Starbucks vs. Harley Davidson: What you see and what you don't

We live in a consumer-driven economy, liberals often say, and how much more can we produce until we’re too chock-full of gadgets and gizmos? This concern is easily manifested in a company like Starbucks: How can they grow when they’re already located on every street corner in every city? Such concerns, like so many misunderstandings about the economy, come back to Henry Hazlitt’s single lesson about economics: What you don’t see is often more important than what you see. We’ll begin by talking about what we see, which is too many Starbucks stores.

What you See

Starbucks originally hooked me on coffee. I was in 8th grade and a location next to my school was giving out samples of their new Frapuccino with brownie bits. Since around that time, Starbucks expanded to over 16,000 locations worldwide. Its horizons seemed endless, as numerous books popped up about the genius idea behind the business, no doubt perhaps conceived in the cozy intellectual confines of the coffee shop’s atmosphere.

But in 2006, way before our current recession, it was clear that Starbucks had over-expanded itself. Since then, it’s closed over almost 1,000 stores and has plans to close hundreds more. In the meanwhile, Starbucks has certainly lost its edge. The issue seems simple enough, and the conversation almost one-dimensional: They need to open more stores. More stores means more money. But the economy - maybe even the world - isn’t big enough. They can only open so many stores in the same city before there’s no room left to expand. Companies rely on growth. What are they to do? In the meanwhile, they’re worried that the Starbucks brand has become stale and too expensive for a society in recession.

What you Don't

The solution to the path that Starbucks should have taken struck me while I was reading about The Harley Davidson Company in Motley Fool’s recent book, Million Dollar Portfolio. The following quote summarizes a bit of the history of Harley Davidson before getting into their success:

In 1901, a 21-year-old William Harley designed a motor to put onto a bicycle. He was soon joined by his good friend Arthur Davidson, and together they started a company that would eventually build motorcycles. Over the next 70 years, the company was private, surviving the ups and downs of the American economy, with major contributions to the war efforts of both World I and World War II. By the 1950’s and 1960’s, though, the company saw its reputation diminished, as it was associated with the Hell’s Angels and other less savory characters.

In 1967, the company was bought by American Machinery and Foundry (AMF), which produced leisure equipment such as snow skis, golf clubs, and bowling balls. AMF mismanaged the company to the point of near death, and sold it for $80 million in 1981 to a group of private investors, including Willie Davidson, a descendant of the original Davidson family. They rebuilt the company, placing a new emphasis on quality that had gotten away from them for decades. Customers returned. In 1987, Davidson and Friends took the company public.

That was the beginning of a spectacular ride. Shares of Harley at the end of 2007 were worth roughly 110 times what they traded for when the maker of the Fat Boy first went public…(p. 85-6)

What was responsible for this turnaround?

For the better part of two decades, Harley had the opportunity to do the right thing with its profits – sink them back into the business, making new and better products, and reaching out to loyal customers. In fact, the true glory years for Harley’s stock were those when management limited how fast the company made bikes. Rather than make all the hogs it could sell, Harley increased production at a rate of only %10 a year, lower than what the marketplace could bear. The ensuing scarcity of bikes raised the value of those machines that did make it to the market. For the better part of a decade, customers were willing to pay more than the manufacturer’s recommended price. (p. 86)

Something clicked when I read this, as I realized that Starbucks’ problem was not over-expansion, but a lopsided view on the meaning of growth.

Certainly more locations is one way to increase profit, but did it never occur to them to improve their product, similar to Harley Davidson? Starbucks' extra cash placed them in a position to improve their product, or at least to make it more efficiently. Or they could have experimented with real cappuccinos, which are generally thicker and have less foam, rather than switching to automated machines. Or they could have lowered the price of their products, which would have enabled them to compete more effectively with McDonalds and Dunkin Donuts. Instead, they’re stuck with too many stores which need to charge an arm and a leg for a cup of coffee in order to make a profit.

None of these strategies were guaranteed to work, but they get at a very basic aspect of economics: Differentiating between what you see and what you don’t see. Starbucks chose to err on the former by expanding everywhere, rather than the latter. However, the alternative strategies – which err on what you don’t see – were certainly viable, as seen in the success of Dunkin Donuts. In a very real sense, both were strategies behind growth. Yet do you hear liberals decry that Dunkin Donuts is taking over the world with their expansion of quality and lowering of price?

As Harley Davidson’s history shows, companies don’t just grow by getting physically bigger and taking up more space. As Hazlitt proclaimed in 1946, growth in areas that you don’t physically see right in front of you are often the most important types of growth.

The More Important

I want to end on this concept because I’m entranced by it.

Mankind necessarily begins with the concrete and what’s right in front of him, and over generations he forms laws of nature, which get at what Plato called underlying forms. Plato believed that the forms behind the manifestation of reality are inherently more important than physical objects, because the forms govern their existence. In other words, the law of gravitation is more important than the objects which are being gravitated, because the law allows us to understand the objects.

Hazlitt was saying something very similar, only in relation to economics: What we don’t see is often more important than what we see. We visually see Starbucks everywhere, but we don’t visually see the quality of coffee increasing. Hazlitt elaborated with an analogy to a broken shop window: If a shop’s window breaks, we see extra business go to the repair man. Judging just from what we see, broken windows are good because they produce business. What we don’t see, however, is more important. We don't see the foregone opportunities given up by shop owner. Perhaps he now has to make his goods more expensive, or he can’t expand his business. Economist John Maynard Keynes - whose influence has exceeded Marx in determining liberal economic policy - was notorious in his inability to grasp Hazlitt's law. He once famously suggested that we should bury money under ground, so that industries can form by digging holes to get them out.

I’m fond of intellectualizing issues, often to a fault (see this post and every other). For this reason, though, I’m often amazed at how intellectual liberals fail to grasp anything about the economy that's not in plain sight in front of their eyes; because Hazlitt’s law is the bare essence of intellectualization, by moving the discussion to the underlying principles, rather than just what’s out there in front of you. How can you be intellectual and fail to grasp that there’s more to the world than just what you see?

Nonetheless, liberals often chide at attempts to get at the underlying forms of the economy, such as Adam Smith's notion of the invisible hand, under the presumption that it's an oversimplified attempt to avoid reality. On the contrary, however, discussing physical economic things without reference their underlying economic form is like trying to move a rotating object without thinking about gravitational forces. Stated more succintly, its easy to change something's outward physical appearance, like an item's price, but its not easy to alter the form, like the information that a price conveys.

Of course, applied to the economy, this mistake is not specific to intellectual liberals. Many economists and politicians, in the tradition of Keynes, overemphasize consumer goods and end-products, which we see, over investments and savings, which we don't see. One instance of this was when former President Bush urged Americans to go shopping after 9/11 upon the assumption that this would stimulate the economy. Contrary to Bush's intention, buying random things when you don’t need them is pointless, and spending beyond your means is in fact harmful for the economy. When you buy a product that you need and can afford, you’re signaling to the manufacturer – along with anyone involved in its profit – that the product is valuable. You're telling them that you enjoy their product more than you would have enjoyed your extra money somewhere else. You're signaling them to make more of that product, or to keep doing what they were doing. Buying useless products that you can’t afford just adds noise to that signal, and it depletes from your savings. Savings again represent what you don’t see: They don’t just sit in a bank vault. They’re loaned to businesses or people, or are reinvested into the economy. That money is given a purpose, and in line with Hazlitt, that purpose is arguably more important than your consumption, particularly if you don’t need or want that consumption.

This misconception is magnified in the use of GDP – gross domestic product – to measure the macroeconomy. GDP is the total measure of exactly what you see: product. It doesn’t include what you don’t see, particularly savings and investment. When a window breaks, or another Starbucks opens, GDP increases, regardless of any depletion in savings; when a company like Harley Davidson focuses on making better motorcycles (and spends on R&D), GDP suffers.

Economist Mark Skousen, among a few others, hotly debates the usefulness of GDP. Using a statistic called gross output, he estimates that end-product consumer goods account for only a third of the economy. And this makes sense, because changes in the GDP usually lag behind changes in the stock market by a few months. It takes money to make money, and it also takes money in the right hands as well. That's why savings and investments are more important than consumption.

Right now most every company is in trouble, although to varying degrees. Starbucks used one strategy for expansion, though it certainly wasn’t the only strategy, and in hindsight it probably wasn’t the wisest. Harley Davidson management has recently turned south as well, as they’ve somehow managed to pile on a huge amount of debt while being aware of their shrinking baby-boomer customer base. But the important lesson is that these companies had options, as growth doesn’t always occur in areas that you see. Often the best things in life – love, joy, happiness – you can't see directly at all.

-KJ

_______________
Media (in order of appearance):

Photo: (1) Careful, 11/10/2006, by Carlos Aldana; (2) Fuel, 09/30/2006, by Nathan Makan; (3) 1907 Harley Davidson, photo by Rmhermen; (4) Harley Davidson Heritage Model 2004; (5) DUNKIN' DONUTS, 12/03/2006, by Paul Downey; (6) Concave modular origami : collection so far, 11/17/2008, by fdecomite; (7) Shattered Lens, 03/06/2006, by kandyjaxx; (8) Westfield White City, 11/25/2008, by Manuel. Sphere: Related Content

Top 15 of 2008

I thought about doing one of those year-end lists (like best CDs of the year) but I'm never very in touch with what's been released any given year. And furthermore half the time I find myself amazed by old things as if they were new (like a few years ago when I discovered Marvin Gayes' 1971 R&B classic, What's Goinig On). Society has a strong preference for the new, but sometimes old ideas can seem all the more relevant. So I decided to make a list of just top stuff in my life this year. Some are ideas and areas of study while others are new media and entertainment. Think of them as influencers in my life this year. In that sense, they're all things that proved to be novel to me in 2008 (that's why you won't find the sun rising) like little surprises or discoveries for the year. And in that sense as well I hope some of them you might find novel in your life.

______________

15. Dogs

Previously I never understood why people become so attached to them, though I never gave it much thought. But with new roommates I'm now living with a bunch of dogs and they’re a whole lot of fun like good buds. Dogs definitely make life just a bit richer.

14. The Washington Redskins

Being fully away from any form of school I’ve been able to get back into football. I enjoyed following the Skins throughout high school, but now that my mind’s a bit more matured I suddenly see there’s so much more to the game. This has become my new religion insofar as I set aside time each Sunday and think about it all week...and insofar as it’s not really a religion.

13. The Stock Market

Stock prices fluctuate in relation to demand for them not in relation to how good a company is. On a very intuitive level, this has never made sense to me, and it still doesn’t. But this year I’ve become intrigued with finding good intro books, reading about the market, researching companies, and even buying my first couple of shares. It’s essentially a mind-puzzle, a very tempered and controlled form of gambling. But boy is it intriguing. Sometimes I’ll just go to finance.google.com and watch the numbers change.

12. iTunes Genius

iTunes Genius is like an automated DJ who works with your digital music collection. You “play a song, click the Genius button, and iTunes creates a playlist of other songs from your library that go great together. Genius playlists help you discover songs in your library you never knew you had — and rediscover forgotten favorites.” Each song transition is tasteful and perhaps even artistic. It’s not perfect as it doesn’t recognize every song, and you can only use it for one song at a time. But its playlists really rival my own, some of which I've spent some time on. Even if you prefer to make your own mixes, you can use Genius to generate new ideas when you're stuck.
11. Motley Fool Caps

Motley Fool CAPS is an addictive stock market stimulator in which you vote on which stock picks will out- or under-perform the S&P. It’s as close as you’ll get to a true social networking community focusing on the stock market. And it’s taught me a good bit the market, both through making picks and reading others’ commentary. Tons of people use it and many stocks have thousands of predictions. For instance, Apple is currently the most frequently rated stock with 19,512 members for it and 1,593 members against it. TMF collects the data to generate all sorts of stats on players and stocks. It's only been around since 2006, and they're constantly tweaking it for the better. No one is even sure yet how it’ll turn out: Will it provide accurate real-world predictions? Will the highest rated stocks win out in the long run? In the meanwhile though who cares because it’s more fun than real investing.

10. Good cappuccinos

I’m not one to make elite aesthetic distinctions – they're often just puffs of ego and semantics. But this year a friend introduced me to a coffee shop that makes “real” cappuccinos and boy what a difference. Ones that look like this:

Cappuccinos are supposed to be thick and made with whole milk. The whole point in adding milk is so the dairy fat can bring out the flavor of the coffee. I'm hooked, and Starbucks' – who recently made skim milk their default for cappuccinos – now taste pretty empty to me.

9. metacritic.com

Metacritic.com combines critics' reviews on any given movie, music album, video game, or TV show. Each item gets a combined score across all critics, similar to rottentomatoes but with more media and a more user-friendly layout. I’ll often check it out before – and sometimes after – seeing or purchasing related media. The service is topnotch, since being bought by CBS, who've supplied it with more than adequate bandwidth, better quality control, and new features.

8. Coldplay’s album Viva la Vida

Like a revelation unfolded in sound. The collaboration between Coldplay and producer(/ambient maestro) Brian Eno worked perfectly. Coldplay and Eno are each intellectual aurally-aware introverts – sometimes to a fault – but here they build off each other quite well.



7. Improv acting classes

A few months ago I capriciously decided to give improv acting classes a try, as inspired through this article at CNN. It's taught me some unique life lessons, which I wrote about previously, but moreso it’s just a great release.

6. Slumdog Millionaire

The world is getting more connected, and we could only go on for so long before some artsy director pondered "why not make an American version of a Bollywood film?", and Slumdog Millionaire is the glorified result. An intense journey through the deepest reaches of poverty and fantasy, it’s the sort of film that could only have been released – or made money – this decade. Americans are truly getting smarter with each passing generation. Movies like Slumdog Millionaire or the Dark Knight are too complex and edgy to have been widely accepted a couple of decades ago. I loved them. We’re demanding more from pop-culture Mecca’s like Hollywood, and they’re giving us the goods. For more see Steven Johnson’s book Everything Bad Is Good for You: How Today's Popular Culture Is Actually Making Us Smarter. Check out Slumdog's soundtrack as well.

5. iTunes audio-books

I enjoy music and my iPod gives me freedom to listen to it anywhere. But I’ve recently begun digging iTunes’ audio-books as much as its music. At first I thought that I’d rather just listen to my favorite tunes everywhere and get into a groove. But audio-books have slipped into my daily iPod use with surprising ease. Just be sure to pick ones that aren’t too complex to listen to on the go. For example, an audio version of Newton’s Principia Mathematica won't work.

4. New Balance motion control sneakers

A few months ago I decided to give these shoes a go. They're called motion control shoes, because they have extra support around the arch in order to force your foot into correct pronation. They’ve completely corrected my posture, solved a running injury that I’ve had for years, and allowed me to run again. Who would’ve thought? The New Balance store by me has exceptional customer service as well, far exceeding similar high-end running shoe stores that I tried.

"Graphite Rollbar® is a boomeranging positioned piece of graphite in the midsole which maximizes rearfoot stability. Rollbar can be combined with a TPU medial and/or lateral post for motion control."

3. Economics

Economics suddenly intrigues me to no end. I don’t know what it is, but this topic seems to pervade everything. This year I’ve spent some time trying to finding the right books to teach myself about economics, and so far my picks have exceeded my expectations. Among the top is Thomas Sowell’s Basic Economics.

2. Sleep

This year I’ve reached new plateaus in how good my sleep feels. Wrote Vladimir Nabokov, “Sleep is a rose the Persians say.” (For more see a previous post).

1. Robert Pirsig's Zen & the art of Motorcycle Maintenance

I've returned to this book for the first time since a teen and it hits the spot like a popsicle on a hot day. I first read it a decade ago but it seems so much more relevant now. You can feel yourself learning with each page. And I even see how its lessons – which I’d forgotten explicitly came from the book – left their mark on my thinking since I was teenager, such as: the importance of analysis, both regarding its benefits and limits; the notion of honest work; quality and gumption; the limits of ego, opinion, and rigid-thinking. Other lessons are particularly relevant to my life now: the notion of moving laterally in life instead of forward; that roadblocks in life or in the mind are equally or more important than success; the severe limits of the empirical sciences. His discussion on lateral movement is exactly what I find so fascinating about free markets and alternative uses of scarce resources. But the book's reach extends far beyond.

-KJ
_______________
Media (in order of appearance):

Photo: (1) Jason Taylor, 08/16/2008, jf; (2) iTunes Genius logo; (3) CAPPUCCINO, 07/22/2007, by kina3; (4) Movie poster from the 2008 film Slumdog Millionaire, fair use rationale to provide commentary on film; (5) 365/365: Audiobooks, 01/09/2008, by David D Muir; (6) New Balance motion control technology; (7) Cover from Pirsig's Zen and the Art of Motorcycle Maintenance.

Video: (1) Music video from caleismachinegun of the song "Lost" by Coldplay from the 2008 album Viva La Vida. Sphere: Related Content