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 BLOG >> March 2021

Business Terminology [Definitions
Posted on March 29, 2021 @ 04:37:00 PM by Paul Meagher

In today's blog I want to define some terms used in finance and investing that I think are worth knowing. I hope to make a habit of devoting future blogs to defining useful business terms. Some terms in finance and investing are "mind tools" that can help us think more clearly about certain business problems. Just like farmers have invented tools to make farming easier, academic and practicing business people have created business terms that make thinking about business problems easier. Here are some terms to start with.

Loan To Value (LTV): Loan to value is a ratio (L / V). It is the ratio of the amount of loan L used to acquire an asset to the assessed value of an asset V. Lenders may specify an LTV of say 70% meaning they will only loan up to 70 percent of the value of the asset. So, for a house assessed at $100,000, the maximum loan the lender will provide is $70,000. The portion the buyer is expected to pay is sometimes called "the haircut" (in this example 30% or $30,000) . The higher the LTV value on a loan, the riskier the loan is. Different lenders may offer different LTV rates and some may originate riskier loans. One of the factors that led to the economic crisis of 2008 was that mortgage originators were offering loans with high LTV's. In Investopedia's article The Fuel That Fed The Subprime Meltdown they describe what happened to LTV rates:

As a result of this activity, it became very profitable to originate mortgages—even risky ones. It wasn't long before even basic requirements like proof of income and a down payment were being overlooked by mortgage lenders; 125% loan-to-value mortgages were being underwritten and given to prospective homeowners. The logic being that with real estate prices rising so fast (median home prices were rising as much as 14% annually by 2005), a 125% LTV mortgage would be above water in less than two years.

Time Under Water: Measures how long it takes for some measure of business performance to return after it goes down in value. If you made, say, 50,000 in February of 2020 but your revenues took a hit as a result of COVID, then you could measure how long it takes to get back to making 50k a month again. The time under water would be the number of months it takes to get back to making 50k a month again. The time under water could be measured in days or years depending on the context. Many small businesses are continuing to spend time under water as a result of the pandemic. If you were making, say, 50k per month before the pandemic and then your revenue dropped to 10k per month, that drop of 40k would be the drawdown amount. If it was the largest drop in revenue you have ever experienced, then it would be the maximum drawdown, and your recovery back to making 50k a month again would be time spent deep underwater. When assessing the risk associated with different stock market investments, you might measure the average time under water and maximum drawdown of different stocks to create a risk profile for them.


Source: Optimal Portfolios with Traditional and Alternative Investments: An Empirical Investigation

It might be worth noting that if you are in the situation of having a mortgage loan where the value of the loan is greater then the value of the house, then your loan is said to be under water.

Arbitrage: An arbitrage opportunity arises when there is the possibility of buying something for a low price in one market and selling it for a higher price in another market. A stock that is priced lower in one stock exchange, for example, can be exploited by quickly buying up stock on the lower priced exchange and selling it on the higher priced exchange. Hedge funds will often use leverage to buy large quantities of shares to make it worth their while to make these arbitrage trades. The difference in price between the two markets is the gross profit. There are transaction costs in executing a trade which may wipe out the profits if you are not careful. Retail arbitrage involves buying items in one retail environment at a low price and selling it in another retail environment at a higher price. Some Amazon sellers, for example, use retail arbitrage to make money on the items they buy on clearance at Walmart and sell on Amazon. An example of arbitrage in rural areas might involve a store owner buying retail items in a larger big box store and selling them at a higher price in a rural general store.

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Predictions, Decisions, Plans [Agriculture
Posted on March 19, 2021 @ 02:26:00 PM by Paul Meagher

Trying to plan for the future is difficult in this limbo state between lockdowns and openings.

A central part of planning is a making set of decisions as to what actions should take place to achieve desired outcomes within certain timeframes.

How can we make good decisions when the ability to achieve desired outcomes depends to a significant extent on pandemic factors outside of our control? Perhaps there is some decision making approach involving, say, scenario planning that might give us tools to make better decisions or at least anticipate and react to possible futures better. One can engage in scenario planning as a mostly qualitative approach to understanding possible futures and how we might prepare for them. A good example of the power of a qualitative scenarios approach is David Holmgren's scenario planning work. A qualitative scenarios approach doesn't preclude the use of powerful visualizations to express ideas but usually doesn't involve getting into math and logic notations to make the main points. You can also choose to implement scenarios as complex models that you have to implement and run to get a sense of the possible dynamics of the system. The Limits to Growth book is a good practical example of the power of scenario modelling to envision how the future might unfold. Qualitative approaches may and often are informed by quantitative models, especially the limits to growth modelling.

Another way we might make good decisions is by making the decision based on the simplest approach that works. Instead of engaging with the full complexity of the world with rich scenarios of possible futures, we can also ignore most of the real world complexity and focus on one cue or indicator that can be used to make a decision. Maybe just one indicator or cue is not enough, but two might be sufficient for reasonable predictions upon which our decisions would be based.

Take as an example predicting the price of a residential house on the market. A simple valuation model might be square footage x neighborhood price per square footage = value of the house. So predicting what a house should cost in a certain neighborhood might be achieved by estimating the square footage and the average price per square foot in that neighborhood to arrive at a valuation of the price of the home. The estimate price might be sufficient for us to make certain decisions about whether to buy if it is being offered below the price estimated by a simple square footage valuation model. Of course we can add many more variables to get a better estimate of the "true" value of a home in a neighborhood but the additional model complexity may come with little additional benefit. It depends on how much more of the variance we can capture by adding the additional variables to our model. Instead of 156k price the improved model might predict 161k for a house. The actual selling price might be 160k. The complex model was a bit closer, but the simple model wasn't too bad either. If the offerring price was 150k then both valuation models produce the same buy decision. So perhaps making a decision during the pandemic that depends on predicting the future might involve only taking into account one or two variables in making a prediction upon which a decison will be made. A simple model has the benefit that you can easily determine if it is wrong and can change your model quickly to use another indicator or two indicators that might be more predictive.

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Supply Chain Opportunities [Trends
Posted on March 11, 2021 @ 07:47:00 AM by Paul Meagher

I recently went to a local appliance store to inquire about their fridges. They mostly carry General Electric appliances. When I arrived I was quite surprised to see that they had hardly any inventory. I was informed that the limited inventory I could see was already spoken for. I asked about getting a fridge and was told I could be waiting 4 months for delivery.

It is likely that there will be supply chain issues for common types of lumber from 2 x 4's, plywood, and decking especially as we emerge from the pandemic and the season for building/renovation/diy projects starts to heat up.

From the point of view of the end consumer, these supply chain issues are major frustrations both in terms of not being able to get a product you want/need or having to pay higher amounts because of scarcity. From the point of view of an entrepreneur, these disruptions signal an unmet demand and an opportunity to provide some type of supply chain solution. Where the news media might use the term "disruption" an entrepreneur might substitute the word "opportunity".

We encountered supply chain issues in the early days of the pandemic when there was a lack of Personal Protective Equipment (PPE). There was a huge demand that was not being met and this was a signal for many different companies to step forward to help meet the demand. The shift to working and spending more time at home has spawned increased demand for many products and is causing ongoing supply chain issues. The shortage in GE Appliances, for example, is being attributed in part to increased home renovations and replacement of appliances.

As we exit the pandemic there are likely to be supply chain issues if the economy starts to heat up and there is not enough supply to meet demand. An entrepreneur or investor looking for opportunities might want to research these disruptions, their causes, and the possible solutions to identity potential opportunities. Maybe it involves manufacturing items that are typically manufactured elsewhere, or obtaining needed items from other sources, or solving a logistics issue, or creating software that sources/monitors supply chain items, or anticipating demand and obtaining items that will be in demand later. An example of the later is some automotive companies that anticipated potential supply chain issues with computer chips and stockpiled them. They are now sitting pretty compared to other automotive manufacturers who did not anticipate shortages and can't roll out new vehicles until they can obtain a supply of computer chips.

I'm also seeing supply chain issues in ordering fruit trees, berry plants, and vegetable seeds. The primary producers are running out of stock on the most desirable items. It will also be interesting to monitor the types of foods that might be in short supply. There was a run of on flour last year when everyone started baking at home. As we emerge from the pandemic what food supply chain issues might we see?

Where I live residential real estate has been hot with house prices going up, houses not staying on the market very long, and in some cases bidding wars leading to closing prices above the asking price. There doesn't seem to be enough real estate supply to meet demand. This may be the biggest supply chain issue of them all especially considering the quickly rising cost of standard building materials that make purchasing an existing home even more attractive. Opportunities abound for entrepreneurs and investors in the residential real estate supply chain.

In conclusion, supply chain disruptions are frustrating for the companies trying to manufacturer products and for the end consumer. They also signal opportunities for those who seek to understand the causes and the possible solutions that might appeal to the manufacturers (B2B) and consumers (B2C). Many people are unaware of the supply chains and what it takes to keep them running smoothly. When they are disrupted we start to see under the hood that they involve numerous physical and computational steps that can potentially be disrupted. We have become more aware of supply chains as a result of pandemic shortages but there is still much to learn if you want to understand where entrepreneurial and investment opportunities might lie.

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Getting ready for the reopening of the economy [Trends
Posted on March 1, 2021 @ 08:44:00 AM by Paul Meagher

The pandemic has been going on for so long that it is getting hard to imagine that it might soon come to an end and that we should be starting to prepare for a post pandemic world. It might even come sooner than we think if the vaccines help to create herd immunity quicker than anticipated.

I am a fan of Dr John Campbell's Youtube channel where, since the pandemic began, he has been discussing empirical data and scientific studies on various aspects of the pandemic. Israel is ahead of most countries in administering vaccines to its population and there is now a good large scale Israeli study published (+1 million sample) demonstrating the effectiveness of the vaccine in stopping the spread of Covid-19, hospitalizations and death. The results of the Pfizer vaccine rollout in Israel is very impressive and a cause for hope.

It is hard for startups and small businesses to plan when the outlook is bleak and uncertain. In this situation you may find yourself looking at the world through a scarcity lens rather than the abundance lens that is more typical of entrepreneurial thinking. What happens when the world starts getting back to normal where we can again gather in larger groups, socialize freely, travel without restrictions and do other things that we took for granted before? Will there be pent up demand?

It is still tricky to estimate when the economy will "reopen" but we should be starting to imagine it and what possibilities might open up when it does. Take, for example, a wedding venue business that I have been thinking about offering at our farm property. Last year was not a good year for holding weddings and many people put it off. In colder climates, that means putting it off until this summer. Will there be pent up demand for wedding venues this year? Will they generally be smaller due to international travel restrictions? Do I start advertising now and what should my marketing message be?

What about restaurants and bar venues? Increased demand here might be a result not only of people wanting to publicly socialize again, but also due to the pandemic forcing the closure of competing bars and restaurants leaving fewer venues to satisfy demand.

Is it a time to privately invest to get ready for demand? Valuations on many small businesses are lower than they were pre-pandemic and many small business owners are fed up and wanting to exit the business at lower valuation levels. How long will these valuations last if it appears that the economy might start to reopen and that demand might start to return or exceed pre-pandemic levels?

Just like many entrepreneurs and investors had to adapt to the pandemic world, forward looking entrepreneurs and investors are already looking to adapt and scout out opportunities in the post-pandemic world.

It may be important to monitor places like Israel and Scotland that will be leading the pack in terms of reopening their economies as a result their vaccines efforts to see what the trends and opportunities might be in a post-pandemic world.

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