I was speaking with a good friend of mine, who was reflecting optimistically on the possible positives to come out of the COVID crisis. The economic system may, thanks to 2020, become less fragile as we are collectively realizing that certain aspects of our system have become very vulnerable to breakage with serious attendant consequences. (Being more of a cynic, I should note that I don’t think this antifragility extends to financial market pricing, certainly at the moment.)
For example, he noted, most meat processing in our country is done by a very small number of processors, so when COVID forces a shutdown it can mean…no meat. Most of the saline bags, he told me, are made in Puerto Rico. Of course, we all now know that most of the active pharmaceutical ingredients (APIs) come from one country, China.
Years ago, we had this problem when OPEC controlled the vast majority of the world’s oil. This is less of a problem today, because the market worked on it: high prices created an incentive for innovation in the field of energy extraction. Now there are lots of sources of oil, although OPEC still controls a plurality of it. But the system is less fragile, for sure.
As an inflation guy, I am regularly intrigued by the ways that the world has become more fragile with respect to inflation over time, as the threat of inflation has receded into the misty depths of memory. Insurance companies, for example, have only a sketchy institutional memory (and generally only near the top of the organization where the old folks are) of how the inflation of the late ‘70s eviscerated their financial condition. In 2021, we find ourselves at a point in history where it has been nearly 30 years since we have seen a core CPI reading above 3%. And people will run around as if their hair is on fire when we get it again, even though from the perspective of 1985 that would have seemed a funny problem.
But I’m actually not here to talk about inflation but rather another old habit that we’ve “evolved” away from in the C-suites of American industry, and that’s carrying inventory. Now, carrying an inventory balance is one way to reduce a firm’s exposure to inflation, so I’m not entirely ignoring the inflation angle here; the grander point though is that carrying inventory is insurance against lots of things. To name just a few:
- your supplier shutting down because of some disease or some authoritarian lockdown measure
- sudden increases in tariffs on raw goods, or embargos
- a sudden surge in demand for your finished goods because some other supplier was unable to provide
- transportation issues and bottlenecks slowing the receipt of raw goods, such as a shortage of containers at the ports or a closure of border traffic
- large but temporary spikes in the cost of freight, as a result of same
Inventory protects against a multitude of sources of volatility, that is. Of course, this protection comes at a cost, since inventory is a use of capital and capital costs money. Now, being an old option trader (and not merely a trader of old options) that says to me that holding inventory is very much like a financial option: a countable and defined cost, that is paid no matter what your inventory turns are, and an occasional highly significant and non-linear payoff at random times, when you need it.
Owning options is neither a good nor a bad thing, inherently. Paying too much for options that have value only very infrequently is a bad thing, but even in that case if the bad thing is a very bad thing, then you’re willing to ‘overpay’ relative to the actuarial value of the option. We do this all the time with various casualty insurances (we obviously overpay relative to the actuarial likelihood of our home catching on fire or being burgled, since if we paid the ‘fair’ price then the insurance company wouldn’t be able to exist), because the negative value to us of a large loss is not proportional to the negative value of the small cost of the insurance premium…even if that premium is ‘too large.’
So it is interesting, then, that “just-in-time” inventory management, and in general the focus on reducing inventory levels, has progressed to such a level as to be almost fetishistic. And I would argue the main reason this has happened is that the episodes of loss, where the ‘inventory option’ would be ‘in the money’ have been fairly infrequent, as we have improved the supply chain architecture over the years.
But this has clearly changed, and we are seeing manufacturing enterprises – not to mention homeowners, as I stockpile soup against the possibility of another COVID-like lockdown – build precautionary inventories of inputs, and BTB enterprises increasing finished goods inventories. Because lots of these folks have been burned. It only takes one fire in your neighborhood to sell a lot of fire insurance.
And by the way, it makes perfect sense that companies should be retreating from lean-inventory models. Capital is super cheap right now; literally the cheapest in history. Carrying inventory is therefore not only an option with a bigger chance of paying off than it used to, but it’s also a really cheap option.
Here are some other option theorems in the inventory context:
- Options have more value, the more volatility there is. The a priori cost of the option varies with implied volatility and the ex post value of the option is related to realized volatility. Therefore, the inventory option is more valuable now, as we have greater economic volatility.
- Corollary: higher expected future volatility should raise the sticker price of an option. In the case of inventory, the price of the option is related to the cost of capital. Ergo, more volatile economic outcomes should raise the cost of capital. So far, they haven’t, which means the inventory option is probably irrationally cheap.
- Some older option trader once told me “don’t be a weenie and sell a teenie.” That is, taking in a small amount of money to sell ‘lottery tickets’ that are very unlikely to hit is still a bad long-term decision because being short one lottery ticket that hits can end the game. Similarly, it makes no sense not to carry large inventories of inexpensive items. Think thread, or fasteners. “For want of a nail, the horseshoe was lost….” Or APIs. Or soup.
That’s all I have to say about real business options, except for the obligatory (for this column) observation: inventory is not just an option, but also a hedge against future price changes. When inflation is low and stable, this hedge has little value and can work against you as well as for you. When inflation is rising, though, the incentive increases to invest more in inventories that will be worth more (once converted to finish goods, or sold to a customer) the longer the inventory is held.