Where would you expect to see high returns on equity?

Last week I posted some data showing the pre-tax rate of return on equity (ROE) for different sectors of New Zealand business, based on the latest Annual Enterprise Survey (AES) from Stats, and taken back over the past five years. Going by hits on the post, there was a lot of interest - partly, I think, because profitability is an interesting and important concept, and partly because nobody else seemed to be mining the rich seam of data in the AES, or not in public at least, so the results were new to a lot of people.

One of the conclusions I came to was that some sectors seemed to be achieving rates of profitability that looked rather high for the kinds of activity they're in, with wholesaling, retailing and construction, in particular, earning what looked like high rates of return for what looked like relatively workaday industries (although recently high ROEs in housebuilding were more explicable, given the very large post-earthquakes demand for scarce housebuilding resources). It's possible that there are subcurrents in the data that are exaggerating the ROEs being earned: for example, some industries don't need much capital invested in them, so any profits at all get compared with a small investment, giving you a large ROE. Or returns to human capital are being misattributed to physical or financial capital. But overall it still looked to me as if some industries seemed to be earning quite generous profits, given what they do.

That, however, was based on a rather subjective view of the relative riskiness of each sector of business. And it seemed reasonable to do that, at least for some sectors: without doing any sophisticated analysis at all, I'd have rated the more infrastructural activities like electricity, water, gas, transport, and warehousing as relatively low risk, everyday activities that would be consistent with earning modest ROEs, and indeed that's exactly what the AES data show. But for all I know there's more risk in some sectors than amateur navel-gazers might guess from the outside, and higher ROEs might well be appropriate compensation for those real risks.

Which was why I was interested to come across this guest post, 'The Industries Plagued by the Most Uncertainty', on the Harvard Business Review blog site. The three authors came up with one of these 2 x 2 tables, with an index of technological uncertainty along the horizontal axis and an index of demand uncertainty on the vertical axis. Here are the results: they're on American data, but I don't think that makes much difference, though we obviously don't have some of the industries that the States does (such as aircraft manufacture, or big pharma).

This seems to me to provide quite a nice anchor for the ROEs you might expect to see in an industry: it may not cover absolutely everything that an equity investor might expect to be compensated for, but it certainly captures two of the major kinds of risks, In the bottom left, you'd expect lower ROEs, since there isn't a lot of demand or technology risk that investors need to be compensated for, and you'd expect higher ROEs in the top right corner, where both risks are high. And when you look in detail the results, they seem commonsensical. The utilities, for example, feature where you'd expect them (bottom left), as do the high tech sectors (top right).

The bottom line is that I'm still left with some of the same conundrums as before. Why, for example does wholesaling, which on this analysis is one of the least risky business activities (and which you might have guessed was, without ever seeing this analysis), earn an ROE in New Zealand in 20-22% territory? Twice the return that manufacturing earns?

And it's not just industry sectors earning more than you'd think they ought - there are also some strange examples of industries earning less than you'd think they should be. Agriculture on this analysis is reasonably risky - it squeaks into the top right quadrant - but in New Zealand it earns a pitiful, pre-tax, 5% return on equity in recent years.

So there are some real puzzles here. And even for those of us who reckon that markets in general are a pretty good way of getting the most out of our resources and best delivering what people want, you find yourself wondering if something isn't working out the way it should.  On face value, these patterns of profitability don't sit comfortably with the view that competition will deal to excessive profitability, or (consequently or independently) that capital is being allocated to its most productive use.

An inequality story in four graphs

Inequality isn't one of my core research interests, but over the last few days I've found myself absorbed in lots of interesting bits of research on inequality all arriving at once (I wrote up one of them yesterday).

Here's the latest one, which I've extracted from the OECD's mammoth Education at A Glance 2014, which appeared last week. The four graphs are quite large, which would make for an over-long post, so I've put them "over the fold", as they say. The gist of it is that we've got a developing problem in equitable access to good educational outcomes: right, on to the graphs.

So far so good

Today's Reserve Bank monetary policy decision came as no surprise - as predicted, for example in this survey, the cash rate was left unchanged. Can't argue with the decision, either: more "wait and see" was exactly right while we see the ramifications of previous rate increases (which are indeed cooling the housing market), lower export prices (especially in the dairy trade), and, of course, what the post-election government looks like.

I was also encouraged by a graph (below) which the RBNZ included in the Monetary Policy Statement, and which showed that the rate of domestic non-tradables inflation is very modest indeed outside of the construction sector.The overall non-tradables inflation rate is 2.7%, but on the RBNZ's estimates nearly all of this is down to the understandable cost pressures in the building trades.

I'd thought that our home-generated non-tradables inflation, other than on the building site, was running hotter than this, and didn't like the look of it, but so far, so good. Looking ahead, domestically sourced inflation will pick up from here, given that the currently strong economy is running above its "potential output" level, so let's hope that the Bank's view is correct that "the pick-up in non-tradables inflation is assumed to be gradual, and annual non-tradables inflation is forecast to peak at 3.4 percent in 2016". I'm a bit more agnostic about a 'cost plus' mentality in the more sheltered parts of the New Zealand economy, but let's see.

Another interesting graph (below) was the one showing the relationship between export prices in our main trading partners and import prices here in New Zealand.

The Bank has been fortunate that global events have helped keep local imported inflation low: export prices in our main trading partners have actually been falling, reflecting sub-par or outright weak economic conditions in some of our import suppliers. At some point the international tide will turn, and the global economic cycle won't be flattering our apparent inflation control quite so much: if there's a place the Bank does not want to find itself in, it's the one where imported inflation rises and domestic non-tradables inflation rises around the same time. That would produce some really ugly headline inflation rates.

Finally, and maybe this is just an issue of shades of terminology, I was left wondering how to reconcile this statement on the Kiwi dollar in the 'Policy assessment' bit - "Its current level remains unjustified and unsustainable. We expect a further significant depreciation, which should be reinforced as monetary policy in the US begins to normalise" - with this one on p17 of the Statement: "The New Zealand dollar is assumed to remain relatively strong given New Zealand’s relatively favourable economic outlook and positive interest rate differentials". I suppose the overall message is, "we expect the Kiwi to come a cropper, but maybe not as much of a cropper as it deserves, and it mightn't be tomorrow or the day after", which is probably as specific as anyone is ever able to be in the very inexact art of exchange rate forecasting.

Inequality in New Zealand

Yesterday evening in Auckland we had another interesting Law and Economics Association (LEANZ) event, with Max Rashbrooke talking on 'Inequality in New Zealand', largely based on his book Inequality: A New Zealand Crisis, published by Bridget William Books last year. Max is a fine presenter, and he's also got an interesting website (a joint project with the New Zealand Council for Christian Social Services), Inequality: A New Zealand Conversation, which among other things includes a calculator where you can figure out where you lie on New Zealand's income distribution. You may have also seen it on the Herald's website, where (according to Max last night) it rapidly got 100,000 hits.

As the hitcount shows, inequality is clearly much further up the public agenda than it used to be, partly influenced by work along Max's lines and partly propelled by the various debates set off by Thomas Piketty's Capital in the Twenty-First Century.

My own take - as I'll be explaining in another forum shortly so I'll keep it brief here - is that I can understand some focus on inequality per se, and particularly the inequality that's left after we've taken account of the impact of the progressive income tax and social welfare systems, but I've always been more concerned about inequality of opportunity than I am about inequality of outcomes.

I'm having to reconsider that a bit, though: as Max said last night, and others have also argued, you may not be able to separate out the two concepts of outcomes and opportunity so neatly. It's possible (for example) that high inequality might reduce a country's rate of growth, which is a bit of a problem for us fans of equality of opportunity: maybe a deeply unequal society can't generate the high rates of growth that equality of opportunity enthusiasts would champion as one of the best ways to help those at the bottom of the income ladder. Standard & Poor's for example came out recently with a report that said precisely that about the US economy: "Standard & Poor's sees extreme income inequality as a drag on long-run economic growth. We've reduced our 10-year U.S. growth forecast to a 2.5% rate. We expected 2.8% five years ago".

There's also a line of argument that says inequality actually interferes with people's ability to take fair advantage of opportunities. Here's what's been catchily called The Great Gatsby Curve (originally by Alan Krueger, chairman of the Council of Economic Advisers in the US, in 2012). This version comes from a Canadian economics professor, Miles Corak, who updated the original graph with more countries. You can find his write-up here at his website. Max also put a version up as a slide yesterday.

If you haven't seen it before, here's how it works. The horizontal scale is a country's income inequality, as summarised by its Gini coefficient: the further to the right, the more unequal. The vertical scale is a bit of a mouthful, but what it means is the percentage of a person's earnings that can be explained by their parent's earnings, so it is a measure of intergenerational mobility: the further up the axis you are, the more parents' income determines their kids' outcomes, so the less mobile a country is.

What you get is an overall pattern where the more unequal countries tend to be the less intergenerationally mobile. We, and Australia, don't show up too badly, by the way: we're a bit above the median level of inequality in this particular sample of counties, but on the other hand we're more open than many. We have much the same level of income inequality as Spain, the UK or Italy, but parents' income explains far less of our children's incomes than they do in those countries.
There are those who would make a strong argument from this graph - that it's the inequality that is causing the lack of mobility, and in turn that would tend to take you down a policy route emphasising redistributive policy.

I don't think that's necessarily true: I'm rather inclined to view both these outcomes (inequality and immobility) as caused by a third factor again, namely the social and economic openness of a society. In the UK you've got the class system; in much of continental Europe you've got insider/outsider labour markets. I'd still be tempted to bang away at those sorts of barriers to equality of opportunity: as far as I'm concerned, you can jack up the progressivity of the income tax system all you like, but it's not going to make a blind bit of difference to the career prospects of the young Arab girl in a French slum.

In any event, you can see the sorts of interesting ideas that arise at these LEANZ seminars. So sign up with LEANZ - you can do it here - it's a charity and can do with the subs and any spare donations you care to make. And if you've got any ideas you've been wanting to share, these seminars are a great opportunity to take them out over the fences (my hands are clean - here's a write-up of the LEANZ presentation I gave a wee while back).

Thanks finally to Ed Willis at Webb Henderson who organised the event and provided the premises and the drinks and nibbles.

Two 5 - 0 defeats

Chorus got bowled like ninepins this morning by the  Court of Appeal, having earlier been skittled by the High Court.

The cases were about the Commerce Commission proposing a big reduction in the price Chorus could charge for UBA, or as it is formally defined, "the additional UBA service component, which allowed access seekers to supply broadband services over Telecom’s copper access lines without investing in their own equipment or software". In other words, the bits and bobs that carry broadband traffic across the gap between the copper line from your place and the start of an ISP's network.

The reduction (roughly halving the price) had been based  on a benchmarking exercise, where the Commission (as required by the Telecommunications Act) looked at the prices overseas for UBA as a quick and dirty proxy for what it might well cost here. There's lots more about the exact details of the benchmarking comparability exercise, but that's the gist of it.

The Court's decision is here as a pdf and there's a shorter media release pdf if you prefer. Chorus's reaction is here: essentially, not surprised by the outcome, but felt they had to make a point about what they see as a regulatory regime mess around pricing of broadband services.

I'd reckoned, as I said some time ago, that (a) Chorus had very little chance of succeeding and (b) in any event the whole exercise was a waste of money, but Chorus went ahead anyway. And this morning, sure enough, they got squashed like a bug. Chorus had raised five issues: the Court said No to each and every one of them, as the High Court had earlier. While Chorus has said it is studying the decision, and I suppose could take it to the Supreme Court, after two successive 5 - 0 defeats you'd think they'd flag the game away.

Chorus didn't get anything helpful about any incoherence in the regulatory regime, either. The reverse, if anything, when the Court of Appeal said at [44], "the mandatory requirement for the Commission to carry out the “benchmarking” exercise...is itself designed to implement the statutory purpose, not to contradict or undermine it". In other words, the Telco Act is internally consistent.

So now on we go to the Commission's final word on the UBA price, which will be determined by modelling the actual costs of an efficient provider in New Zealand (Chorus had exercised its right to object to the benchmark stab at the price and to have local costs estimated explicitly). According to its media statement welcoming the decision, the Commission says it expects to have the first draft of the "real" cost (my words) in December.

Who knows what that price will be, but I wouldn't be in the least bit surprised if it came out within cooee of the original benchmarked stab at it. As I've said before,  my experience across a number of contexts is that  often benchmarking gets you to an approximately correct place, and far quicker and much more cheaply than the model-building route. I didn't start at that position - in fact, I originally thought the exercise would be too flaky to rely on - but what you find, when you get your hands dirty, is that you can say, the cost of this thing is somewhere around X. It might really be 1.1 times X, or 0.9 times X, but it sure isn't twice X or  half X. And that shouldn't be too surprising: in areas like telecoms, for example, companies tend to be delivering much the same sort of thing with the same sort of technology.

It's all moot now, as we're donkey deep in the formal cost modelling, but I'll say it anyway: I have a soft spot for simple, practical-enough regulation options like benchmarking. For all our general preference for light handed regulation and our national propensity to come up with a cheap and cheerful Number 8 fencing wire answer to things, our current regulatory approaches seem to be favouring ever more complicated, ever more expensive, ever slower, ever more intrusive options, as anyone who's had anything to do with the regulation of electricity lines businesses (for example) would agree.

We're currently having a review of the telco regulatory policy regime. It would be nice, as an outcome, if simplicity and speed got more of a look in than they do now.

Where the profits come from

In the last couple of posts I've been looking at the profitability of different sectors of New Zealand business, using the data from Stats' latest Annual Enterprise Survey.

For some reason the fascinating data in the Survey don't seem to get a great deal of airtime, so partly to make the case for greater use of it, and partly because the trends in the data are fascinating, and as a little bit of a public service (the numbers need a degree of assembly), I've pulled together this composite picture of business profitability over the past five years.

I've broken down some of the line items into sub-sectors where it seemed interesting, though there are still lots of sub-sector alleyways I haven't gone up, for example within agriculture and manufacturing. And in some sectors I've split out an "ex government" breakdown (eg in education and health where government is a big player) to get a better feel how private business is faring in those sectors. Profitability, by the way, is pre-tax return on equity. The years are financial years ending in March.

You'll see the unsurprising effect of the overall business cycle on profitability: ROE across all industries was only 6.2% in recessionary 2008-09, and has worked its way higher to the latest 9.1% (and I wouldn't be surprised if it edged higher in 2013-14). There may be additional cyclical stuff going on in the manufacturing ROE too: I wonder if that fall in the 2013 year was down to the impact of the high Kiwi dollar?

And you can see the impact of the Canterbury earthquakes in the 'health and general insurance' line, which took a hammering in financial 2011 and 2012. You see it again, less directly, in the ROE on residential construction in 2013, which rose to extravagant levels. There's quite a bit of year to year volatility at a sub-sector level, so I wouldn't read volumes into the latest reported 48.4% ROE on housebuilding, but whatever the number is, it's clearly happy days in the building trades.

Generally the pattern of profitability is much as you might expect a priori, with (for example) the utility/infrastructure end having a relatively low ROE. I'd hoped to unpack that 'information media and telecoms' line a bit more to see the infrastructural component, but confidentiality issues mean that Stats was only able to release a breakdown for 2013, so I flagged it away.

As I've noted before, some of the returns look on the high side for the kind of business they are - wholesaling, retailing, and construction in particular (the ROE on the various parts of construction was quite high even before the earthquakes). At a blind guess, before seeing the data, I'd have picked their ROEs as somewhere around the mid teens, but they're well north of that. It's hard to go past the thought that these are all non-tradable sectors that don't face the degree of competitive pressures more trade-exposed sectors like manufacturing have to cope with.

And while I'm open to anyone who can show some other realistic explanation of the high returns in these domestic sectors, I doubt that there's enough domestic competition to adequately constrain ROEs, either. Look at the comparison with the banks, for example: there are some sceptics who wonder about high profits from a banking oligopoly, and it was the explicit premise behind the formation of Kiwibank, But the returns from wholesaling, retailing and construction are all substantially above the ROE in banking, even if you take a generously high view of the banks' ROE (15.8% in the latest year).

The professional services sectors show an interesting pattern, too. The reported ROEs for the likes of science, architecture, doctors and vets, IT professionals, and lawyers and accountants are all quite high. And I don't have a problem with that (always assuming that the high ROEs aren't the result of gatekeeper restriction on supply). You'd expect it: these are scarce, often highly specialist skills that you'd imagine can command high returns as high productivity inputs.

But clearly there's something odd in attributing all of the return to the monetary capital invested in the business. The reported return on shareholders' funds grossly exaggerates the return on the capital invested, as it conflates the return to the tangible assets with the real source of the high returns - the intangible capital between the professionals' ears. And in turn that makes me wonder about some of the conclusions that Thomas Piketty comes to in Capital in the Twenty-First Century, where that 'high' rate of return on capital that he quotes must also be inflated by including returns that should more properly be attributed to a different factor of production. And the inflation will be getting worse as high knowledge activities progressively account for more of a modern economy
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In any event, that's only one of the ideas that might come to you when you start using this data. There's lots more there - I've chosen to focus on ROE, but you could look at sales or profit per employee, balance sheet structures, margins on sales - so if you've got an interest in the performance of New Zealand business, tuck in. It's an invaluable resource.

Outrageous fortunes

Yesterday I posted some data showing the profitability of different sectors of New Zealand business, based on Stats' brand new release of the Annual Enterprise Survey for 2013. And based on a quick squizz at the data I concluded that "you start thinking deep, dark thoughts about whether there are strong enough competitive pressures at work to constrain the profitability of some lines of activity".
I've done a bit more fossicking in the data, and I've ended up thinking even darker thoughts about the state of competition in parts of retailing - and the supermarkets in particular.

Here is what has been happening to the pre-tax rate of return on equity (ROE) in the main sectors of retailing. I've taken the data back to 2009 (which is where Stats started publishing more detailed sub-sector breakdowns), which helps to sort out whether any high recent ROEs are just a cyclical artefact of the recently strong economy rather than evidence of structurally limited competition.

There is no credible explanation for the high ROE of the "supermarket, groceries and specialised food" sector other than limited competition.

This is not a sector where you'd expect high ROEs because of the exercise of scarce, highly specialised skills. And it's not a "high beta" sector exposed to a high degree of cyclical risk - unlike the car yards (who made no money in the tough market of 2008-9) or the sellers of consumer durables (who lost money in 2008-09). If anything, the supermarkets' profitability increased in the tough times.

Let's be clear - the supermarkets are fully entitled to these ROEs. There's nothing wrong with charging what the market will bear. And if you were a duopoly behind reasonably formidable barriers to entry, you'd expect to coin it, too.

But the sooner a hard nosed, low priced Costco or Aldi comes along and upsets their apple cart, the better off we'll all be.

Good profit, bad profit

Many people are ambivalent about corporate profits: they don't know whether to cheer a successful business or boo an exploitative rort. Look at the recent reactions, for example, to the 45% increase in Air New Zealand's after-tax profit:  is this good management of a New Zealand business icon (especially when compared with the humongous losses at Qantas), or, as commentators from the Prime Minister downwards have wondered, a right royal rip-off of travellers on the regional routes?

I've got no problem per se with businesses making money hand over fist. Quite the contrary: that's kind of the point of it all, and in any event healthy profits are the engine that drives investment, hiring and innovation. Where I join the critics is when the profits aren't made on the battlefield of competitive markets: if, instead, they're being coined behind a monopolistic or oligopolistic or protectionist or regulatory moat, then there's good economic reason to push back against the profiteering.

As it happens, on Friday Statistics New Zealand released some data that throws light on the profitability of New Zealand businesses. It's the latest Annual Enterprise Survey, for 2013. It's fascinating - no, really, it is - and it leaves you wondering why some sectors make so little money and why others make so much.

Here's a table I've constructed from the Survey results, on industries' pre-tax return on equity in financial years 2012 and 2013.

Some of this is reasonably well-known: agriculture, for example, while it may be the backbone of the economy, generates a remarkably low 5%-and-a-bit pre-tax return on the equity invested in it.

But some of the other results are rather more surprising.

Why is the ROE in wholesaling so high? It looks to be one of the more humdrum, everyday sectors with (you'd think) not a lot of reason to be earning the sort of ROE a higher-risk, higher-innovation line of business might earn. But there it is, up among the higher earning sectors.

And then you look at retail trade, again earning one of the higher ROEs. And it's at this point, if wholesaling hadn't already got you beginning to think along those lines, that you start thinking deep, dark thoughts about whether there are strong enough competitive pressures at work to constrain the profitability of some lines of activity.

If you go down into the details of the Survey, within retailing (on 2013 data) you find that the accommodation and food services bit of it had an ROE of 15.3% (unusually high that year, it was lower in 2011 and 2012). Car yards and petrol stations did all right, too, with an ROE of 20.2% (again, to be fair, it had been quite a bit lower in the previous two years). There's an assorted 'other' category, where the ROE was 23.1%. But then you come to the 'supermarket, grocery stores and specialised food retailing' segment, and guess what: you find an ROE of 33%. And it had been a lot higher again in 2011 (46.7%) and 2012 (45.1%).

These are outsize rates of return, that - given the bread and butter nature of the sector - are not consistent with fully effective competition in the retail trade.

I'd say the same about construction, except that there are obviously unusual post-earthquake market conditions distorting the numbers which likely explain some or all of the observed ROEs in 2013 - particularly residential building's 48.5% (up from 29.9% the previous year and 27.8% in 2011), But there also looks to be an element of entrenched super-normal profitability in areas such as construction services (ROE averaging 31.2% over the past three years) and heavy and civil engineering construction (21.7% over the past three years). Non-residential building construction on the other hand had quite a modest average ROE (14.2%).

Perhaps there is another, better explanation. But for now, what these figures say to me is this: we have a bunch of domestic, non-tradable sectors that look as if they badly need more effective competition to drive down profits to more sensible levels.