Value Investing Lab

The 6 Principles of Scarcity

1. Scarcity is universal and inescapable — it is not a "problem" that can be solved with policies, it is a permanent condition of physical reality.
2. What "everyone wants" adds up to more than what is available. That IS scarcity. It exists in EVERY society.
3. Different economic systems are simply different ways of making inevitable trade-offs.
4. Economics studies the consequences of decisions, not the intentions.
5. Productivity — not natural resources nor money — determines the standard of living. Resource-rich countries (Venezuela) can be poor; resource-poor countries (Japan, Switzerland) can be rich.
6. If a government could create prosperity by printing money, poverty would not exist.

The 3 Simultaneous Functions of Prices

1. INFORMATION TRANSMISSION: Prices condense dispersed information among millions of people without anyone needing to know WHY they changed. If new iron deposits are discovered, the price of steel drops and everyone adjusts — even though 99% don't know about the discovery.

2. INCENTIVES FOR PRODUCTION: High prices incentivize greater production and attract investment; low prices disincentivize it. The "greed" of producers solves scarcity faster than any bureaucracy.

3. RATIONING OF SCARCITY: Prices determine who gets what. They are not the CAUSE of scarcity — they are the REFLECTION of it. Beachfront houses are expensive because they are physically scarce, not because a "greedy" seller set a high price.

Principles for Analyzing Companies

• There is NO objective "real value" — value is subjective. Transactions occur because BOTH parties gain.
• Prices are NOT set arbitrarily — competition limits what anyone can charge.
• Quantity demanded varies inversely with price; quantity supplied directly.
• High prices are NOT obstacles — they are signals that the resource is urgently needed.
• Allocation is INCREMENTAL, not binary. Resources flow at the margin toward their most valued uses.

Price Ceilings = Artificial Scarcity

A price ceiling below the market ALWAYS causes scarcity. Not because there is physically less of the good, but because demand increases artificially and supply contracts artificially.

Emblematic case — Rent control:
• San Francisco: 49% of rent-controlled apartments occupied by ONE person, while thousands couldn't find housing
• Melbourne: 9 years after controls, ZERO new buildings constructed
• Washington DC: In 8 years, stock fell from 199,000 to 176,000 units
• Paradoxical result: cities with controls end up with AVERAGE rents higher than cities without controls

Profits as Incentives

• Profits are NOT "arbitrary charges" — they are what forces producers to serve the consumer efficiently.
• Great fortunes (Ford, Rockefeller, Walton) were created by REDUCING costs to charge LESS, not more.
• A supermarket with 1% margin can generate massive returns if inventory turns 30x per year.
• Profit on sales ≠ Profit on investment. They can go in opposite directions.
• Average return on corporate assets in the U.S.: 4-12% before taxes, 2-8% after.

Losses as a Correction Mechanism

• Losses tell the producer what to STOP doing — what to stop producing, where to stop investing.
• In socialism, errors are perpetuated indefinitely. In capitalism, losses FORCE rapid correction.
• Bankruptcy frees workers, capital, and materials for more productive uses.
• A poorly managed company is worth MORE to external investors than to its current owners (justification for takeovers).
• Capitalism has a visible cost (profits); socialism an invisible cost (inefficiency) — which is MUCH greater.

Economies of Scale (why big = cheap)

• There is no single "the" cost of producing something — it varies enormously with volume. Ford cut the price of the Model T in HALF between 1910 and 1916.
• Fixed costs (machinery, R&D, advertising) are divided among more units → unit cost drops.
• Small stores cannot compete with large chains for this reason.
• Advertising can REDUCE total cost: by increasing volume, it activates economies of scale that exceed the advertising cost.

Diseconomies of Scale (why too big = inefficient)

• There is a point where costs per unit RISE as size increases. That's why there isn't a single monopoly in every industry.
• AT&T CEO: "AT&T is so big that if you kick it today, the head says 'ouch' two years later."
• Large organizations lose flexibility, accumulate bureaucracy, and local managers cannot decide without central approval.
• GM: world's largest automaker but cost/car hundreds of dollars more than smaller competitors.

Competition as a Dynamic Process

• Prices and returns TEND toward equality — like water seeks its level — but are never in static "equilibrium."
• Toyota surpassed GM, but then had to recall 8M cars. Intel dominated with 80% market share but AMD forced it to innovate "frenetically."
• In protectionist India (pre-1991): the most popular car was the Ambassador — a copy of a 1950s Morris Oxford, "poor finish, heavy handling, and alarming accidents." But there was a MONTHS-long waiting list.
• When India opened the market → the Ambassador disappeared. Competition enormously benefited the consumer.

Natural Monopoly vs. Artificial Monopoly

Natural Monopoly (based on efficiency):
Standard Oil reached 90% market share NOT through predatory practices but through innovation: tank cars, byproducts, process efficiency. The price of kerosene FELL from $0.58 to $0.08/gallon. The consumer won.

Artificial Monopoly (protected by government):
Protects the incumbent from competition, harms the consumer with high prices and no innovation. It is FRAGILE to political changes.

Rule for investors: Prefer natural monopolies (proven efficiency) over regulatory monopolies (vulnerable to policy changes).

Productivity = Wages (in the long run)

• Real wages ONLY rise if productivity rises. There is no political shortcut.
• A worker cannot be paid more than what they produce indefinitely without destroying the company.
• Capital and labor are complements AND competitors. When labor is artificially expensive, companies substitute labor with capital (automation).
• "Efficiency" depends on relative factor prices. What is efficient in the U.S. (capital-intensive) may be inefficient in India (labor-intensive).

Minimum Wage = Price Floor = Unemployment

• A minimum price above the market creates SURPLUS. In the case of labor, it's called unemployment.
• The REAL minimum wage is always ZERO — that is the wage of those who lose their jobs because of the law.
• Most affected: young people, inexperienced workers, minorities — those who most need the opportunity.
• Switzerland (no minimum): 3.1% unemployment. Singapore (no minimum): 2.1%.

The Rules of Pass-Through

RULE 1: A company can ONLY pass on a cost increase if ALL its competitors face the SAME increase. If only it faces it, it must absorb it or lose share.

RULE 2: If a company achieves innovation that reduces costs, it can keep the savings as profit (charging the same as competitors) OR lower prices to steal customers.

RULE 3: Over time, competitors adopt the same innovations and savings are passed to the consumer. The innovator's profits are temporary — but that period is the INCENTIVE that generates innovation.

Practical Application — Key Questions

• Margins rising during inflation? → REAL PRICING POWER ✅
• Margins stable with costs rising? → Pass-through works ✅
• Margins falling with costs rising? → Cannot pass through → DANGER ❌
• Volume falling with high prices? → The market rejects the pricing → ALERT ❌

Example: Coca-Cola raised prices +5% organic in FY2025 and STILL grew volume = PERFECT pass-through.

The Informational Argument

• The price system forces each person to decide based on the PARTICULAR knowledge they possess of THEIR situation — it does not require total knowledge.
• The government can NEVER have the dispersed knowledge that millions of individuals possess. That's why central planning fails.
• People are forced to "put their money where their mouth is" — this incentivizes them to be honest and precise, something that intellectual "articulation" does not achieve.
• Errors are inevitable in ANY system. The question is: what incentives force CORRECTION of errors? In capitalism: losses. In socialism: nothing.

Application: The Rise and Fall of Companies

• Business management is one of the scarcest resources. A study showed that the death of a CEO's child reduced profitability by 21% — the impact of one person.
• When an industry changes rapidly, past leaders are the ones who have the most difficulty adapting (Howard Johnson vs McDonald's).
• The first successful McDonald's franchisees were not experienced entrepreneurs but working-class couples. People "without alternatives" sometimes have the greatest incentives.
• A free market needs competition to expand the successful AND a mechanism to EXPEL the inefficient.

🔍 Price Signals

Do input prices reflect real supply/demand or are they distorted by intervention?

Can the company pass on cost increases? (Only if ALL competitors face the same increase)

Are product prices rising (scarcity) or falling (excess capacity)?

Are there price controls — ceilings or floors — affecting the sector?

💰 Profits and Losses

Does profitability come from creating real value or capturing government subsidies?

If subsidies were eliminated tomorrow, would the company still be profitable?

Are margins extraordinary? Are there REAL barriers preventing competitors from matching them?

Are profits on SALES or on INVESTMENT? (They can go in opposite directions)

⚔️ Competition and Market Position

Does it operate in a competitive, oligopolistic, or monopolistic market?

Is its dominance based on efficiency/innovation (sustainable) or regulatory protection (fragile)?

Does international competition force it to improve or is it displacing it?

Is there excess capacity in the sector? (Signal that prices and profits will fall)

Is there a risk of disruption from a new entrant with better technology?

📏 Scale and Efficiency

Is it in the economies of scale zone or has it crossed into diseconomies?

Is it appropriately specialized or trying to do too much internally?

Reliable suppliers (allows just-in-time) or needs excessive inventories?

Supply chain concentrated in few monopolistic suppliers?

🎯 Incentives and Management

Does management have "skin in the game" (significant ownership)?

Do incentives reward long-term value creation or short-term metrics?

Is there separation between "power" and "knowledge"? (Managers far from customers)

Is the opportunity cost of capital better here than in alternatives?

🏛️ Government Intervention

Does it depend on subsidies, tariffs, or tax credits to be profitable?

What % of revenue comes directly or indirectly from the government?

Does regulation function as a barrier to entry (protects) or as a burden (compresses)?

Is there risk of new regulation (antitrust, environmental, labor)?

Do export controls, tariffs, or sanctions affect it?

⚠️ Systemic Risk

Geographically diversified or concentrated in a vulnerable region?

Does it depend on a single customer, supplier, or market for critical revenue?

How do interest rates, inflation, and economic cycles affect it?

Is the political system of the country where it operates stable and respects property rights?