When I was a kid, I visited the Lake of the Ozarks in Missouri with my dad. It was around 2001 or 2002, and we were walking through a parkland path that would lead you to great views overlooking the lake. There was very modest lakefront construction at the time, and large tracts of idle area. At some point, my dad said to me, “Timmy, come back here in ten to fifteen years, and this will all be built out.”
My dad was right. When I visited the area again earlier this summer, I saw that there was property construction as far as the eye could see–in fact, I couldn’t find any extended area of lakefront land that wasn’t being developed.
My dad’s intuition about the future development of Ozark property is often described in economic textbooks as the “highest valued use” hypothesis. This theory assumes that the ultimate ownership of a property will go the person that values it the most, and the person that values it the most will be the one that gets the most utility out of it. In 1960, Ronald Coase wrote “The Problem of Social Cost” that discussed how inhibitions such as transaction costs will prevent resources from flowing to the person that values it the most. If you value property x at a rate of $5,000 more than I do, but it will cost us $10,000 in lawyer fees to draw up a contract that would transfer the property, then the property will remain with me even though I value it less than you do.
My own view is that the social costs discussed in Coase’s work also need to be modified by the economic value of behavioral quirks and general uncertainty, so that my conclusion would be: Ownership of resources will flow towards those who value them most net of transactional, social, behavioral, and governmental costs.
This mindset can help you predict the future of business organizations, and can also help you figure out which stocks have assets that are most likely to unlock value over long time periods.
Among my friends, I privately predicted that the four major sports leagues (NBA, NHL, MLB, and NFL) would eventually drape their athletes in advertising to look like NASCAR drivers. Why? Because eventually, potential advertisers would realize that they value the advertisements on jerseys more than the team owner values having a “clean” uniform. In May 2016, the NBA announced that the Philadelphia 76ers reached a deal with Stubhub to place a 2.5 inch by 2.5 inch logo on the top right corner of jerseys for the next three years at a rate of $5 million per year. In economic terms, Stubhub values the top right corner of a 76ers jersey more than the 76ers ownership group does–presumably, the value of a clean jersey devoid of all advertising is worth somewhere in the high $4 million range to 76ers owners. Once the “cleanness” of the jersey is broken, each additional advertisement should command lower and lower rates.
Over the next ten years, you will probably see all sports teams move towards an advertising logo in the four corners of the front, up and down on the back, and then on the helmet as well. Why? Because advertisers will find millions of dollars of value in advertising their product on the jerseys of players that kids idolize and adults follow, and this is more than the value that the ownership places on building their brand. It’s the same logic that led to field-naming rights and hundreds of advertisements throughout stadiums, arenas, and ballparks. Because jerseys involve some dilution of brand value compared to field advertising and naming, it makes sense that this is the last holdout.
The best example of Coasian/highest valued use bargaining I’ve seen out in the wild? Two years ago, I got an Amazon Kindle Fire with advertisements on the lock screen. To get rid of the ads, I would have to pay Amazon $15. That’s equilibrium bargaining in action. Amazon, in a rare move to actually monetize its business, figured that the value of eyeball access to the lockscreen was worth somewhere in the vicinity of $15. Hence, the customer choice: accept the advertisers that Amazon hosts, or pay Amazon the full economic value of that lockscreen to remove the eyesores.
Thinking about Coasian bargaining and the highest valued use hypothesis does help me value companies.
Most notably, it led me to the conclusion that Bank of America (BAC) stock in the low teens is an absolutely goldmine investment, as the bank will eventually spin off Merrill Lynch and this spin-off will unlock a substantial amount of shareholder value. How can I have confidence in this pick? Because, for most of the financial crisis aftermath, it benefitted Bank of America to keep Merrill Lynch under its roof to add lucrative profits and prestige to a bank that sorely lacked both after ruining a century of a reputation built on conservatism through the singular act of acquiring Countrywide Financial.
As the mortgage crisis losses and litigation abated, Bank of America has been able to stand on its feet. As the dividend will eventually climb substantially, and the $1.5 billion in profits per month continues to grow alongside rising interest rates and general loan portfolio growth, Bank of America will establish firm footing and trade somewhere in the neighborhood of 15x normalized earnings.
Once it proves the strength of its footing to the investor community, you will eventually see a move to spin-off shares of Merrill Lynch. That is because Merrill Lynch has higher quality profits and better returns on total capital than Bank of America, and ought to be valued somewhere around 20x earnings. When you are trying to build wealth, it makes sense to divest business lines that warrant a much higher premium than the parent business as a whole.
To be sure, there are impediments to this happening–executives that like empire building and exercising direct control over crown jewel assets–but an agitated activist shareholder or an executive pay policy that gets the incentives right and rewards long-term wealth building will eventually lead to a Merrill Lynch separation from Bank of America. It just deserves too high of a market multiple compared to Bank of America to remain tucked inside of it forever.
This theory also explains why uncertain “best use” leads to perpetual asset shuffling. It is understandable that Coca-Cola seems to perpetually divest and then rebuy its bottlers. It’s hard to tell whether the bottlers belong inside the syrup and liquid manufacturer. One one hand, the core Coca-Cola business generates 26% returns on equity and it doesn’t make sense to get bogged down with an “inferior” business that will only generate 12% on each dollar of capital that you deploy. On the other hand, there is a control premium value to controlling every aspect of beverage manufacturing, and with 3.5% of all liquids in the world consumed through Coca-Cola, it’s hard to find a better use for significant chunks of retained earnings than bottlers.
The highest valued use hypothesis, net of various costs, is a compelling way of understanding how resources get allocated over time. See an old farm near a university? It shouldn’t surprise you when it gets converted into a bar or apartment complex–the cover fees or rents will almost certainly generate more profit than corn, and explain why the former will be willing to value the property much more than the latter. See a large crown jewel asset sitting inside a recovering or languishing business? Expect a spin-off sooner rather than later, as deserved P/E expansion is one of the easiest ways to build legitimate and immediate wealth. It’s a theory that helps you out in your day to day life as well as investment thinking–anytime a resource doesn’t flow to its most valued use, you can almost immediately identify an impediment that explains why the expected efficiency is not being carried out.
Originally posted 2016-05-25 23:05:36.