds true in Brazil: the public
school system is far behind its peers in other
G20 countries, and students in the very worst
of Brazilian schools are an estimated two years
behind their peers in the best schools. At the
age of five, Brazilian children are either directed into the dilapidated public system or,
if they can pay, into the high-achieving private
system—there is no middle ground (Otis). Rio
de Janeiro’s education secretary quotes this as
being “educational apartheid” (Costin). The
education system has become such that it promotes two separate classes rather than a healthy
middle class. With a GINI coefficient of 54.7,
Brazil has the second highest rate of inequality
in the G20 (World Bank). This disparity, because it has been present for decades, has created problems that manifest themselves in the
older demographics.
Economic Context
Throughout the recessions of 2008 and 2009,
as well as the ensuing times of turbulent economic activity, Brazil has symbolized growth
prospects in emerging economies. After having
been awarded the 2014 World Cup in 2007
and Rio de Janeiro being named host of the
2016 Olympics in 2009, it was anticipated that
Brazil would be at the forefront of a global economic resurgence. However, six years after being named World Cup host, economic growth
has stalled as many historical problems prevail.
As preparations are being made throughout
the country for the World Cup and Olympics,
Quarterly GDP Growth in Brazil
Brazil has been facing its worst economic slowdown in recent years.
At a glance, Brazil holds many qualities that
foreign investors find appealing. The country’s
political system has become more conducive
to business growth; policies have been put into
place to influence growth of the domestic economy, and incentives for foreign investment have
been created. A large proponent of Brazil’s
rapid growth through the late nineties and early
2000s was because of its strong manufacturing
and industrial sector. For an economy with
such promise, growth has been hesitant. The
fundamental problem faced in Brazil’s economy is high inflation and low domestic growth.
GDP growth, for Q1 of 2013, was a mere 0.6%
despite inflation sitting at 6.5%. (Economist).
Foreign demand for Brazilian goods has
stayed high, however their problems center
on the lack of domestic demand. Rather surprisingly, the central bank has decided to keep
interest rates high in an attempt to prioritize
lowering inflation rather than influencing higher growth. Impacts of this slow-moving economy can be seen throughout the country, with
an alarming lack of infrastructural development
and comparatively low wages. The slowdown is
appearing in World Cup preparations as well as
many projects which have been put on hold because of lack of funding. Because of stagnating
economic momentum, it has been near impossible to complete many of the necessary projects for the World Cup. The Brazilian public
is attempting to voice its opinions regarding the
effects of social and economic tensions created
by the weakening domestic economy and vast
inequalities throughout the country.
Recent Uproar
June 6th, 2013 is a day that will haunt Sao Paulo
municipal politicians for years to come. On this
day, bus fares were increased by 20 centavo, or
9 cents. This action, a spark that has ignited a
bonfire of uproar, has turned into one of the
largest protests in the history of Brazil. Protests
that kindled in Sao Paolo rapidly spread across
the country. In what has become known as the
‘V for Vinegar’ movement, the focus of the
public’s frustration centers on the dated social
systems throughout the country (The Economist). The crux of the problem lies within the
manner in which Brazil will be spending huge
amounts on sporting events in the next three
years, while still retaining debilitated education
and infrastructure. The protesters believe they
have picked an opportune time to make their
claims— the watching eyes of the world will only
amplify their collective voices. Similar protests
occurred prior to South Africa’s World Cup;
however, in general, the population of South
Africa was more receptive to the tournament
than that of Brazil. A change in domestic perception will be crucial to making the next three
years successful.
Looking to the World Cup
June 12 of 2014 is the first day of Brazil’s World
Cup. By then, many issues must be resolved.
Firstly, there is the issue of infrastructure. Most
of the stadiums have yet to be finished. Of the
twelve stadiums the tournament will be using,
only 6 of them had been completed at the start
of 2014. Originally with a budget of $1.3 billion
(USD), the project has vastly exceeded this ceiling, with costs estimated to go beyond $4 billion. Although the common perception is that
an international sporting event will give a substantial boost to the host nation’s economy, this
is far from the truth. Of the 17 Olympic Games
since Montreal in 1976, only seven have been
profitable for the host cities (CNBC). Similarly,
The FIFA World Cup is not much better in financing the cost of their events. For example, if
you take into account the decrease in GDP for
the host country during the competitions compared to non-World Cup times, the US World
Cup in 1994 suffered a cumulative loss of 5.6
billion dollars, despite FIFA recording record
profits (Los Angeles Times). Similarly, South
Africa is expected to recoup a loss after paying
off its debt from the 2010 tournament. With estimated stadium costs of $4.2 billion, the 2014
tournament is expected to be among the most
expensive World Cups of all time (Reuters). It
will be a tricky proposition for Brazil to derive
an economic benefit from their hosting of the
sporting event.
After the past decade of slow growth and
high inflation in Brazil, any economic boost is
necessary. The World Cup however, is unlikely to provide this. The tournament looks to
be shining a spotlight on the systematic problems occurring in the nation. If the next three
years are to run smoothly, key issues must be
rapidly addressed. The unrest caused by educational, racial and financial inequality is one of
the largest challenges, and it is near impossible
for the event to succeed if the current level of
negligence persists. The extensive project costs
have already demonstrated a grave mishandling
World Cup Stadium Costs (000's)
Growth in the country is screeching to a halt.
10%
Costs of building a stadium have been increasing
$5,000
CNBC. (2012, June). Olympic Cities; Boom or Bust. Retrieved from
CNBC.
Costin, C. (2013, January 7). Educational Apartheid.
Economist. (2013). Brazil Stuck in the Mud. Retrieved from
Economist.
Los Angeles Times. (2010, January). Give the World Cup Bid a Red
Card. Retrieved from Los Angeles Times.
Otis, J. (2012, January 13). Educational Apartheid in Brazil. Retrieved
July 2013, from Global Post: http://www.globalpost.com/dispatch/
news/regions/americas/brazil/130111/brazil-education-income-inequality
Reuters. (2013, April). Soccer Stadiums on Track but Costs Soar.
Retrieved from Reuters.
The Economist. (2013, June 22). Taking to the Street. Retrieved from
The Economist: http://www.economist.com/news/americas/21579857bubbling-anger-about-high-prices-corruption-and-poor-public-servicesboils-over
8%
$4,000
6%
$3,000
4%
$2,000
2%
$1,000
0%
2010 Q1
2010 Q4
2011 Q3
2012 Q2
2013 Q1
$0
Germany 2006
South Africa 2010
Brazil 2014
World Bank
- 12 -
by the tournament organizers. If the organizers
and the Brazilian government wish to see the
long lasting benefits from the World Cup they
must follow a drastically different path to those
of preceding tournaments.
Firstly, the World Cup must be used as
an exhibition of investment potential in Brazil. With the eyes of the world focused on the
nation, Brazil has an excellent opportunity to
demonstrate the competitiveness of their business. Current protectionism measures such
as high tariffs have recently been ineffective.
Brazil could benefit by looking to its smaller
neighbour, Uruguay, which has successfully
promoted its foreign competitiveness by forming numerous, lucrative bilateral trade deals. As
mentioned, the domestic economy has drastically slowed; therefore Brazil must look to
foreign trade and take advantage of the World
Cup as a way to stimulate growth and activity.
Secondly, political and social reform must
be executed. Brazil has one of the worst government services of any G20 country. The infrastructure necessary for the tournament will be
able to provide some help. The recently implemented improved transit system and other public services may scratch the surface of addressing Brazil’s structural problems, however more
high-level change is needed. A firm commitment to invest in better healthcare and stronger
education systems must accompany any boost
that improved infrastructure provides. If this is
executed, social tensions will be eased as growth
is enabled and more Brazilians will be able to
move into the middle class.
It is already well-known that the Brazilian
World Cup will be a monumental expense.
With the event quickly approaching, very little
can be done to change this. The odds are not
working in Brazil’s favor to create a successful
event. However, this does not mean that the nation cannot benefit from its position as host. If
the tournament is used as a catalyst for foreign
investment, and it has long-lasting infrastructure
and social benefits, then there is no doubt that
the World Cup will be prosperous. Of course,
a home team victory would help.
It is a difficult task to predict how the
World Cup and Olympics will affect the country, and, with the negative public perceptions
and institutional problems these projects face,
organizers will find it a challenge to deliver on
their promise. No matter how this era in Brazil’s history will be remembered, it is certain to
have a lasting effect.
Reuters
- 13 -
February 2014, The Queen’s Business Review
The Business of Attention
Internet has the second highest attention and third highest ad spend today
50%
Is My Social Network
Worth $180,000?
42% 43%
40%
30%
20%
The democratization of sharing media online
inspired the creation of “cultural value,”
which subsequently increases the valuation of
socially-driven startups.
10%
26%
23%
14%
6%
22%
12%
10%
3%
0%
Print
TOM KEWLEY
Radio
Time Spent (%)
TV
Internet
Mobile
Ad Spend (%)
U.S. 2012, KPCB
I
n the past two years, Facebook has made
two significant acquisition offers. The first
was to Instagram, for $1 billion in cash and
stock options. It was accepted, and closed as a
$715 million transaction in 2012. The second
was to Snapchat, for $3 billion. That offer was
rejected in 2013. Both of these offers are immense sums of money, especially as each target
possessed zero dollars in revenue. It is at times
like these, with infinite valuation multiples for
fledgling tech companies, when market commentators say venture capitalists are not smart
investors, valuations are frothy, and the world
has gone crazy. Real, revenue-generating businesses are struggling, while those without clear
business models are thriving.
Modern culture, which can be loosely
defined as including art, communication, and
interrelation between people, has increasingly
featured technology as the middle-man for
its dissemination. If one considers the role
that Instagram plays in photography, and
that Snapchat plays in communication – with
millions of users, and even more millions of
interactions between those users – then it is clear
that within the depths of the ‘social graph’ there
is financial value. Therefore, it is conceivable
that holding a slice of market share within this
industry of culture will give certain companies
an intangible component to their valuations:
cultural value. Famous artists transform human
emotion and the world around them into art
using a paintbrush on canvas. Now, the digital
democratization of sharing media online has
spurred the creation of a new “cultural value”
that contributes to the valuation of certain
hot technology companies such as Facebook,
Instagram and Snapchat.
Instagram
Instagram transforms people’s ho-hum smartphone photos into beautiful, sharable snapshots
of their lives through the careful application of
one of 19 digital filters. According to Robin
Kelsey, a professor of photography at Harvard,
what we are seeing in the market today is “a watershed time when we are moving away from
photography as a way of recording and storing a
past moment, [and we are] turning photography
into a communication medium.”
Instagram has done an incredible job of
“democratizing” the field of photography so
that amateurs can compete on photo quality
with professionals using a few taps of their
finger. Instagram now has over 150 million
active users on its platform, threatening the
social networking giant Facebook with its
rapidly increasing mindshare among the
coveted teenage and early-20s demographic.
From Facebook’s perspective, the risk of a loss
of users and diminishing engagement on its
own platform are two factors that would equally
terrify the advertisers that support Facebook’s
$140 billion market capitalization. Therefore,
there is immense value in investing in fledgling
From $0 to $180,000?
An average student is worth upwards of $180,000 to advertisers
First-Degree
Connections
Service Total
Users (mm)
Valuation
($mm)
Value per
Connection ($)
My Social
Valuation ($)
Facebook
637
1,100
140,000
127.27
81,073
Twitter
188
218
31,000
142.20
26,734
LinkedIn
540
225
27,000
120.00
64,800
Snapchat
61
8
860
107.50
6,558
Instagram
142
150
715
4.77
Total
- 14 -
677
$
179,841.04
Source
companies that provide value outside of what
larger firms are able to develop internally.
Buying a product that organically develops a
loyal user base, where those users spent a great
deal of time, is a natural move for Facebook,
who wants to attract more impressions for its
advertisers. It is common to see fairly intense
bidding in M&A processes like this, for many
firms can see the obvious competitive value of
building a defensive moat around their core
consumer product. Instagram is an excellent
example of strategic value meeting and creating
cultural value.
Snapchat
Not to be outdone, another popular social
communication app, Snapchat, similarly allows
people to instantly share microcosms of their
lives in the form of self-destructing photos.
Like Robin Kelsey’s analysis, well-respected
tech commentator, Gary Vaynerchuk, recently wrote an article titled “You See Snapchat as
Sexting and a Fad. I See the Future.” His thesis
argues that all companies are in the business of
attention, and, in a world where microseconds
are prized by consumers and advertisers alike,
forcing consumption of content for 3-10 seconds is a very unique and addictive restriction.
Vaynerchuk’s piece earned attention in the tech
community and a response from Pando Daily’s
Ryan Hoover. Hoover further develops the
thesis, arguing that Snapchat, in a similar vein
as Instagram, has created habitual engagement.
According to Hoover, Snapchat has done this
a few ways: through friction-free creation, lowered inhibitions, one-to-one ‘hyper-personal’
communication at scale, read receipts, and
feeding individual curiosity.
Snapchat’s user base sends 350 million
photo messages per day. Its 23-year old CEO,
Evan Spiegel, raised $60 million in capital for
his 17-person company at a jaw-dropping $860
million valuation in June 2013. Snapchat’s
rapid ascent into such a dominant position in
the instant messaging space has caught many,
including venture capitalists, off guard. The
same question has to be asked – how is this
company worth $860 million if it is not making
any money? Facebook, again, is terrified by the
prospect of lost users and lost advertising dollars.
In response, they tried to make a Snapchat
clone, Poke, which failed. On October 25,
2013, Snapchat announced its intention to raise
more venture capital at a $3.5 billion valuation.
That same day, rumors surfaced that Spiegel
Fail to go far enough, and report one too many
‘revenue-free quarters,’ and you will eventually
go bankrupt unless supported by a third-party investor. This time period, referred to as
the ‘death valley curve,’ is essentially the time
post-financing, pre-revenue. Overflow this territory with high-valuation companies, and you
have speculative risk being absorbed by venture capital firms, and headlines in major news
publications speaking of an impending bubble.
Snapchat remains in this territory. Instagram
escaped it by being acquired.
Advertising is the logical way out of this
chasm. Within media, advertising is king.
Facebook’s acquisition offer valuations are
based on future advertising spending. In terms
of advertising spending versus time spent by
TODAY, AVERAGE TEENAGERS HAVE SOCIAL
NETWORKS AND ONLINE ‘BRANDS’ WORTH
6-FIGURES
reportedly rejected the advances of Zuckerberg
and another $1 billion offer. Facebook’s
Instagram has even developed a competitive
product, Instagram Direct, which seeks to
capture users’ attention with hyper-personal
messaging. Again, this strategic value, coupled
with the inherent (and defensible) social and
behavioural value that Snapchat has created,
gives the company significant cultural value.
Startups Bridging the Death Valley Curve
In the early days of a socially-based tech startup,
making money is the wrong goal. To a point,
user metrics are superior indicators. In a blog
post titled, “How will they make money?” reputed Silicon Valley venture capitalist Josh
Elman of Greylock Partners, says, “There is
a reason that the first five slides of Facebook’s
quarterly earnings reports are exclusively dedicated to reporting user numbers.” With Facebook’s market capitalization now exceeding
$140 billion, the question posed by Elman was
one that plagued the company for the first era
of its existence. In the social realm, the path to
monetization of a user base is dangerous. Go
too far, and you risk alienating your user base.
medium, there is now a material shift away
from traditional media (print, radio and TV)
toward new media (Internet and mobile). Mary
Meeker, of KPCB, a large California-based
venture capital firm, cites the upside of this shift
as a $20 billion opportunity in the United States
alone. Many firms and investors are attempting
to earn their share of this opportunity; closely
following the time spent can be a leading
indicator for dollars spent. This is the root of
the cultural value Facebook has identified in
Snapchat and Instagram.
Implications for the Individual
If the trends of the population have a value,
then the individual’s social networks must also
have a role in the conversation. In 2003, Instagram, Facebook, and Snapchat did not exist.
Neither did other major players in the social
realm, such as LinkedIn or Twitter. Today, average teenagers have social networks and online
‘brands’ worth 6-figures to advertisers and other
tech companies.
With this in mind, it is no wonder that
a sense of narcissism develops around the
individual’s creation and curation of his or
- 15 -
her ‘art.’ This is the ‘industry of culture,’ the
‘business of attention.’ Nathan Jurgenson, in a
recent piece for The Atlantic, took the whole
idea of fueling a narcissistic feedback loop
one step further. He proposes that people
– especially young people – are in danger of
developing a ‘Facebook Eye,’ with “moments of
everyday life increasingly informed by thoughts
of what might best translate into a Facebook
post that will draw the most comments and
likes.” Jurgenson is not the first to assert that
“Facebook’s most valuable asset is not simply
its millions of users, but the millions who are
constantly updating their likes and dislikes, their
friends and acquaintances – and, increasingly,
their daily behaviour down to the minute.”
This is a daunting proposition. But it is also
why social applications that gain mass following
‘DEATH VALLEY
CURVE,’ IS
ESSENTIALLY
THE TIME POSTFINANCING, PREREVENUE
will always hold value. Get too much attention
from a loyal user base and you will get acquired
(Instagram), or get massive rounds of venture
financing (Snapchat), or file for your own public
offering (LinkedIn, Facebook, Twitter).
Valuing a low-revenue startup is difficult.
Investors are simply trying to place a bet
that there will be logical path to ‘exit’ so they
are able to return dividends to themselves
or their limited partners. Applications that
change the fundamental psychology and
sociology of human communication must
be worth something. Relying on predictions
and unscientific intuition, there’s no telling
whether that statement will be accurate over
the long-term, or whether we are currently
seeing the second great bubble of the consumer
technology industry.
How I calculated the value of my social network: The average value
per connection on each platform is calculated using most recent
private or public valuation figures of each company, divided by the
disclosed number of users each service claims. Roughly taking firstdegree connections (followers on Twitter, connections on LinkedIn,
or friends on Facebook) as a proxy for ‘connectedness’ into each
respective social graph, a valuation can be assigned to an individual’s
social network.
http://www.huffingtonpost.com/2013/04/09/tinder-datingapp_n_3044472.html
http://www.theatlantic.com/technology/archive/2012/01/the-facebookeye/251377/
http://www.huffingtonpost.com/2013/04/09/tinder-datingapp_n_3044472.html
http://bits.blogs.nytimes.com/2013/06/30/disruptions-social-mediaimages-form-a-new-language-online/?_php=true&_type=blogs&_r=0
http://www.linkedin.com/today/post/article/2013072914255010486099-you-see-sexting-and-a-fad-and-i-see-the-future?trk=todhome-art-large_0
http://bits.blogs.nytimes.com/2013/06/30/disruptions-social-mediaimages-form-a-new-language-online/?_php=true&_type=blogs&_r=0
February 2014, The Queen’s Business Review
A Look That’s Here to
Stay
Copycats, consumer fears and easy access
to products make the fashion industry move
slower than it should.
TUSAANI KUMARAVADIVEL
I
t is assumed that increased access to information is a catalyst for innovation. Interconnectivity, particularly via the Internet, has
removed the barriers to most types of resources. At the same time, increased access allows
consumers to view and evaluate product differentiation in the marketplace. However, there is
a curious exception to this rule: fashion. While
other industries develop “new and improved”
wherever possible, the majority of the fashion
industry is characterized by uniformity. This is
not necessarily the fault of the industry itself;
consumers also share the blame for the blatant
copying and lack of originality in the industry.
Fashion choices are generally a result of
strong marketing ideas and commercialization.
Clothing and accessories also enable individuals to feel a sense of belonging. Additionally,
fashion choices can act as an identifier of things
such as class, position, taste, age, and preferred
sports team. More often than not, individuals
hope that their style sense does not ostracize
them or single them out as different. For example, a recent survey of American women
showed that 42% of women feel pressured to
wear “fashionable” clothes and that 55% have
purchased something they did not like but felt
was fashionable. Therefore, it is not surprising
that the average person seeks brands and looks
that will enable him or her to fit in more.
In the past, fashion houses enjoyed some
degree of autonomy because replication was
difficult. New styles that were introduced by
industry leaders were not easily accessible un-
til they were on outlet shelves. Copying even
simpler items such as skirts would be a long
process. Miucci Prada, fashion designer and
granddaughter of Mario Prada, founder of the
high-end fashion brand, once said, “We let
others copy us. And when they do, we drop
it.” This was a model that worked well when
less prestigious firms lacked immediate access
to new designs and the capacity to copy those
designs immediately. The trickle down theory
suggests that the fashion trends adopted by the
upper-class will be emulated by lower classes.
Today, evidence for the trickle down theory
in the fashion industry is stronger than ever as
copycat products can be produced in less than
a week on a large scale.
newer organizations are often forced to leave
the marketplace because consumers cannot
adopt fast enough. Meanwhile, copycat firms
dive in just when (and if) consumers begin to
show interest. Globalization has also made the
mainstream Western fashion industry tighter.
While Asia and Africa often served as “inspiration” for new designs (sometimes even drawing
on questionable assumptions of overseas cultures), mass adoption of Western wear in these
nations has limited this area of differentiation
as well.
There is a seemingly strong criticism of the
belief that innovation in the fashion industry is
repressed. Some argue that since copycats take
popular styles, there is a need for leaders in the
industry to keep churning new products. However, the current model is profitable for both
couture fashion firms and mass producers.
Imitators often promote a style in a way that is
easily accessible to the average consumer. Consumers, because they want to fit in, propagate
this style, anchoring it. This is profitable for the
higher-end chain because they can continue
promoting a certain style for a longer period
of time and not incur the additional increased
costs of commissioning a new design and marketing a new style. At the same time, the original
designers (who tend to be established companies as start-ups rarely survive in the long term),
benefit because a genuinely high-end accessory
from a company such as Hermès will attract
more respect and attention than an imitation
product by a mass-retailer such as Forever 21.
SINCE COPYCATS TAKE POPULAR STYLES,
THERE IS A NEED FOR LEADERS IN THE
INDUSTRY TO KEEP CHURNING NEW
PRODUCTS. HOWEVER, THE CURRENT
MODEL IS PROFITABLE FOR BOTH COUTURE
FASHION FIRMS AND MASS PRODUCERS
Patent law is difficult to administrate in
the fashion industry. For example, attempts
to trademark the name “UGG,” and the boots
themselves, have failed. Smaller shoe manufacturers openly sell boots that are clearly meant
to imitate the original product that is credited
to an Australian firm. These actions are tolerated because it is difficult for any company to
prove originality. Accusations of replication are
not just limited to small-name firms. Recently,
Canada Goose launched a lawsuit against Sears
Canada over a look-alike parka. Canada Goose
has long battled counterfeiters and imitators,
perhaps with more gusto than most firms who
consider such nuisances to be a part of the industry. When cheating is so wide spread, there
is very little incentive for firms to push new,
possibly unprofitable products.
Newcomers to the industry who are truly
innovative face additional challenges. Without
the brand power to spur interest in new styles,
- 16 -
The average consumer, for the most part,
is not interested in seeing a fashion industry
that is consistently changing direction. Consumers want to maintain a reasonable level of
prestige. Websites such as Pinterest and Tumblr, and online papers such as GQ Magazine
and LouLou make it easier than ever to find
an “acceptable” style. For example, a search on
Pinterest for “dress,” yields a high number of
lace dresses, a trend that has been extremely
popular since 2012. A slowed pace of change
is most likely a good thing for consumers, who
can rest easy knowing that their current wardrobe will not be considered to be passé by the
end of the month.
Canadian Grocery
Retail: A Cramped
Space
The face of Canadian food retail is already
undergoing fundamental transformation, but
the biggest wildcard, grocery e-commerce, has
only just arrived.
VIVIAN LAU
T
he year 2013 marked the waking of an
industry that seemed to be hibernating
under the comfortable cover of steady
food sales growth. From 2006 to 2011, food
sales in Canada jumped 17% but there was
clearly more at work than met the eye. The past
year became a battleground for Canada’s biggest players in food retail who were mobilizing
in response to the clamor of some even bigger
players approaching from the south. Some say
it is about time that an influx of American retailers, who have always been just a fence-hop
away, made their entrance into Canada. Given
lackluster performances in the U.S. during the recession, foreign retailers have
trouble meeting their growth targets.
This, coupled with the fact that Canada
operates under a similar culture, language, and retail format, made it a safe
and ripe target for expansion.
having to handle the disastrous Bangladesh factory collapse, Loblaw announced a $12.4 billion takeover of Shoppers Drug Mart in July.
Since Shoppers Drug Mart’s strong health and
beauty performance complements Loblaw’s
current grocery and Joe Fresh clothing portfolio, the merger allows Loblaw to compete with
hypermarkets like Wal-Mart and Target across
all product offerings. In the same month, Loblaw announced plans to pilot a new banner
store called Nutshell in Toronto to cater to the
health-conscious shopper. Nutshell’s plan to
open in 2014 is a pre-emptive move to capture
the natural and organic foods market, ahead
of any concrete plans by Whole Foods. Finally, Loblaw rolled out its loyalty plan, PC Plus,
nationwide in November. As a loyalty program
feel the pressure of changing competitors and
customer purchasing habits. According to the
Canadian Grocer, overall industry growth is
shrinking. In 2011 and 2012, total sales grew
1% and 1.1% respectively, compared with the
historical average of 3% or more.
Considering Target’s successful expansion
and the Loblaw-Shoppers mega-merger, 2013
was a year full of firsts and surprises. However,
the biggest change arrived quietly as the year
drew to a close.
The Invisible Threat
In November, Amazon entered the Canadian
grocery scene by offering 15,000 non-perishable
products on their website. They are currently
testing fresh grocery delivery, coined AmazonFresh, in Los Angeles and San Francisco.
If this model works, fresh grocery delivery
would be brought closer to Canada. Some
speculate that Toronto or Vancouver, being bustling metropolises not far from the
border, are attractive options for AmazonFresh. However, Amazon is not alone in
the game as Wal-Mart also announced an
online offering in September with 2000
non-refrigerated products and 1000 items
added monthly. Although current online
grocery sales contribute a negligible 0.5%
of total online sales in Canada, Amazon
should not be discounted as a competitor
in the grocery business. The retail titan
has the scale and enough profitable revenue streams to absorb losses while perfecting this new business model. Recalling
how Amazon leap-frogged the print industry is
enough to be wary of its interest in any market, no matter how small it currently is. Loblaw
seems to have taken note as it began selling Joe
Fresh online in September – an indication that
it could be gearing up to sell groceries online
sometime soon.
In observing the business of online shopping in markets other than Canada, signs point
to a future where online grocery is a profitable
gig. In late 2013, Morrison’s, the last of the big
four supermarket chains in the U.K. began offering products online. This represents common acknowledgement that customers are demanding change in the U.K., where total online
grocery sales currently represent about 3.5% of
the total grocery market.
In the U.S., online sales make up 2.5-3%
IN NOVEMBER, AMAZON
ENTERED THE CANADIAN
GROCERY SCENE BY
OFFERING 15,000 NONPERISHABLE PRODUCTS ON
THEIR WEBSITE
A Nationwide Food Fight
Canadian grocery has traditionally been
a competitive space, as proven in 2013,
and things are only going uphill from
here. Despite Zellers’s exit from the retail landscape, total grocery retail square
footage increased by 3.5 % in 2013. Target, Wal-Mart, Costco, and even Longo’s increased their footprint. In Ontario
alone, grocery space has grown at double
the historical level, a trend that will continue
into the next few years. The most aggressive
transformation was initiated by Target, which
opened an unprecedented 124 stores nationwide. Even Whole Foods, America’s largest organic and natural supermarket, has expressed
keen interest in Canada and hopes to open 40
more Canadian stores in the near future. However, these retailers are fighting for a slice of a
fixed pie. According to Statistics Canada, the
population grew only 1.2% in 2013, a figure
consistent with the historical average.
This inflow of foreign competition forced
the hand of Canada’s largest grocers, as Loblaw, Sobeys, and Metro (number 1, 2, and
3 respectively) made groundbreaking strategic moves of their own. Loblaw arguably had
the busiest and most innovative year. Despite
that rewards customers with discounts based on
their buying history, it is Loblaw’s grab for big
data, but also capitalizes on a shifting Canadian
tendency to now buy groceries on discount and
use coupons.
Sobeys made a big-ticket transaction of its
own. In June, it announced a $5.3 billion takeover of the fourth largest grocer, Safeway, which
ensures Sobeys a strong hold on the western
market. Compared to its bigger competitors,
Metro has broken the least news. For them,
2013 was a year to either close stores entirely
or streamline down its discount banner, Food
Basics. This $40 million expenditure on the
Ontario network indicates what costly changes
retailers in Canada must undergo to combat
shrinking margins and increased competition.
However, Metro is not the only retailer to
- 17 -
February 2014, The Queen’s Business Review
of the $857 billion grocery market and experts
estimate that these figures can rise to between
$100 and $110 billion by 2025. According
to Blischok, a retail strategist at Booz & Co,
this analysis is based on the observation that,
in the U.S., 40% of the total grocery market is
comprised of “stock-up good” sales. These are
characterized as staple, non-perishable items
that customers buy less frequently and in larger portions, compared to “top-up goods” that
are mainly fresh ingredients that customers buy
for dinner the same night. It is projected that
online grocery sales will grow if mostly “stock-
INTENT TO
PURCHASE FOOD
AND BEVERAGE
PRODUCTS ONLINE
GREW 44% FROM
2010 TO 2012
up” items are offered. This combats some of
what skeptics argue are the biggest hurdles of
grocery e-commerce, such as keeping foods
in good shape during transport, a customer’s
desire to inspect his or her produce before he
or she buys, and the commoditized nature of
food, which negates the benefit of side-by-side
price comparison that comes with online purchases. By this logic, Blischok anticipates the
same tenfold e-commerce growth in the grocery
business in Canada.
The prospect of e-commerce success is
even more feasible when considering global
online shopping trends. According to Neilson,
general intent to purchase food and beverage
products online grew 44% from 2010 to 2012,
with 60% of respondents stating that they already do grocery shopping research on the Internet to some degree.
The next decade will see the ladder of
leaders in Canadian food retail change drastically because those stores who follow Amazon,
and thus capitalize on the potential of grocery
e-commerce, will benefit. Since Canada has
such a strong network of existing grocery infra-
structure, it would be best leveraged in synergy
with e-commerce. Loblaw, Sobeys, or Metro
can refit their many grocery stores to act also
as distribution centers and offer a mix of online
and physical services, a strategy known as omni-channel retailing. Perhaps the “click and collect” shopping style from the U.K. will prosper,
where people pick out the groceries they want
online and then go to the store to pick it up,
drive-through style. Alternatively, more innovative options could be pursued. To illustrate,
take Well.ca’s pilot virtual store for example.
This storefront was set up in Toronto for a
month in 2012 so people could peruse photographic representations of popular health and
beauty products, use their cell phones to scan
and buy items, and then have them later delivered to their home. The store was the first of
its kind in North America and could be revised
to a grocery store format for retailers who are
looking to expedite and innovate the customer
experience. With an increasing omni-channel
presence in brick and mortar stores, Amazon
will struggle in the short and medium term as a
purely online presence.
With retailers vying for our business, Canadians will be able to enjoy low prices at their desired convenience level. These changes in grocery retail are just the tip of the iceberg. With
exciting news breaking in other areas of retail
such as clothing and auto goods, those living
in major Canadian hubs can expect extensive
upscale transformation to come.
USDA Foreign Agricultural Service (January 2013) “Canada Retail
Food Sector Report” http://gain.fas.usda.gov/Recent%20GAIN%20
Publications/Retail%20Foods_Ottawa_Canada_3-9-2012.pdf
University of Guelph (December 2012) “Food Price Index” http://
www.uoguelph.ca/cpa/Food-Index-2013.pdf
http://business.financialpost.com/2013/05/22/whole-foods-says-grocerwants-to-open-40-more-canadian-stores/
http://www.theglobeandmail.com/report-on-business/retailers-warn-of-spreading-bloodbath/article14391282/
http://www.canadiangrocer.com/top-stories/state-of-the-canadian-grocery-industry-31101
http://www.canadiangrocer.com/top-stories/will-amazon-take-over-thegrocery-world-36492
http://globalnews.ca/news/938270/amazon-ca-starts-selling-groceries-online-in-canada/
http://business.financialpost.com/2013/09/30/joe-fresh-debuts-onlineshopping-in-canada-as-j-c-penney-outlook-sours/
http://www.theglobeandmail.com/report-on-business/wal-marts-onlinefood-foray-opens-new-front-in-grocery-battle/article14854841/
http://www.strategy-business.com/blog/What-if-Clay-Christensen-IsRight-about-the-Grocery-Business-and-Amazon-Is-Wrong?gko=58cde
Nielson (August 2012) “How Digital Influences How We Shop
Around the World” http://es.nielsen.com/site/documents/NielsenGlobalDigitalShoppingReportAugust2012.pdf
http://www.ic.gc.ca/eic/site/oca-bc.nsf/eng/ca02855.html
http://business.financialpost.com/2013/10/30/amazon-canada-expandsshopping-list-adds-some-grocery-auto-goods/
A Breakdown of Value
Where value accrues to, based on a 50/50 division of excess value between labour and capital.
100%
80%
60%
40%
20%
0%
Most Efficient
Marginal Cost
Least Efficient
Value to Labour
Value to Capital
Required Return on Investment
David Kong
- 18 -
Intellectual Rent
Capital is owned by the most knowledgeable
provider. He is able to earn economic rent
without ever using his knowledge.
DAVID KONG
I
n Marxist Economics, capital skims away
gains that rightfully belong to labour.
However, this school of thought has been
refuted. Profit is the positive result of good ideas and the risk-taking required to implement
them. But some businesses require few good
ideas and take no risk at all. In such systems,
profit might be viewed unkindly as the result of
economic rent: the profit that accrues to those
with privileged and often undeserved access to
scarce resources. A new such form is generated from knowledge, precisely the knowledge
required to replace the business’s employees.
The bargaining power of labour and capital determine how much of the economic
value generated by the business is accumulated by each party. In a talent-driven business,
where capital is widespread or unimportant
and skilled-labour is in demand, the economic
value flows mainly to labour. Partnerships like
law firms and accountancies are good examples. Conversely, a capital-centric business is
characterized by widespread labour and scarce
capital, so the economic value flows largely to
capital. McDonald’s and Wal-Mart fall into this
category. But most businesses fall between the
two categories. Technology firms, for example,
have intellectual capital but depend highly on
skilled-labour as well.
Today, the value of capital is immense.
Corporate profit margins are at their highest.
Between 1979 and 2007, the top 1% of Americans, the capitalists, saw incomes rise by 275%
compared to an 18% rise for the bottom 20%
(i.e. labour). New companies in the Silicon
Valley have outrageous valuations with few
employees. Yet, labour has its own merits in
the modern age, and skilled labour is in high
demand. Despite the unemployment in the
United States, 50% of businesses find it hard
to find qualified labour. Young graduates from
schools like ours are paid well in excess of their
reservation payments.
Most modern businesses require both:
skilled people and a competitive edge that drives
profit. So what determines the price at which
the labour is willing to work for the capital? In
other words, what determines the amount of
economic value that accrues to labour versus
capital? Labour must receive its wages and capital must receive its required return on investment. But assuming labour and capital are well
differentiated, they are both able to command a
price above their reservation payments. To simplify, it is assumed that labour and capital have
equal power, and so negotiations will cleave the
economic benefit in two. That is, they will reach
a price that is halfway between each of their reservation payments. Thus the market-clearing
price is affected by both the reservation payments of labour (and therefore, the opportunity
costs), and capital.
The reservation payment of labour is the
amount the employee charges for providing the
service. This is likely to be the opportunity cost
of time (e.g. $30 an hour). The reservation payment of capital is the cost of the
best alternative to hiring labour. We limit
our analysis to markets where the most
appropriate substitute for labour is the
capital-provider himself. For example,
an enterprising student running a tutoring
service can either decide to hire a tutor or
run the tutorial himself. This assumption
is restrictive because the most globalized
and competitive markets will have many
substitutes and so our analysis will not
apply. Instead, our situation might exist
in highly specialized markets in particular localities, where expertise is centralized in a
handful of people. The tutorial business is such
an example because the tutors must be drawn
from students in the program who have recently
taken the desired course, are able to give the
lecture convincingly, and have the reputation to
draw in customers.
But our assumption is not overly-Draconian. In fact, it is not unlikely for the capital-owner to be the best alternative to labour in these
markets. Thus, the owner of capital is able to
provide the service himself. In business speak,
this might be considered “in-sourcing.” The
reservation payment of capital is the cost for
the capital-holder to provide the same service.
Therefore, a more knowledgeable capital-holder, one who can more easily replace labour, can
extract greater value from his employees than a
less knowledgeable capital-holder. This knowl-
edge lowers capital’s reservation price and thus
lowers the price at which labour will transact
with capital.
Consider the group of enterprising students
who bid for a set of course notes (the capital) so
that they can host paid tutorials for the courses.
The student who, himself, can do the tutorials
for the lowest marginal cost, will have the greatest leverage when employing the other tutors
because, above a certain price, the most efficient student would rather conduct the tutorial
himself. Therefore, such a student will have
for the labour. In a specialized and localized
market where a limited number of people have
the required expertise, theoretically, the most
efficient employee owns capital. Because he
can substitute for the lowest price, he is able to
hire his employees for the lowest price.
Now consider an analogous example in a
large corporation that is trying to expand its operations to another region. The company may
decide to outsource the operations, but will
only do so if it is cheaper than developing the
operations internally. The most knowledgeable
firms will demand the lowest price, make
the most profit, and end up owning the
capital. The above example is a widespread application of this theory, which is
applicable to larger firms in a specialized,
knowledge economy.
The concept of creating economic
value from knowledge is not new. Economic rent theory stipulates that supernormal profit accrues to holders of
scarce resources. But in this particular
case, economic value accrues to the most
efficient knowledge-holder, without him
ever using his knowledge.
This theory also explains who owns capital.
He who is able to create the greatest profit is
the one who can offer the highest price for it,
and so he should own the business. It also explains the power that knowledge provides, and
how it can be used to accrue economic benefit.
Maybe Marx was not far off when he argued
that capital skims off of labour. But there is
nothing unfair about it. In a specialized market
where knowledge is exceedingly scarce, capital
goes to the most knowledgeable and efficient
provider of labour. Given the complexities of
businesses of the future, markets like these will
not be hard to find.
MARX WAS NOT FAR OFF
WHEN HE ARGUED THAT
CAPITAL SKIMS OFF OF
LABOUR. BUT THERE IS
NOTHING UNFAIR ABOUT IT
most to gain from the course notes and will pay
the most for them. He owns the capital while
the other students will be employees. The most
efficient student uses his ability to conduct the
tutorials to gain a supernormal profit despite
not having to actually use the ability at all.
Theoretically, capital should be owned by
whoever can assume the greatest return for it.
As exhibited by this example, the most appropriate capitalist would be the most knowledgeable and efficient employee. Yet, if the most efficient labourer owns the capital, why would he
pay someone rather than simply fulfill the demand himself at a lower cost? The explanation
is an upward sloping marginal cost curve that
makes additional units more difficult to supply,
thus allowing for employees to provide labour
at a lower cost. By this account, it is not unlikely
for the capital-holder to be the best substitute
- 19 -
February 2014, The Queen’s Business Review
IPOs as a Monopoly
Overly exuberant investors may not be the sole
cause of the IPO jump, monopoly sellers can
charge a price above intrinsic value.
DAN MCGEE
I
n the wake of the recent Twitter IPO,
and with 2013 capping the best year for
single-day returns on IPOs since the tech
bubble of 2000, with an average 17% return,
investors might wonder how these companies
can command such lofty valuations. Typically,
the assumption is that valuations are driven by
investors’ risk tolerance and their expectations
of the future. The impact of these expectations
on the economy as a whole was first recognized
by John Maynard Keynes as “animal spirits,”
giving rise to today’s bullishness and bearishness, and was applied specifically to financial
markets by former Federal Reserve Chairman,
Alan Greenspan, as “irrational exuberance.”
However, historical analysis of the financial
markets has assumed that the stock markets ultimately function as perfectly competitive markets, with many buyers and sellers. In a highly
liquid market for many securities, this is a reasonable assumption to make. However, on the
day of an IPO, there are far fewer sellers; at
the precise time of the IPO only the company
itself can sell shares to the markets. Since an
IPO represents a short-lived monopoly for the
company going public, its market power should
allow them to harvest a greater economic ben-
efit than a seller in a perfectly competitive market. In the case of a company going public, this
would mean that it could sell its shares for more
than their intrinsic value.
The value of an asset that will perpetually
make payments to its owner is simply the discounted present value of all said payments.
Since this value is dependent on both the required return on the asset, which is determined
by its risk profile and the expectations of the
growth of these payments, different investors
may arrive at different valuations of the same
asset when facing uncertainty regarding the asset’s future.
In the case of an IPO, the marginal revenue
and marginal cost curves both depend on the
discounted cash flow value of the shares. Since
IPOs do not offer the company an opportunity
to practice any kind of price discrimination, the
structure of the marginal revenue curve will be
directly determined by the demand curve. If the
demand curve is downward sloping, as would
be true for a monopoly, the marginal revenue
curve will have a steeper slope in order to capture the lower price received for all shares sold
when the monopolist chooses to sell a larger
quantity. Assuming that investors are willing
to pay up to their valuations of the shares, the
demand curve will encompass all investors’ valuations in decreasing order.
Investors have different perceptions of the
risks involved in any particular company, as well
as different expectations of the future, and will
cause them to each arrive at different valuations
for the company. Arranging these valuations in
descending order will yield the downward sloping demand curve faced by the monopolist. As
such, the marginal revenue curve will be downward sloping and steeper than the demand
curve, resulting in the company’s monopoly
power during the IPO.
The marginal cost of selling a share during
the IPO will be the present value of all future
earnings because this is the opportunity cost
of selling a share for the company. Twitter, for
example, in its trailing twelve months (TTM)
operating earnings prior to the IPO, lost about
$100 million and thus any earnings multiple
would be a meaningless figure. To avoid this
problem, we can use its adjusted EBITDA and
the enterprise value of the firm. By this figure,
the firm earned about $42 million in the twelve
months before the IPO. At an enterprise value
of $14 billion, based on the IPO price, the firm
IN THE LONG-TERM, AS MORE
INFORMATION IS REVEALED, THE RANGE OF
VALUATIONS WILL NARROW
Although the value of an asset is a function
of its expected cash flow to its owner and the
required return on its level of risk, the market
price of that asset is also determined by the
structure of the market and, specifically, the
relative power of that asset’s buyers and sellers.
In a market characterized by a monopoly, the
seller chooses to sell its product up to the point
at which the marginal revenue of an additional sale, as a decreasing function of quantity, is
equal to the marginal cost of selling another
unit. This is typically an increasing function of
the quantity sold. At this point, the price will
be determined by the elasticity of demand as
a markup over marginal cost. In general, less
elastic demand will mean a price with a higher
markup over the marginal cost.
- 20 -
was valued at 333x EV/EBITDA.
This price leaves two possibilities. First, it
could represent the fair economic value for the
shares, meaning the growth rate of its earnings
will only be 0.3% below the required return on
its capital. Second, it could mean that the company was able to sell the shares for more than
its marginal cost, which would be evidence of
market power.
To maximize profits, the company will sell
the number of shares that equates marginal revenue and marginal cost. Since the company faces some uncertainty regarding how much investors are willing to pay for its shares, they have
an incentive to talk to major potential buyers
and institutions. These discussions will attempt
to gain an understanding of the demand curve
Supernormal Profit in IPOs
Issuers can charge a price above the value of the shares
Price
A Misleading Indicator
While the current equity risk premium (ERP)
is above historic norms, rising interest rates
call for an evaluation of this ERP as a bullish
indicator.
Demand
KEENAN MURRAY
Profit
Marginal Cost,
Average Cost
Quantity
Marginal Revenue
David Kong
so that they can accurately predict the marginal revenue. Thus, the pre-IPO ‘roadshow’ is as
much for the company’s benefit as it is for the
investors’ benefit.
The company will then price its shares
according to the demand curve, which will be
above the marginal cost curve at that point. Because the marginal cost is constant, this is also
the average cost curve. The difference between
price and average cost will be the additional
profits earned from monopoly power.
Once the shares have been sold into the
market there will likely be a burst of trading
activity. This is the result of the investors who
are willing to pay and purchase shares from
others because said shares are pseudo-randomly allocated rather than by a system that takes
into account the investors’ valuations, such as
an auction. However, once all the shares in the
market are owned by those who value them the
highest, the only thing that will sustain trading
is the fluctuation in people’s perceived value
of the shares.
In the short-term, this could mean that
people will buy shares expecting that someone
else will increase their valuation and be willing
to pay a higher price. However, in the longterm, as more information about the company
is revealed, the range of valuations will narrow,
causing the demand curve for the market to become flat, ultimately eliminating any abnormal
profits from trading in the shares.
Although, in today’s markets, this is not
particularly good news for exuberant investors
in highly valued companies, it does accord well
with our intuitions regarding perfectly competitive markets. In those markets, abnormal
profits or losses will cause investors to enter or
exit until all economic profits are wiped out.
Likewise, the markets do not offer abnormal
opportunities to those buying financial products
everyone else can buy as well.
A
fter the greatest calendar year advance
in U.S. equity indices since 1997, many
investors are questioning the health of
the overall stock market, and talk of bubble-like
assets is becoming more common. As investors
turn to strategists for guidance into 2014, many
valuation methods are contested to determine
the current health of equity markets, and what
the future may hold. Among the most popular is the basic price-earnings ratio, as well as
dividend discount models. Another common
practice is to examine the equity risk premium.
The ERP, which is widely applied in financial theory valuation, measures the difference
between the expected return of a risky asset and
the relevant risk-free rate. Therefore, the greater the ERP, the greater the reward for investing
in risk-bearing asset classes, and the more incentivized investors are to allocate funds away
from risk-free assets. Thus, high ERPs are interpreted as bullish market indicators, for a high
ERP implies greater reward for taking on risk.
In the past, the ERP has been a useful predictor of overall market movements. A chart
by Aswath Damodaran, a finance professor
at New York University, graphs the ERPs of
the past fifty years, highlighting certain major
events. The expected return of the S&P 500
is calculated using a dividend discount model,
which derives an intrinsic value of the index by
discounting the expected dividends and share
buybacks. Specifically, this dividend discount
model uses the average cash yield, dividends,
and share buybacks, on the S&P 500 from the
past ten years. This cash yield grows at a rate
equal to the expected growth rate of earnings
for stocks in the index, as predicted by analysts.
The total dividends and buybacks are then discounted by the expected return on the index
for a period of five years, when a terminal value
is then calculated and discounted. The sum of
the discounted terminal value, dividends, and
buybacks gives the intrinsic value of the index.
The percentage difference between the intrinsic value and the current value becomes the
expected return on the index. Subtracting the
relevant risk free rate (in this case it being the
U.S. ten-year Treasury bond yield) from the
expected return on the index gives the equity
risk premium.
The average over this time frame is roughly 4%. Historically, when the ERP has risen
- 21 -
above 5%, it has been a good time to buy the
stock market as an index. In 1979-80 there was
a 6.45% ERP, and the S&P 500 returned over
30%. In 2008, during the midst of the financial
crises, the ERP was over 6%, and the S&P 500
has more than doubled since then. Most recently, in 2012, the ERP was again above 6%,
and again accompanied by very high S&P 500
returns. In essence, an above-average ERP has
been an excellent indicator of superior stock
market returns.
As measured using a dividend discount
model the current ERP is almost 5%. Historically, this number is quite high, and, using
the above examples, should be a pre-cursor
to very promising S&P 500 returns. However,
the ERP of today is comprised of low interest
rates, which are rising. As the Federal Reserve
has started to taper back its aggressive asset purchase program, with the outlook of ending it in
2014, U.S. Treasury yields have been on the
rise. This is largely expected to continue as interest rates are so far below normal levels. The
fifty-year average yield on the ten-year Treasury
is roughly 6%, well above the current level of
THE ERP OF TODAY IS
COMPRISED OF VERY
LOW INTEREST RATES
3%. Although the Fed is committed to keeping
rates low over the next two years, rates will not
fall any further, barring an economic collapse.
In the past, high ERP levels were comprised
more of large expected returns, than low riskfree yields. In 1979, for example, the expected
return on the S&P 500 was nearly 20%, compared to around 8% today. In essence, the current ERP is largely affected by Fed policy, and
thus as Fed policy leaves the market and interest rates climb, the ERP will decline.
Many strategists have claimed that the market is now reasonably valued and that headline
economic growth and real earnings growth will
lead equity prices higher. The ERP currently
suggests above average returns, which may be
misleading. Although stocks are expected to
outperform bonds, investors should worry less
about asset classes, and more about individual
security selection. Because as both interest rates
and the ERP revert towards normal levels, the
incentive for investors to take on risk declines
from the levels seen in the past five years. This
reduces the likelihood of such broad stock market outperformance, which would be suggested
by the current ERP, as compared to historical
ERPs. Today, market bulls need to have more
powerful arguments for equities than just high
equity risk premiums.
February 2014, The Queen’s Business Review
Comparison of Direct Investing vs. Benchmark Returns
Forms of Private
Forms
Equity
of Private
Investing
Forms
EquityofInvesting
Private Equity Investing
1. Traditional Fund
1. Traditional
InvestingFund
1. Traditional
Investing Fund Investing
At the Top of its Class
Limited
General
Partner
Partner
Limited
General
Portfolio
Partner
Partner
Companies
2. Direct Investing
2. Direct Investing
2. Direct Investing
How Teachers’ Private Capital grew from a
trivial experiment to become Canada’s buyout
king.
Limited
Partner
JONATHAN CLAXTON
Limited
Portfolio
Partner
Companies
Limited
Partner
Origins
In 1990, with the goal of a $2 billion dollar private equity portfolio in 10 years, Claude Lamoureaux led what was then a nascent Teachers’
Private Capital through its early years. A year
in, the division invested its first $100 million
in seven privately-held Canadian companies,
three of which were direct investments, the rest
traditional fund or LP investments. Uncommon at that point in time, Teachers’ decision
to invest both directly and indirectly was made
SINCE INCEPTION,
TEACHERS’ PRIVATE
CAPITAL HAS
GENERATED AN IRR
OF 19.2%
to broaden the range of available investments
and accelerate the development of the firm’s inhouse capabilities. Because of its still-small size,
the institution had to rely on external partners
to both co-invest on larger deals and provide
niche expertise on certain industries.
In the Canadian context, Teachers’ Private
Capital was years ahead of its most notable peer,
Canada Pension Plan Investment Board (CP-
Performance
Since inception, Teachers’ Private Capital has
generated an Internal Rate of Return (the standard industry measure of annualized returns) of
19.2%. In the last 18 years (after which no return data is available), TPC has returned more
than its benchmark 16 times, on an average of
9.6 percentage points. The division has generated Alpha (outperformance over the benchmark index) of 11% with a Beta (a measure of
volatility relative to the benchmark index) of
0.89. This outperformance could be driven by
the selection of higher-performing private equity firms for fund investments, superior value
creation through direct and co-investments, or
a combination of the two.
These returns are not only good on an
absolute basis; they are good on a relative and
Regression Analysis
Net Assets
Since 1995, TPC has generated Alpha of 11% with a Beta of 0.89
Since its inception in 1990, Teachers' Private Capital has grown to approximately 9.5% of OTPP's
net assets
Teachers' Private Capital
Returns
140
Assets at Year End ($ B)
PIB). CPPIB solely held government bonds up
until 1998, moved into a fund-based private equity model in 2001 and only in 2006 gradually
began investing directly. Globally, institutional
attitudes towards private equity varied, from
Norway’s Government Pension Fund, which
had zero allocation, to the Yale University
Endowment, which invested exclusively via external funds, to the Government of Singapore
Investment Corporation, which limited direct
investments to minority stakes .
120
100
80
60
40
20
0
1997
1999
2001
2003
2005
2007
2009
2011
60%
y = 0.889x + 0.1097
R² = 0.6557
40%
20%
0%
-30%
-20%
-10%
0%
10%
20%
30%
40%
-20%
Benchmark Returns
OTPP Annual Reports
- 22 -
Jonathan Claxton; Teachers' Private Capital
General
Partner
Preqin
Burgiss
Preqin
All Direct
Investments
Benchmark Return
Portfolio
Companies
Portfolio
Companies
Preqin
Burgiss
Co Investments
Direct Investing Excess Return
Josh Lerner et al., Harvard University; Preqin Global PE Benchmark; Burgiss Global PE Benchmark
General
Partner
Betting on Direct Investing
At the end of 2012, Teachers’ Private Capital
had a near even weighting of direct and co-investments, and fund investments within its $12
billion private equity portfolio. Although the respective returns of these two methods vary over
the years because of their sensitivity to both
industry cyclicality and the performance of individual portfolio companies, in the long run,
direct and co-investments have outperformed
fund investments by 5% annually since 1990.
That direct investing yields greater returns
than fund investing was also the conclusion of
a recent study by Harvard Business School researchers.
The study, “The Disintermediation of Financial Markets: Direct Investing in Private Equity,” analyzed a sample of direct investments
from seven large institutional investors, and
found that direct investments outperformed traditional private equity fund benchmarks . It also
concluded that, of the direct investments, those
carried out unaccompanied were more lucrative than those done with a partner or through
co-investing. By eliminating the middleman, institutional investors are able to bypass the fancy
Burgiss
Solo
Wall Street private equity shops and eschew
the hefty fees that go along with them. What’s
more,
investing
independently, institutional
Josh Lerner et al.,Josh
Harvard
Lerner
University
et al., Harvard
Josh Lerner
University
et al.,by
Harvard
University
investors are able to avoid an economic dilemrisk-adjusted one as well. The information ra- ma known as the Lemons Problem: the more
tio, a risk-adjusted performance measure of ex- comprehensive information available to the pricess returns above the benchmark, of TPC is vate equity partner (general partner) the more
1.00. Ontario Teachers’ Pension Plan’s entire likely they are to offer below-average quality
portfolio has an information ratio of only 0.53. deals to their co-investors (limited partners).
This difference implies that the private equity
Teachers’ Private Capital has chosen to
portfolio is delivering greater risk-adjusted re- do both solo and co-investing. However, it has
turns than the rest of the portfolio.
THE DEMOGRAPHICS
OF TEACHERS’ IS
OLDER THAN THAT
OF THE GENERAL
POPULATION
been its decision to enter early and forcefully
into direct investing as a whole that has driven
returns higher than those of its peer group.
$100 million invested in 1990 would be worth
$2.3 billion had it been invested in funds and
$5.5 billion had it been invested directly, according to the company’s annualized returns.
The Path Forward
Despite recording consistently positive results
over the past few years, Ontario Teachers’ Pension Plan began 2013 with a preliminary funding shortfall of $5.1 billion. That is, the cost of
Direct Investing vs. TPC Fund InvestmentReturns
Within Teachers' Private Capital, Direct & Co-Investments have outperformed Fund
Investments by 5% annually since 1990
Net Annualized Return
General
Partner
I
t would, at one point, have seemed fitting that Ontario Teachers’ Pension Plan
(OTPP) had its head office far removed
from Toronto’s financial district. The mega
pension fund responsible for the retirement
of more than 300,000 members was ascribed a
conservative, unsophisticated, and bureaucratic
stigma – a legacy from the days when it was an
obscure government commission.
Today, Teachers’ operates out of the same
building as before, but its growing track record
as a sophisticated institutional investor is commanding greater respect from the financial establishment. Its most notable achievement and
highest returning asset class, Teachers’ Private
Capital (TPC), has grown from a trivial experiment in the early 1990s to become Canada’s
buyout king, with a presence and reputation
that spans the globe.
Behind TPC’s success is a contrarian decision to invest directly in companies rather than
through traditional private equity funds. The
result has been impressive even by the strictest
standards. Annual returns have rivaled those
of the major industry benchmarks and iconic
Wall Street names like Kohlberg Kravis Roberts, and The Blackstone Group.
Since its inception in 1990, Teachers’ Private Capital has grown to approximately 9.5%
of Ontario Teachers’ Pension Plan’s net assets.
Just as that number has risen over the past two
decades, so too might it rise over the coming
ones in light of the division’s mounting success
and an intensifying need for yield to battle funding shortfalls.
1995
Portfolio
Companies
40%
30%
20%
10%
0%
Limited
Partner
Portfolio
Companies
1993
Limited
Portfolio
Partner
Companies
Portfolio
Companies
3. Co-Investing3. Co-Investing 3. Co-Investing
Limited
Partner
1991
General
Portfolio
Partner
Companies
IRR
Limited
Partner
Direct Investments outperform traditional fund investments as seen by their excess returns
over global PE benchmarks
40%
30%
the future pensions exceeded the current plan
assets combined with future contributions. According to the organization, this deficit stems
primarily from demographic and economic
factors, including the fact that the ratio of working-to-retired members is decreasing, and that
pensioners are living longer lives and thus collecting a pension for longer. Because of the large
number of teachers hired to educate the baby
boomers, the demographics of Teachers’ is older than that of the general population. In 1970
there were 10 working teachers for each retiree.
Today that number is 1.5 and projected to drop
to 1.3 by 2020. In contrast, for the Healthcare
of Ontario Pension Plan (HOOPP), the aging
demography means a jump in hiring to help to
provide care for the elderly. HOOPP’s ratio of
working to retired workers is in no immediate
danger of falling, meaning fewer funding challenges. A further factor affecting all pensions is
that low interest rates of the past few years require that Teachers’ set aside more money for
its future obligations.
In terms of strategy, what this means is that
Ontario Teachers’ Pension Plan will have to
find more creative ways to generate returns,
while still managing risk prudently. Leveraging
its private equity operation would be a great way
to achieve this. A reallocation of both human
and financial capital from its Funds division to
its Direct Investing division would allow the organization to capitalize on higher yield, lessening the funding shortfall.
The funding problems facing Teachers’ are
not uncommon. The same demographic and
economic headwinds plague the entire Canadian pension landscape, so much so that the topic
of pension reform has inched its way to a prominent spot in the country’s political discourse.
With an established platform developed over
the course of 23 years, Teachers’ has a unique
and enviable opportunity to reap the benefits
of direct private equity investing, eliminate the
funding shortfalls, and enter a stable, sustainable state where it can fully meet its obligations.
20%
10%
0%
1990 - 2000
2000 - 2006
Fund Investments
2006 - 2011
1990 - 2011
Direct & Co-Investments
INSEAD; Teachers' Private Capital
- 23 -
Fang, Lily H. and Ivashina, Victoria and Lerner, Josh, The Disintermediation of Financial Markets: Direct Investing in Private Equity
(June 30, 2013). Available at SSRN: http://ssrn.com/abstract=2159229
or http://dx.doi.org/10.2139/ssrn.2159229
Ontario Teachers’ Pension Plan Annual Report. Rep. Ontario Teachers’ Pension Plan, 2000-2012. Web.
Ramanathan, Deepa. Going Direct: The Case of Teachers’ Private
Capital. N.p.: INSEAD, n.d. Oct. 2013. Web.
U.S. Private Equity Index ® and Selected Benchmark Statistics. Rep.
Cambridge Associates LLC, 30 June 2013. Web.
February 2014, The Queen’s Business Review
All That Mines Gold is
Not Gold
Even with higher gold prices, gold companies
(companies who mine gold) around the globe
are poor investments due to increasing cost
pressures.
YINGXI LIAO, CHRIS HALIBURTON
Gold and TSX Global Gold Index Returns, 2003-2013
Gold has underperformed the Gold Index
500%
Returns
400%
300%
200%
100%
0%
2003
-100%
2005
2007
Gold
2009
2011
2013
TSX Global Gold Index ETF
Google Finance
- 24 -
Resource Nationalism
Another important reason that the costs of
gold companies mining have increased so considerably is because third-world governments
have hit these companies with higher taxes and
costly regulations. Because undeveloped gold
mines, in good jurisdictions, with secure property rights were rare, gold companies ventured
into the third-world to find profitable, low-cost
mines. As a result, from 2006-2012, annual
gold production in emerging markets increased
by 7.6 million ounces while production in mature markets decreased by 5 million ounces.
However, the results of this venture were
a disaster. As gold prices soared, third-world
governments stepped in to take their share and
Remaining global gold deposits are concentrated in the low-grade buckets
Ore Grade
Increased Prices of Mining Inputs
A second reason that gold companies’ costs
have increased at such a rate is that key inputs
for mining such as labor, energy, and equipment have become much more expensive. As
gold prices soared in 2009-12, and gold companies rushed to expand production, the demand
for mining equipment rose greatly, allowing the
equipment suppliers to increase their prices
dramatically. Energy has also become more
expensive because oil prices have remained
high in recent years. In addition, the cost of
inputs such as skilled labor and raw materials
also rose greatly as many new capital projects
were started simultaneously and competed with
each other for resources. This situation was
especially the case in recent years when most
new projects were located in previously marginal locations, making it difficult for companies
to attract workers and supply the site without
being charged a large premium.
Unfortunately for those investing in gold
companies, the increase in mining input costs
from 2008-2012 was not an aberration; future
increases in gold prices will likely see this trend
repeat itself. As a result of the inelastic supply
of many inputs for gold mining, much of the
benefits of rising gold prices will end up going
to gold machinery suppliers, rather than the
mining companies themselves.
Remaining Global Gold Deposits
1-3 g/t
3-5 g/t
5-7 g/t
7-9 g/t
9-11 g/t
11-13 g/t
13-15 g/t
>17 g/t
15-17 g/t
0
50
100
150
200
250
300
Number of Deposits
Visual Capitalist
destroyed gold companies wealth in the process. In the past year alone, The Philippines,
Argentina, Brazil, Bolivia, Mozambique and
13 other countries have all increased taxes on
gold mines and implemented regulations such
as restricting currency transactions (preventing
gold companies from repatriating their prof-
GOLD COMPANIES
WILL EXPERIENCE
A DRAMATIC
DECREASE IN ORE
GRADES ONCE THEIR
CURRENT RESERVES
ARE EXHAUSTED
its) and imposing local manufacturing requirements (forcing gold companies to process their
ore in inefficient, high-cost, local manufacturing
operations). In comparison, only two countries,
Vietnam and Ukraine, took measures such
as reducing taxes and privatizing state-owned
mines which improved the investment climate
for foreign investors.
Gold companies are particularly vulnerable
to this type of shakedown for two reasons. First,
gold mines can’t move. While foreign investors
in other industries can restrain host governments from expropriating them by threatening
to move their capital to other countries, gold
companies can’t recover or move their investment once they’ve spent billions to create an
operational mine. Therefore gold companies
must keep producing as long as the host government does not increase taxes so much that mining operations become unprofitable. Second,
it’s easy for host governments to secure popular
support for measures targeting gold companies,
because rich foreigners profiting off of local resources are not popular anywhere. The aftermath of the 2008-09 crisis, which led to higher
government deficits around the world and increased animosity towards foreign investments,
have strengthened resource nationalism by
rendering taxing gold companies an irresistible
and easy option for third-world governments in
need of additional revenue.
Declining ore grades, increased prices for
mining inputs, and resource nationalism have
all contributed to drastically higher costs for
gold companies, and explain why they have underperformed the price of gold. For investors,
the takeaway from this experience is simple:
when valuing a business, remember that revenue growth does not necessarily equal higher
profits. Many investors bought shares in gold
companies based on the simple theory that
higher gold prices equated to higher profits.
However, the golden rule that can be taken
away from this lesson is that a company is only
as profitable as its costs make it out to be.
Historical Exploration Costs and Reserve Sizes
Exploration costs have increased in the last decade
140
6
120
5
100
4
80
3
60
2
40
1
20
0
2000
2001 2002 2003
Primary Gold
2004 2005 2006
Copper-Gold
Exploration Spending (US$ B)
T
he most newsworthy commodity of
the past several years has undoubtedly
been gold. After increasing for 12 years
consecutively, gold spot prices then plummeted
in 2013, devastating gold mining stocks. However, a cursory examination reveals a seemingly inexplicable paradox: in bull or bear gold
markets, gold mining stock prices have greatly
underperformed the price of gold. After the
recent crash, the TSX’s Global Gold Index is
now below the levels it traded at in 2003, when
gold prices were less than $350 an ounce. Interestingly enough, gold mining companies have
seen their stock prices decrease over the last 5
to 10 years, even though gold prices were far
lower back then, a phenomenon that most investors would find incredible.
The reasons for this paradox highlight an
important lesson for investors: even if a certain
commodity is performing well, the companies
mining this commodity will not necessarily
prosper. The main reason that gold company
Declining Ore Grades
The first reason for this drastic rise in production costs is that the average ore grades of
producing gold mines are steadily declining.
Currently, the average ore grade of producing
mines is 1.18 g/ton , while the average ore grade
of undeveloped deposits is 0.89 g/ton. These
undeveloped mines account for 66 percent of
all deposits left on earth, which means that gold
companies will experience a dramatic decrease
in ore grades once their current reserves are exhausted and they are forced to replace existing
production with low-grade mines. This decline
has been occurring since 1997 and has accelerated in the post-2008 period of rapidly rising
gold prices, when gold companies expanded
largely by lowering the cutoff grade for new
projects. As a result, from 2005 to 2012 gold
mining companies suffered a 21 percent decline in average gold grades while production
increased by around 3 percent despite billions
being spent on capital expenditures. Gold production per share for 80 global gold companies
actually went down 9.29 percent from 2008 to
2012 despite achieving an increase of 14 percent in gold production, which was far above
the industry average. If ore grades continue to
decline, the costs of gold companies associated
with gold mining will rise as companies will get
less in return for each ton of ore processed.
The only way that this trend can be reversed is if new discoveries of large, low-cost
ore bodies are made. However, recent exploration results have been disappointing. Out of
the 74 significant gold discoveries (defined as
an ore body with more than 3 million ounces of
gold) from 1991 to 2012, only five were found
since 2007, and their gold content was far below ore bodies discovered in the 1990s. With
the drastic decline in ore grades and size of
reserves, many companies are having to spend
significantly more on exploration costs, and are
finding less gold in return. The continuance of
rising exploration costs will be a common scene
within the gold industry because all easily accessible gold has been discovered and mined.
Endowment (M Oz)
shares have underperformed gold prices is simple: although the price of gold has increased,
costs have increased faster. This is the most important reason why investors who bought shares
of individual gold companies, and saw their
predictions of higher gold prices confirmed,
have nevertheless reaped abysmal to negative
returns. Other factors relative to gold, such as
the emergence of gold ETFs and gold mining
companies’ operating leverage, have also contributed to this debacle, but they are secondary
to the issue of cost pressures.
Investors often cite expectations of high inflation as a reason to invest in gold, but in no
industry has cost inflation been such an issue as
gold mining. In the six years prior to November
2012, the average cost of producing gold increased by 80 percent. This figure understates
cost inflation for gold companies due to the
capital-intensive nature of the industry. As a
result of soaring equipment costs, gold companies have to spend much higher amounts just
to sustain their production (“sustaining capex”)
than historical data would indicate, so past cash
costs actually underestimate the levels of capital
expenditures (“capex”) required by gold companies. The three main reasons that the costs
of gold companies have increased are declining
ore grades, the increased prices of mining inputs, and resource nationalism.
0
2007 2008 2009
Exploration Costs
Visual Capitalist
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http://www.usfunds.com/media/files/pdfs/researchreports/2012-research-reports/USGlobalInvestors-Gold_Special_Report.pdf
http://business.financialpost.com/2013/02/07/all-in-cash-costs-dontgo-far-enough/
http://www.visualcapitalist.com/global-gold-mine-and-deposit-rankings-2013
http://www.usfunds.com/media/files/pdfs/researchreports/2012-research-reports/USGlobalInvestors-Gold_Special_Report.pdf
http://www.usfunds.com/media/files/pdfs/advisor-content/2013/13-513_GoldSpecialReport_Inst_web.pdf
http://www.theglobeandmail.com/report-on-business/industry-news/
property-report/climbing-costs-make-mining-growth-problematic/
article4184840/
http://www.ey.com/Publication/vwLUAssets/Business-risk-facingmining-and-metals-2012-2013/$FILE/Business-risk-facing-mining-andmetals-2012-2013.pdf
http://www.usfunds.com/media/files/pdfs/researchreports/2012-research-reports/USGlobalInvestors-Gold_Special_Report.pdf
http://www.ey.com/Publication/vwLUAssets/EY-M-and-M-Resource-nationalism-update-October-2013/$FILE/EY-M-and-M-Resource-nationalism-update-October-2013.pdf
February 2014, The Queen’s Business Review
F
Brand Yourself
How to distinguish yourself among others: an
important measure to becoming memorable in
today’s business world.
JACLYN SANSCARTIER
or the past few months, I began recognizing the sharp difference between people
that strongly resonated with me - individuals with the power to make an impression,
and bystanders that seemed to drift from the
conscious mind. Quite simply, there were those
who separated from the crowd with ease, and
those who were more prone to blending in.
C. Joyball C. once wrote, “I don’t fit into
any stereotypes, and I like myself that way.”
Whether you have the characteristics of a
strong-minded athlete, a quiet café blogger, or
an outgoing social butterfly, it’s important to
further differentiate yourself from the crowd.
I once met a football player that loved fashion
and alternative jazz. He wasn’t particularly trying to be different; rather he was more honest
with what his interests truly were. The otherwise
known “jock” diverged from the stereotype’s
ideals. With a sound understanding of the
components that comprised his personality and
appearance, he became instantly popular with
people. The football player redefined what it
meant to be a “jock,” becoming his own brand
in the process.
A business giant that embodies this concept
in all certainty is recently appointed CEO of
Yahoo!, Marissa Mayer. According to an article
on venturebeat.com, she’s a part of the small
14 percent of women who currently hold executive positions in tech companies (Christina
Perr, Let’s Talk About “Women in Tech”).
It was only 1999 when Marissa Mayer entered
Google, establishing herself as the first female
engineer ever hired at the search-engine leader.
Actively participating in an industry dominated
by men, she has already made an impression
through her controversial restructuring decisions at Yahoo!.
Mayer is developing a well-respected career
in technology. However, in spite of this, she has
been repeatedly criticized for taking “provocative” pictures for Vogue.
Aside from her business wit, what I admire
most about Mayer is her self-confidence as a
woman in power. Her title at Yahoo! has not
jaded her interests in fashion or changed the
way she sees herself. In opposition to succumbing to stereotypes, Marissa Mayer understands
that her perception as an established intellectual has no limits on whom she can or cannot be,
which sets an important branding precedent for
all females in the workplace. Instead of bowing her head to critical reviews of the photo
being “inappropriate” for CEO behavior, she
does not apologize for her actions. Mayer’s assurance of her Vogue shoot only indicates her
proper place as a branded leader; she ignores
criticism and remains consistent with the image
she portrays.
Although it is true that the most vital part
of an individual is his or her personality, appearances play a role in realizing a recognizable
brand too. Steve Jobs did this branding perfectly, as his appearance directly correlated to the
type of person he was. Consider the clean-cut,
- 26 -
modernized intellectual image he portrayed
with respect to Apple. Jobs changed the common perception of computer geeks everywhere
and developed a love for technology that was
trendy and hip. He was the CEO that personified his company in a classic black turtleneck,
coolly sporting John Lennon specs and New
Balance Sneakers. He was a distinct businessman, and one of the few corporate leaders that
could make a distinguished public impression
surpassing the widespread attention of his own
company.
THEY DO NOT FALL
PRIVY TO POPULAR
THINKING, AND
THIS IS WHAT
MAKES THEM SO
INTRIGUING TO
FOLLOW.
Sometimes I catch myself thinking of someone, and I wonder what it takes to be remembered. The alternative jock, the woman taking
leadership, and the revolutionary CEO can all
be described as memorable individuals because
of their strong sense of self, as they surpass
lingering stereotypes and promote their differentiating qualities. The reason why these types
of leaders strongly resonate with people is their
confidence. They are described as different,
unpredictable, and innovative in society. They
do not fall privy to popular thinking, and this is
what makes them so intriguing to follow.
As businessmen and women, we are faced
with an abundance of opportunities each and
every day. Looking forward, success will be
achieved by those who can portray a unique,
reputable image that is impossible to categorize
with others. Whether it be in an interview or a
work setting, branding yourself is an important
measure to embed a lasting impression, and it is
what makes you gold in a crowd of grey.
Picture: Photographed by Norman Jean Roy. From the Archives:
Google’s Marissa Mayer in Vogue. Posted August 2009, www.vogue.
com
American Institute of CPAs. Five Tips to Branding Yourself. Posted
2006-2014, www.aicpa.org
Lisa Quast. Personal Branding 101. Posted April 22, 2013, www.
forbes.com
C. Joybell C. C. Joybell C. Blog. Posted March 2011, www.goodreads.
com
Meghan Casserly. Marissa Mayer Named Yahoo! CEO: New Most
Powerful Woman in Tech? . Posted July 16, 2012, www.forbes.com
John D. Sutter. Marissa Mayer: From Google ‘geek’ to Yahoo CEO.
Posted July 17, 2012, www.cnn.com
QUIC is Canada’s premier student-run
asset management organization
Since inception, the
QUIC Fund has
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outperforming the
S&P/TSX Total Return index by 5.1%
QUIC Alumni have gone on to pursue opportunities at:
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- 27 -
February 2014, The Queen’s Business Review
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Email us at executive@qbreview.org.
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- 28 -