It all started back in the caves. While we prepared to go out hunting bears, this fellow used to come around. He had a big stick, wore the latest bearskin and looked solid and respectable: he would offer to look after our wives and children while we were away, in return for 3 ribsteaks of bear. He would tell us gory stories about what happened to the wives of those who did not take his services the last time around… the first guy to sell fear as a business.
We wondered whether he actually did any protecting, rather like we wonder today about our Police Force, but we were too afraid to ask. The wives never told, and we parted with the ribsteak, never stopping to ask whether he had worked for it.
And so was born security services, a section of society that lived off the fears of the hoi polloi in the real economy (who hunted and worked for a living). From protecting children (a.k.a. schools and crèches), wives (a.k.a. security guards), goats and sheep and later cash (a.k.a. banks) to your own life and earning capacity (Insurance cos) to finally: the value of your Nest Egg (Mutual & Hedge Funds), things grew ever more complex and differentiated, but the core remained the same service: what happens to you (and yours) behind your back?
Then (and now) we were unable to calculate relative probabilities. What was the probability that we would get a big kill, enough to eat for the entire family. But we took that risk on us, offering this fellow certainty of livelihood in return for taking away some uncertainty in our lives. We actually exchanged certainty (of his income) in return for increased uncertainty (in our income), a bum deal that has been going on for centuries. The people sitting on the commanding heights of the economy are those who are on the right side of this (bum) deal.
Look around you. The people who produce the food are too busy salvaging their meagre belongings in Bihar. The people who produce other things are busy fighting politicians in Singur. While yours truly sits at home, plays with the kids and does simply nothing. Oh! I write options, selling (portfolio) insurance to fearful investors terrified of losing their shirts. The fact that I get rich, and the investors do not, would suggest that their fears are misplaced. Why are they scared in a bear market, I don't understand….oh! but I didn't understand why they were NOT scared in a bull market either.
Ricardo pointed out that there were 4 factors of 'production' (a.k.a. sources of 'profit'): land, labour, organisation and capital. If you look at any productive economic enterprise (which does not include Govt and charities), you will find that they extract their surplus in some way or the other from these 4 factors. And there is a hierarchy of profitability among these firms, based on which factor of production the firm lives off.
At the bottom are the 'land' companies, a.k.a. resource cos. These are into agri-products, fossil fuels and other commodities. They use tons of capital and lots of people to produce a meagre profit (barring certain rare periods like now). Their long-term P-E is 5-6.
Then come the 'labour' cos. They use knowledge workers and skilled labour to produce a more sustainable profit, with less capital and fewer workers. Auto component and other manufacturing companies fall into this category. Their long-term P-E is 8-12.
The better companies from the above 2 sets evolve to become good at 'organisation'. They develop networks of suppliers/ distributors and outsourced services, branding and some soft skills (like HR reputations, technology, etc). Infosys is more than an arbitrageur of labour costs now, and so is ITC as a networker of suppliers and distributors. HLL creates huge value out of very basic everyday products, thanks to its 'networked' organisation and superior branding. Their profitability is more sustainable than their earlier avatars, justifying premium valuations of 5- 20 times Book Value.
At the top are companies that develop a superior understanding of Risk Capital and build it into their business models. Often misunderstood as 'trading' companies, they use almost no capital and very few (but very valuable) people to produce very sustainable profit. Risk is the ultimate fear business, where you create a very sustainable, non-volatile cashflow out of your industry's volatile business interfaces. That is, a petrochemical company that understands how to trade crude oil, or a sugar company that uses its position in the industry to emerge as a jobber of the commodity, will soon outperform its industry by very large margins. Think of GE (with GE Capital) or Cargill. At home, we have Reliance, Bajaj and Ranbaxy, companies which have developed rare skills in managing their market interfaces: good at managing the cost of capital, or at managing capital by operating in the 6 'perfect' markets: equities, bonds, forex, commodities, real estate and that great inter-market straddling all these markets, derivatives. There is no valuation benchmark for these companies, because the source of their outperformance is not always well-understood. But they will always trade at a premium to their brethren. Renuka Sugars trades at 3 times the valuations of its peer group, a 'sugar' co that is more expensive than Infosys… and is still rated 'best buy' by most analysts tracking the sector.
Many of these companies are almost embarrassed to admit to these skills, pretending that their outperformance is actually embedded in manufacturing or marketing. That is because it is socially reprehensible to profit from 'no work', an attitude that goes back to the caves. Sometimes these processes can become full-scale businesses in themselves, professional Risk Management operations. They go by different names, as investment cos, Prop Trading outfits dressed up as brokerages or NBFCs, or Hedge Funds. There are many models or philosophies of trading, but they all share one claim to fame: they seek to harness volatility, i.e. trade volatility to earn a profit. Their maximum possible loss is the Value at Risk (VaR).
The biggest reason for their outperformance (as compared to normal Land and Labour companies) is not that they produce an extra-ordinary amount of profit, but in that they take almost no capital in producing whatever profit they are producing. Anything divided by zero is infinity, so these "hedge funds" produce astronomical returns on whatever capital is allocated to them. Since Capital is a bulwark against Risk, and that is precisely what these entities seek to manage, one of the first things you notice about them is that they carry no capital, preferring to make do instead with Tier II stand-by capital, or debt-available-on-call. In both cases, you don't see the liabilities for most of the year. GE Capital, for example, started by using the spare debt capacity of the lowly geared GE manufacturing businesses, and then the tail wagged the dog. Today, more than 65% of the profits of GE come from the financial businesses of GE Capital. Risk under-writing, reinsurance portfolio buyouts, buying CDS, etc can all be done with standby capital. Others do Option writing and Volatility Trading in Forward markets, or leveraged trades in the cash market.
While all this is good for companies, humans are designed for 'productive' work. That is why I don't suggest this as a mainline career for any but the laziest (and the most intelligent) of my students. Personally, I would rather do a job for its activity and use this to make money on the side…!