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6/7/2005
Practical Microeconomics, by Victor Niederhoffer

In his book Mangerial Economics Hirschey gives four sources of above-average profits:

1. Frictional profits from the unanticipated shocks that lead to bottlenecks to entry. The drug companies with the $1 billion average cost for a approved drug are a good example here. "Over time, barring impassable barriers to entry and exit, resources flow into the field and profits return back to normal levels." But during interim profits might be above because of frictional factors that prevent instantaneous adjustment.
2. Monopoly profits, high barriers to entry through economies of scale, patents and import protection. Fannie and Freddie would be examples.
3. Innovation profits. coming when a company successfully develops a superior product. Microsoft and McDonald's are examples.
4. Compensatory profits for firms that are good at executing, and maintaining efficient operations. Presumably Dell or Toyota or UPS.

I was interested in applying this to the heroic icon of the Sage and the companies he buys and whether they could be seen to have a place, on average, in the Pantheon of above average profits. Since he likes to buy companies at book or below, there is prima facie evidence against this because such companies invariably return less than the competitive rate of return or else they wouldn't sell below cost. Charlie talked him out of this vis-a-vis the farm equipment companies and regional department stores that he liked to buy. It would seem that about half of the first 20 companies he bought were such companies.

As for innovative profits, they don't exist in companies that don't innovate, and usually innovation is closely related to technology, or patents of the kind that the Sage avoids.

I'm left with compensatory and frictional profits. But consider whether the ability of the Sage to buy companies from a quick look at their balance sheets, at hoped-for bargain prices relative to net assets, i.e., the half of liquidation value favored by his mentor, the Father of Securities Analysis, would put him on the right track for bargain purchases of companies with superior profits, thus confirming Professor Hirschey's appellation of the Sage as "the greatest practical microeconomist alive."

Jim Sogi adds:

One of the valuation metrics in the estate litigation area is the Key Man discount. When the Key Man dies, the company is not worth as much. This will be an issue until 2011 when the estate tax ends. The converse is that a source of profits is the Key Man: charisma, vision, innovation, leadership, risk-taking at the early stages, luck. Think Edison, Ford, Sage, Gates, Dell, Rockefeller. Some businesses are one man industries: Michael Jordan, Tiger Woods, Bill Cosby, Paul McCartney. Consider the role of the Key Man as a source of above average profits.

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