How Agglomerations Swindle the Equity Investor
Why haven’t Wall Street and Hollywood been bigger moneymakers for investors? Groupthink?; Also: Another stock corner (not GameStop)
This will be a bit of a different essay, exploring why companies in superstar cities have historically disappointed investors. It’s not as fun as talking about Piggly Wiggly, but bear with me on this one. Haven’t you read enough about GameStop this week?
Byrne Hobart highlighted last month that 60 of the 100 most valuable companies in the world are headquartered in the US, which is surprising considering the US is only 5% of the global population. A list of the most valuable companies in the world also happens to be a good guide to what companies have created the most total value for investors. It is not a perfect guide, as some companies grow by issuing stock and a few companies enrich investors by returning a lot of cash, but it is reasonably accurate.
A ranking of the top 100 companies is a significant sample for this purpose because of the power law at work in the stock market. The top 100 stocks in the US make up two-thirds of the value of the S&P 500, which in turn is three-quarters of the market value of all of the publicly traded stocks in the US. Looking at a small selection of the biggest winners actually shows us a large portion of the total return to investors over time.
The top of this list is made up of the usual suspects - spots two through six (after Saudi Aramco) are Apple, Microsoft, Amazon, Facebook, and Google, global technology companies worth an average of $1 trillion that have created immense wealth for their investors. These five companies, along with several others further down on the list, are all located in two small metropolitan regions–Seattle and the Bay Area–and would thus seem to demonstrate the value of agglomeration effects.
Agglomeration effects simply describe the benefits to companies from clustering close together, and explain why industries are geographically concentrated. The standard story, developed by the economist Alfred Marshall in the 19th century, is that companies in the same industry can gain by locating in the same city, to benefit from the improved flow of specialized information, labor, and goods. As a result, firms in a given industry will flock to a city and stay there indefinitely.
For example, in the case of software, companies that locate in the Bay Area benefit from a deep market of specialist skilled workers (from engineers to salespeople), quickly learn best practices from neighboring companies (“knowledge spillovers”), and have ample access to specialized customers and suppliers (particularly suppliers of capital - that is, VCs). As they crowd into a small area, rents rise, and landlords rejoice, but the benefit also accrues to employers and employees. The story goes that agglomeration effects explain why people are (were?) willing to spend $4,000 a month for a studio and step over feces on the sidewalk in order to live in San Francisco.
One prediction of this model is that the leading companies located in these agglomerations will have a major advantage over would-be competition from outsiders, because it should be difficult to build a competitor without access to specialized information or supplies or a deep market of talent. The biggest threat should come from upstarts inside the same cluster, or the incumbents should just keep winning.
There are several older major industrial agglomerations in the U.S. we can use to test this theory. The most significant one outside of the Bay Area is the securities industry in New York City, which accounts for 20% of all private sector wages in the Big Apple, despite only employing 5% of workers in the city. The next biggest one is likely the entertainment industry, which employs as many people in Los Angeles as the securities industry does in New York. A third interesting one to study is Detroit, which as the center of the auto industry was the 4th biggest metropolitan area in the US at its peak.
These three industries have seen tremendous growth over the last century. We drive more miles, we watch more movies and TV, and we trade more stocks. These are also industries with generally good economics–each of these industries has minted their share of fortunes for investors, and each of these industries is currently profitable enough to have representatives on this list.
You can probably predict the punchline here. None of these industries have a company on the list headquartered in what most would consider to be that industry’s hometown (with one exception that has not been an exceptional winner for investors). In fact, companies headquartered in that industry’s hometown generally have produced poor returns, and all of the big winners in these industries have come from other cities.
The auto industry is represented on the list by Tesla and Toyota, which have done very well for their investors, as have some other major automakers not on the list, such as Honda. Conversely, the Detroit automakers, once world leaders, have lagged dramatically, with GM and Chrysler going through bankruptcy reorganization in 2009.
The entertainment industry is on the list with Bay Area-based Netflix, which has famously disrupted Hollywood in recent years. Also on the list is Disney, which is based in Los Angeles but was formed over the last quarter century through several big mergers with companies based outside LA that required the issuance of a lot of stock, and as a result, Disney investor returns have only marginally outpaced the broader stock market. The spoils of the media industry in recent decades have almost entirely flowed to investors in companies outside Los Angeles (including those acquired in recent years by Disney) which were quicker to own distribution—first the cable networks, and then Netflix—despite the big advantage Hollywood had as they controlled all of the content.
The securities industry has mostly been a nightmare for investors, with only one representative on the list, and that representative is based outside of New York. Most of the publicly-traded major securities firms in the US were vaporized in the 2008 Global Financial Crisis, including Merrill Lynch, Lehman Brothers, and Bear Stearns, while the two major survivors, Goldman Sachs and Morgan Stanley, were impaired. The best returns in the securities industry have been chalked up by asset managers like Blackrock, retail brokerages like Charles Schwab, and electronic stock exchanges and financial data companies like CME, and for the most part these businesses are not based in New York.
We have these three large, profitable industries, each primarily concentrated in a major American city for over a century, with all of the benefits that agglomeration brings, compounding over decades. Despite this, investors who bet on the players based in these cities have mostly been disappointed, their returns eclipsed by those of industry participants far afield. How is this possible? And what does this portend for the Bay Area?
The only member of the securities industry to make the list comes in at number nine, and is five times more valuable than any other securities company I could find. That company is Omaha-based Berkshire Hathaway, Warren Buffett’s investment company. It achieved success in an unusual way for a securities firm, not by selling securities or managing securities, but mostly by buying and holding securities. As you might imagine, Warren Buffett has a theory on the subject. Here is Buffett, speaking to college students about the securities industry in 1991:
The last thing I want to show you, before we get onto your questions, is an ad that was run June 16, 1969 [ed note: only 22 years ago at the time], for 1,000,000 shares of American Motors. This is a reproduction from the Wall Street Journal of that day. Now does anybody notice anything unusual about that ad?
Everybody in that ad has disappeared. There are 37 investment bankers that sold that issue, plus American Motors, and they are all gone. Maybe that’s why they call them tombstone ads.
All gone in 22 years! Back in 1991! The short shelf life of securities firms is not a recent phenomenon.
Now the average business of the New York Stock exchange in 1969 was 11 million shares. Average volume now is fifteen times as large. Now here’s an industry whose volume has grown 15 to 1 in 20 years. Marvelous growth in the financial world. And here are 37 out of 37, and those are some of the biggest names on Wall Street, and some of them had been around the longest, and 37 out of 37 have disappeared.
And that’s why I say you ought to think about the long-term durability of a business because these people obviously didn’t. These were run by people with high IQs, by people that worked ungodly hard. They were people that had an intense interest in success. They worked long hours. They all thought they were going to be leaders on Wall Street at some point, and they all went around, incidentally, giving advice to other companies about how to run their business.
And the question is, how can you get a result like that? That is not a result that you get by chance. How can people who are bright, who work hard, who have their own money in the business – these are not a bunch of absentee owners – how can they get such a bad result? And I suggest that’s a good thing to think about before you get a job and go out into the world.
I would say that if you had to pick one thing that did it more than anything else, it’s the mindless imitation of one’s peers that produced this result. Whatever the other guy did, the other 36 were like a bunch of lemmings in terms of following.That’s what’s gotten all the big banks in trouble for the past 15 years. Every time somebody big does something dumb, other people can hardly wait to copy it. If you do nothing else when you get out of here, do things only when they make sense to you.
By this theory, the increased flow of information brought on by agglomeration is as much of a bug as a feature. Proximity brings the rapid sharing of best practices, but it also brings the rapid sharing of worst practices - in other words, groupthink. It is comparable to the general story of the Internet, which has substituted for physical proximity when it comes to information flow; it spreads good information and misinformation in equal parts, because people are attracted to seductive but wrong ideas, and as a result it is difficult to tell if the populace today is really better informed than they were before.
This makes sense as a story for the securities industry, particularly when paired with the long and noisy feedback cycle typical of the business. One firm starts loading up on subprime mortgages and reporting higher profits, and their employees are getting larger bonuses. Executives at a second firm learn about this in a chance meeting with employees of the first firm and think it sounds like a good idea–default rates are currently low, financial engineering has somehow made the risk disappear, housing prices have only gone up, it’s free money! You’d be crazy not to load up on subprime! Then two more firms do it, and then two more, and soon everyone starts to assume that if everyone else is doing it, someone must know what they are doing, and it’s best not to get left behind. The cycle doesn’t unwind until later, when the problems become apparent. This is basically a story of negative knowledge spillovers.
Back in the early 1990s, it was securities firms like Drexel Burnham Lambert that were failing, because of junk bonds, insider trading, dumb investments, spiraling employee compensation, and general mismanagement; less than two decades later, it would be firms like Lehman, because of reckless leverage and heavy exposure to housing-related investments and financial derivatives they did not understand. The problems were not totally limited to New York firms, but in hindsight, they do seem to have been concentrated there.
We can see some similar patterns in the media and auto industries. Time Warner CEO Jeff Bewkes dismissed Netflix as the “Albanian Army” as late as 2010, and Hollywood was very slow to take advantage of past technological innovations, allowing the spoils to go to outsiders. There is an element of counter-positioning there, but there is also clearly a pattern of motivated reasoning within Hollywood that has allowed opportunity to slip away. Similarly, Japan was quicker to embrace the quality control ideas of Deming than Detroit, and now Tesla has been faster to make high-end electric cars.
If you look around, there is already a lot of folk wisdom around the idea of proximity driving negative knowledge spillovers. If, as they say, you are the average of the five people you spend time with, it follows that you have to be very careful about who you spend time with. After all, humans are primed to unconsciously mimic the behaviors of those around them. Or, as Patrick McKenzie says, pick your peer group carefully because you’re giving write access to both your unconscious thoughts and your entire worldview.
The career of Warren Buffett is instructive when thinking about ways to deal with positive and negative knowledge spillovers. Buffett spent some of the first few years of his career in New York, first learning from Benjamin Graham at Columbia Business School and later returning to work for him at his firm Graham-Newman. He would move back to Omaha in his 20s but still visit New York and talk to his New York colleagues and brokers regularly by phone. He would at times cite his physical distance from Wall Street as part of his success. He managed to stay close enough to Wall Street to be well informed, but far enough away not to be unduly influenced.
Back in 1890, Alfred Marshall predicted that the railroad, printing press and the telegraph might diminish the power of agglomerations, and today cheap air travel and the Internet are beginning to follow through on that promise. Companies and employees today are increasingly able to be productive remotely, breaking many of the constraints that forced proximity of labor, suppliers, and customers. Access to specialized information is more free than it has ever been. The problem today is curating that information, and filtering out misinformation. Perhaps the best way to do that is to physically and virtually move oneself far away from the firehose, whether it be by aggressively customizing one’s information intake or by moving oneself halfway across the country.
Silicon Valley is a very young agglomeration; HP is considered to be the first company there, and it was founded in 1939, and the most valuable companies in the region were founded in the 1970s or later. There is a popular HBO show about some of the questionable ideas that circulate locally there, and rents are very high, which are both causes for concern, but startups are still reliant on the thick markets for labor and capital that exist there, so it seems likely that new tech companies will be concentrated there for at least a little while longer. However, older, larger tech companies based there already have a major presence in other cities around the globe, and the pandemic is accelerating that. It will be interesting to see how much of a presence they keep in the Bay Area, and if they can continue to thrive.
 The big banks on the list would be an example of the former, having been formed by a series of mergers without producing big returns for investors. Philip Morris would be an example of the latter, having paid a ton of dividends and having executed big stock buybacks and a major spinoff to boot, but it has been so amazingly successful it still made the list.
 For example, in the decade of the 2010s, just one stock, Apple, accounted for 6% of the total return of the S&P 500.
 Part of the story is that big cities offer certain cultural amenities, particularly to rich young people, that merit higher rents.
 These include the 1995 acquisition of Albany, NY-based Capital Cities/ABC for $19 billion (which included ESPN), the 2006 acquisition of Bay Area-based Pixar for $7 billion, and the 2018 acquisition of Fox, which is the successor to Rupert Murdoch’s Australia-based News Corporation, for $71 billion.
 The commercial banks on the list - Bank of America, Chase, Citigroup, and Wells Fargo - all maintain small securities subsidiaries, some of them based in New York.
THE ART OF THE CORNER, PART 2
Matt Levine points us to an obscure short squeeze from 2006 that got the attention of the Securities and Exchange Commission, involving Philip Falcone, then the manager of Harbinger Capital Partners, a distressed debt hedge fund, and the bonds of MAAX Inc., then a leading North American player in the bathroom fixture market. The story begins with Harbinger placing a $55 million bet on the bonds in Spring 2006, buying the majority of the issue:
Falcone...directed and caused the first purchase of the MAAX zips...at least in part, on the recommendation of an analyst with whom he had consulted for years and whom he had hired a month earlier to work at Harbinger (the "Harbinger analyst"). The Harbinger analyst opined that the MAAX bonds would rally with the U.S. and Canadian housing markets...
Between April 13 and June 6, 2006, Falcone and HCP Offshore Manager directed and caused the Master Fund to purchase an additional 103 million MAAX zips. As of June 6, 2006, the fund's position in the MAAX zips stood at 108 million notes, or approximately 63% of the issue (i.e., the outstanding face amount ofthe MAAX zips that had been issued). The total cost of this position was about $54.5 million.
Early 2006 was not the ideal time to be taking a bullish position on the U.S. housing market. Other sources report that he was making other bullish housing bets at the time.
Sometime during the summer of 2006, the Harbinger analyst began hearing rumors that there was aggressive short selling in the MAAX zips. The analyst's sources on the street speculated that one of Harbinger's prime brokers–the Wall Street firm–and its customers were shorting the MAAX zips and trying to drive their price down. The analyst informed Falcone.
Falcone was angered by this. He speculated that the Wall Street firm was putting its proprietary trading interest ahead of his own-that it was undercutting the value of his MAAX position and possibly borrowing his own notes to cover its short position.
The complaint continues on to say that the Wall Street firm (reportedly Goldman Sachs) believed Falcone’s MAAX bonds were worthless and told him so. Other sources report that his firm’s research at the time was also uncovering evidence that the housing market was not all it was cracked up to be.
Generally, when someone tells you that your thesis is wrong, you can keep plowing forward, or change your mind and take your losses. What will Falcone choose? We pick the story up in Gregory Zuckerman’s The Greatest Trade Ever, where Deutsche Bank salesman Greg Lippmann (you know him from the Big Short) is pitching his idea to buy protection on subprime mortgages in the summer of 2006:
It took less than an hour for Lippman to convince Phil Falcone, a hedge-fund manager in New York, who seized on the limited downside and huge potential windfall of the trade. Falcone didn’t even ask about the technical aspects of the mortgage market. The next day, he called Lippmann’s team to buy insurance on $600 million of subprime mortgages. Later he made even more purchases.
Falcone, to his credit, has quickly come full circle. He is willing to admit his bullish housing thesis is wrong, but he is not content to simply close it out. Instead, he takes the next logical step, which is to use what he has learned to make a massive, massive bet against the housing market. He doesn’t care about the details, he just wants to know where he can wire his money. This is the kind of bet that inspires award winning movies, and books entitled, well, The Greatest Trade Ever. In 2007 and 2008, this bet reportedly makes Harbinger a profit of $11 billion. $11 billion. With a B.
He still has this $56 million bet on MAAX, which is now fully hedged, and then some. At this point, he could sell it off at a loss and write it off as so much housing market tuition money. But apparently he is not content to do so. Phil Falcone is never content to do so. He wants to get his vengeance on the Wall Street firm. He decides, against all odds, to place more money into MAAX bonds, to attempt a short squeeze:
Over the next seven weeks, at Falcone's and the other Defendants' direction, Harbinger acquired an additional 64.5 million MAAX zips for both funds at a total cost of approximately $23 million...By October 24, 2006, the Harbinger funds had purchased more than the entire issue of the MAAX zips - its position now stood at 174 million in face value in a 170 million bond issue.
Fast forward to late 2007. By now, Harbinger is reaping billions from his subprime bet the previous year, and MAAX is struggling, and the bonds he owns are likely worthless. A lesser man would be content with his incredible profits, but not satisfied, he is for some reason still trying to close out his little MAAX squeeze:
On September 27, 2007, a senior officer of the Wall Street firm (the "senior officer") and a group of others comprised of trading, compliance and legal personnel called Falcone to discuss the situation with the MAAX zips and its possible resolution.
During the conversation, Falcone insisted that the Wall Street firm buy in the MAAX zips. Falcone stated that he would be willing to settle with the shorts now at 105.
At some point, the conversation turned to the trading in the MAAX bonds. The senior officer asked Falcone how the Wall Street firm might satisfy its obligation to Harbinger. Falcone stated that the Wall Street firm should just keep bidding for the bonds. Falcone acknowledged that the Wall Street firm would suffer some losses doing so, but told the senior officer and the others that sometimes you are just on the wrong side of a trade.
In the course of this discussion, Falcone stated that he knew that the short position in the MAAX zips had created a "long" position in excess of the issue size. When the senior officer asked how he could possibly know this, Falcone stated that he was working the position himself and that he (i.e., Harbinger) had acquired approximately 190 million bonds. The senior officer and the other Wall Street firm personnel were stunned.
I think the moral of this story is that it’s never really about the money. $11 billion, $54 million, those are really just numbers. The Wall Street firm offended Phil Falcone’s honor and that could not stand. He had to stick it to the Man! He was raking in billions on the trade of a lifetime and yet he found time to admit to an absurd small time market manipulation in a meeting to teach a lesson(?). Anyway, as a result, the SEC fined him and barred him from the securities industry for five years (also, for other shenanigans). I hope it was worth it.