Monday, July 25, 2011

Bureaucracy and overcomplexity: Apollo Asia Fund: the manager's report for 2Q2011

In May, seeking a brief escape from markets and bureaucracy alike, I enjoyed a fascinating tour of Qinghai, the Chinese province which is part of Greater Tibet. I was interested to see how the gathering and trading of cordyceps has exploded in recent years. I first encountered cordyceps, the caterpillar fungus, on another trip to Tibet 10-15 years ago. I was intrigued by its biological lifecycle; Hong Kong Chinese friends were riveted by the revelation that a medicine of such high market value could be picked up from the ground, or bought inexpensively from local traders. Now, thanks to mobile phones, the locals are well aware of its value, and cordyceps has brought a new affluence to those areas blessed with an endowment. Cordyceps gathering attracts such a large percentage of the population that the government talks of protecting the grasslands from destruction - and much is being fenced off (so I had questions about possible vested interests in the fencing of land over which nomads formerly roamed, and in the construction of dismal 'social housing' for Tibetans whose former lifestyle may have become impossible). Trading is however quite legal, and there are two major exchanges, in Yushu and Maixinxian. (If you ever go to Maixinxian, and coincide with the cordyceps buyers, book your hotel room well in advance.) Fakes are common. We did not hear of a futures market... My excuse for talking about this is that the progressive consumption and death of the caterpillar provides an excellent metaphor for the hollowing out of prosperity by bureaucracy: what remains still looks like a caterpillar, but is made up entirely of fungus.

The historian Joseph Tainter has observed that societies often respond to new problems by increasing complexity - eg by adding new layers of regulation - at increasingly marginal rates of return, until the total system costs exceed the benefits. As decline sets in, the cost of maintaining the system becomes unaffordable.

The danger of diminishing or negative return on complex investments also applies to companies. Systems can be over-integrated, if failure in one component shuts down the whole, or if operating flexibility is lost. Streamlining, offshoring, and outsourcing the workforce may leave noone on site empowered to take decisions, or with overall understanding of the system. Business process restructuring based on an ideal concept which overlooks real-life variations and contingencies may prove catastrophic. A recent trip to the UK provided startling examples.

As investors, we must try to avoid companies vulnerable to such pitfalls of overambition and poor execution, and to find those which are resilient to fast-changing external conditions. Wish us luck.


Related book: The Collapse of Complex Societies