Wednesday, February 28, 2024

The Hyper-Pareto Distribution Of Profits Is Happening Right Now (plus an anniversary)

It's not some cutesy management* fad or pop insight like "Business secrets of Genghis Khan."

To the rich go the profits and internalizing that fact makes the rest of this portfolio construction/fund management/investing stuff easier to conceptualize and execute.

And AI is accelerating the already extant dynamic.

From ZeroHedge's The Market Ear, February 28:

1 or 0. Tech vs the rest 

Earnings decouple

EPS outlooks for Big Tech and the rest of the S&P 500 continue to decouple... 

Source: Barclays
Earnings recession ex Tech

Excluding the Nasdaq -100 EPS cycle, US and global equities’ EPS would be flat to down over the past two years.

Source: Soc Gen
"Other" earnings being revised down

Downward EPS revisions for SPX over the last 3 months.

Source: Barclays
You cannot spell margin without A & I

Morgan Stanley sees AI-driven productivity adding 30bps to 2025 net margin for the S&P 500 (13.0% net margin in base case). MS's new framework highlights that services-oriented pockets of the market possess a more significant opportunity with respect to AI-driven efficiency gains; these groups include Software & Services, Consumer Services, Health Care Equipment & Services, Financial Services, and Media & Entertainment. Just these groups alone represent over 30% of expected 2025 net income for the S&P 500, which speaks to the potential margin opportunity. (Morgan Stanley)
What if AI is as good as the consultants say...?

UBS highlights that a possible upside surprise for equities this year would be that Generative AI does actually increase productivity growth to 2.5%, fueling a 20% return from equities in 2024.

Source: UBS
Keep it in the happy tech family

Large US Tech stocks account for 40% of Nvidia revenue.

Source: Soc Gen

....MUCH MORE
*Although people had been observing and discussing "rich get richer" and "winner-take-all" dynamics for over a century, one of our favorite pointers toward the current situation did come out of a business school. We've been hammering on this for so long that I start to bore myself. Here's a recapitulation from last year, linking to an article that was published seven years ago today:

HBR—From Pareto To Hyper-Pareto: "AI Is Going to Change the 80/20 Rule"

A prescient article from the Harvard Business Review, February 28, 2017:

Many high-performance organizations remain passionate about Vilfredo Pareto, the incisive Italian engineer and economist. They continue to be inspired by his 80/20 principle, the idea that 80% of effects (sales, revenue, etc.) come from 20% of causes (products, employees, etc). As machine learning and AI algorithmic innovation transform analytics, I’m betting that next-generation algorithms will supercharge Pareto’s empirically provocative paradigm. Here are three important ways that AI and machine learning will redefine how organizations use the Pareto principle to digitally drive profitable innovation to levels beyond conventional analytics.

Smart Paretos
First, greater volumes and variety of data guarantee that algorithms get the training they need to get smarter. Digital networks consequently become Pareto platforms that transform vital vectors of variables into new value.

Novel workplace analytics, for example, mean more organizations can more readily identify the 20% of employees contributing 80% of value to a product, process, or user experience. Ongoing digitalization of business processes, platforms, and customer experiences similarly invites creative Pareto perspectives: What 20% of the platform upgrade creates 80% of its impact? What 20% of customer experience evokes 80% of delight or distaste? Serious C-suites want those data-driven questions algorithmically addressed.

Super-Paretos
Second, traditional distributions have disruptively changed. The dirty little productivity secret of big data is that Pareto’s 80/20 insight has decayed into empirical anachronism. Analytically aggressive firms increasingly see Pareto proportions closer to 10/90, 5/50, 2/30, and 1/25. Depending on how rigorously the data is digitally sliced, diced, and defined, 1/50, 5/75, and, yes, 10/150 Paretos emerge. Pareto’s “vital few” becomes a “vital fewer.”

Extreme distributions transcend and dominate industry. Fewer than 10% of drinkers, for example, account for over half the hard liquor sold. Even more extreme, less than 0.25% of mobile gamers are responsible for half of all in-game revenue.

Clearly identifying and cosseting the “super-Paretos,” however, doesn’t go analytically far enough; market and market growth demand that those descriptive statistics lead to predictive and prescriptive statistics. In other words, turn those data sets into “training sets” for smart algorithms.

Organizations need to identify Pareto propensities, as well — they need to algorithmically crack the code on the tiny adjustments that promote order-of-magnitude business impacts. Managers and their data science teams must reorganize themselves around extreme Pareto potentials and possibilities, not just more and better data.

For instance, one multibillion-euro industrial equipment company with over 2,000 SKUs determined that less than 4% of its offers were responsible for one-third of sales and roughly half of profitability. But extending the analysis to include service and maintenance revealed that roughly 100 products were responsible for over two-thirds of profitability. That pushed the firm to fundamentally rethink pricing and bundling strategies....

....MUCH MORE

This type of information advantage is more and more accruing to the biggest and richest of corporations. It is a type of rich-get-richer advantage akin to the flywheel effect:

And related, now that we see what is happening, what, if anything, should society do about it?

...Much more important than the direct monetization of big data is the strategic advantage it can bestow over time.
In a winner-take-all economy, as in a horse race, small differences in superiority are rewarded all out of proportion to the actual advantage. A top thoroughbred may only be a couple fifths of a second faster than the field but those two lengths over the course of a season can mean triple the earnings for #1 vs. #2.
In commerce the results can be even more dramatic because rather than the 60%/20%/10% purse structure of the racetrack the winning vendor will often get 100% of a customer's business.....

Just to reiterate, every incremental advantage that a company can afford does not affect income production in isolation. They accrete in sometimes unforeseeable combinations:

How to Think About Companies: "Advantage Flywheels"

A very handy conceptual framework first posted after the start of the U.S. lockdowns, April 2020. Schools were closed so it seemed natural to link to a superb mini-MBA module.  
Eat your heat out HBR....

Posted by at