Topic 2- Role of commodities in the modern era

Gold has an important role to play in the society through out the history of mankind. Ever since it was discovered, the ancient people had been using the precious metal for trading purposes, serving as the unofficial currencies of the world economies back then. In the 1900s, the role of gold has diminished substantially as the trading currency, even more so when the majority of the countries in the world adopt the current monetary policy of inflation targeting, which banks on the reputation of central banks around the world rather than the gold-backed greenback exercised in the early to mid 1900s.

With all these changes to the world monetary systems, gold’s role has been relegated to mainly of jewellery uses and futures trading purposes. However, with the recent resurfacing instability of the oil prices and the US dollars, on which gold price is based upon, its existence has taken a higher significance now.

The trade deficit in the US economy has kept on increasing for the past decade, and by logical measure, even if the Chinese devalues the yuan by 10% in the next decade, the gap is only going to get wider & wider. Many economists have predicted that this situation is not sustainable, and the USD will collapse sometime in the future because of the enormity of the debts it owes to many of its government bond holders. Even the richest man in the world, Chairman of Microsoft Corp. Bill Gates, has recently stated that he is hedging his bet against the USD. The question is, if the richest man in the world, plus a lot more of renowned economists, say so, is there a higher chance that the few brains in the White House get their prediction right that the deficit won’t cause any problems?

With this impending issue in mind, let’s analyze its impact on the gold prices. Gold prices have increased by more than 70% in the past 1 year, after remaining roughly constant for more than 6-7 years. It must be noted that the last big fluctuation was during the Asian economy crisis. The empirical evidence suggest that there is a steady equilibrium price for gold during normal times, but there will be an upward surge in price when the currencies are getting unstable, & it will return to its inflation-adjusted equilibrium price slowly after that.

The current upsurge in gold price suggests that investors are getting nervy about the USD, which has devalued by around 7% recently. The situation has also been exacerbated by the recent upsurge in oil prices due to the Iran standoff.

The role of gold as a stabilizer mechanism cannot be denied. In turbulent times, when government’s monetary policy is given less credibility, gold has stepped up and become the unofficial currency again. 1 kg of gold will have the price of 1 kg of gold when the crisis is over, but a 100 USD bill may only have half its value when the tide is gone. The other scenario, when the currency actually appreciates during the crisis, may also happen, but people would rather take the safer option of getting the same value for their ‘money’ by buying gold. Hence, gold plays the role of a hedging mechanism when this scenario occurs.
There is the question of why other commodities, such as oil, can’t have the same role as gold in the economy. To answer this, we have to divide all the other commodities into 2 broad categories: consumable and inconsumable. Consumables refer to commodities such as oil and aluminium, which has to be used everyday to ‘run the world’. Since it has to be used every single day, and it can’t be replenished easily, the choice to use it as a hedge would not make sense as its supply will run out one day. There is also the extra risk of being held hostage by oil producing countries like the OPEC and the Arab nations, which hold almost 75% of the proven oil reserves in the world.

Inconsumable refer to the commodities such as silver, diamonds, and gold. These are commodities that are used minimally in the industries (supply > industry use) and could potentially serve as hedges to the worsening currency crisis. However, since traditionally gold has been used as a currency before, people have the perception that it is a better commodity to use rather than silver which is less valuable in the monetary sense.

As explained above, the escalating gold prices will likely come to a stop in the future, but there is no guarantee that it will come down to its previous level because of the current situation with the oil crisis. It will most likely stay at a new higher equilibrium in the future, before its value is again reassessed in the next crisis.

Topic 1 - Psychological factors in Finance

We learn in the Corporate Finance course that companies that are not 'disciplined', ie stray from their own fields of expertise and ultimately fail in the end, will eventually be subjected to ‘market discipline’. This means that another company, usually a larger company with the same core business or ‘trade hawks’, will come in to acquire the entity. It will then sell off its non-core assets and then attempt a restructure, and for the ‘trade hawk’ case, sell the company in the end for a huge profit after turning around the money-losing firm in a few years time.

The case I want to discuss here is this: if it is so amazingly simple to make the formula work again, ie sell off non-performing units & return to winning ways, why can’t the wannabe conglomerate do that itself? After all, they could have done what the buying company will be doing, ie sell or spin off the non-core assets, and concentrate on the core businesses. I could come up with a few reasons here, in order of importance:

1) Management (psychological issue). Imagine if you were a passenger in the Titanic and you got dragged down to the Atlantic Ocean because of an oversight by the Captain. You survived and took the next ship to head to US and found that the same Captain that almost killed you has also been rescued and WORSE, appointed as the Captain (again) of this ship that you are taking this time. The 1 million dollar question is, would you still take this ship and be led to another disastrous journey? You might even be thinking that you would be better off just swimming off to your destination, because at least you have saved the money for the ticket! Although this scenario may not play out in reality, the psychological effect on the person is undeniable and it is more likely that you will get out and wait for the next ship that goes out.

Exactly the same situation applies to the corporate world. Once the incumbent management team is judged as not doing its job properly, shareholders would demand a change to the team, & if unsuccessful, be likely to dump their shares, getting out of the sinking ship before it meets its final doom. They would rather salvage some value out of it rather than waiting to see if the situation could be reversed. They would then be found pounding themselves when they find out later that all it takes to rescue it is just to throw off the unnecessary luggage aboard (the non-core assets) and the ship (company) will still be able to sail smoothly to its destination (meet its profit target). In the end, panic is the culprit that makes the situation looks even worse than it is, & the trust factor that has disappeared altogether when in a frenzy.

Obviously sometimes it’s not always the situation that the shareholders are just not patient enough when in a crisis. If the management could not see the point of concentrating its effort on the core assets, or that they have some other hidden motives (read: $$ incentives or promotion prospects), then it is definitely time to get rid of it and install someone who can perform the job.

2) Prestige (another psychological issue). While it is true that often the companies that succeed are the ones that stay true to their core businesses, conglomerates are the ones that are held at a higher esteem, at least in the psychological aspect, than the non-diversifying firms. They are often the ones hiring hundreds of thousands of people in their respective countries and are normally revered in their own countries, even by their own respective governments because of their enormous influence on the countries’ economies. Governments’ bailouts of struggling conglomerates have been very common in many countries, simply because of the devastating effects it would have on the economy if they collapse. Hundreds of thousands of jobs are at stake, and the country could be caught in a downward spiral if this happens because of the multiplier effect in the system. As such, these conglomerates are usually very confident in branching out of their industries, as they believe the government would come to their rescue in the case of failure. This will lead to higher confidence from the shareholders as well because the support from the government means a much higher return than other ventures, at an insignificant increase in risk.

Laying off non-performing units would then be seen as financial incapability of their parent units & reflects badly on the conglomerate as a whole. As such, conglomerates tend not to lay off units quickly and try to rescue them by injecting more funds to keep them afloat, without changing the top management of the units. More money is pumped in, but results normally don’t show because they are still run by the same ineffective people.

An example of this is the Mistubishi Corporation of Japan. It has a automobile producing unit that has been losing billions of dollars for many years, but yet has not been shut down because the conglomerate is very powerful in Japan. It keeps channeling the profits from another of its highly profitable unit, Mitsubishi Bank, one of the top four banks in Japan, to plug the deficit in the automobile unit. This results in lower profit for the group, clearly violating the mandate for the management, that is to safeguard the shareholders’ interests.

3) Trade unions. In some countries like US or Germany, trade unions are so powerful that they can hold the companies hostage if necessary. Therefore it is virtually impossible to simply lay off non-performing units and get back on track because they could be liable for hundreds of millions, or even billions, of dollars when they do that. One good recent example is the case of Siemens Mobile. Siemens is a rare conglomerate in Germany and it has ventures in almost every industry, from construction to chemical production. Its Siemens Mobile phone unit has been losing money for years and it has been unable to sell it off or even give it free to other companies because no one is willing to take the risk. In the end, BenQ of Taiwan, a much smaller mobile phone producer contacted Siemens, which at that time held a 5% share in the mobile phone market, about a possible takeover and the agreement was that Siemens had to pay BenQ in excess of US$500 millions for it to be willing to take over the ailing unit. BenQ’s plan is to slowly shift the production out from Germany to Taiwan and reduce the workforce there till it is finally fully shifted out. It could do that because it is an overseas outfit and hence would be less tied to the trade unions’ power if it tries to reduce the workforce in Germany. This will be a win-win situation for both parties.

Out of the 3 reasons above, 2 of them are psychological factors and only one has to do with the economic of the real world. So next time when you read a report on any business magazines or journals, remember that the deal is always more than what it seems. A lot of the companies depend on not just their products, but also their image to survive. Martha Stewart’s Living OmniMedia and Richard Branson’s Virgin are two very good examples, as is Donald Trump’s Trump Organization. Psychological factors feature prominently in business deals, but yet it is not given enough recognition because it can’t be measured in numbers. This has to change.

Introduction

My purpose of creating this blog is to discuss corporate news and issues that can be seen & read everyday in the news. Mergers, acquisitions, spin-offs, etc are so common that people seem to take it with a pinch of salt and rub off their significance.

The truth is, there are a lot of psychological motives behind these moves, even though it might not be at all beneficial for the shareholders of the respective companies. This certainly goes against the basic principle of any business, that is, to safeguard the shareholders' interests.

I will express my views in this blog and they may be totally wrong. Therefore, I hope that the readers could contribute to the discussion and feel free to add on or criticize any of the comments made.
It's only through free discussion that we'll be able to generate the best ideas that will in turn set the best practices.

Disclaimer: Topics discussed in this blog are purely for analytical purposes. The writer of the blog is not in any way liable for the damages incurred by following any advices given in the discussion. Please contact the blog owner if you wish to republish or reuse the information elsewhere.