Finding your arbitrage

THE idea of profit is the difference between cost and selling price.

To make a profit, there must be a difference between the value that people are willing to pay for and the actual cost of the goods or services.

Profit margins are then determined by the percentage based on the willingness to pay.

However, the difference in value is affected by many factors, such as supply and demand, foreign-exchange differences, geographical location, market size, language differences, risk premiums, access to capital, interest rates and many others.

It is hard to pinpoint a single determinant of price, but usually it is a culmination of conditions.

Different conditions also lead to differences in pricing and may present an opportunity to profit from the price gap.

This effectively leads to an outcome called “arbitrage”.

The idea of today’s column is not to talk about making money via price arbitrage, but to encourage readers to see through the lens of “arbitrage in value” in their daily lives and observe how that leads to profit in certain industries, sectors or products.

In addition to that, I hope the takeaway is that readers can find their own arbitrage along the way.

Geographical arbitrage

I would like to start off with an easy illustration. Imagine a common Ming vase in China painted by hand and sculpted through traditional coal firing without using laser or 3D machines.

Ordinarily it would be just another porcelain product selling at affordable pricing in China, available in shops, stores or outlets in any city or province.

Now if you put this same Ming vase in a renowned luxury departmental store in London, the price of the vase would likely be many times more expensive.

Another example would be Sarawak locally grown organic pepper selling in local stores in Kuching. It is widely available and comes at an affordable price, making it an almost “must-buy” for tourists visiting Sarawak.

Assuming the same product was sold in a premium supermarket in New York or San Francisco, surely the price cannot be the same.

Of course, one would argue that the difference in pricing is due to logistics, warehousing, currency differences and even “quality” that has been specially curated by the department store or supermarket chain.

That said, the biggest arbitrage in value is simply the location and availability of the product in question.

This arbitrage exists because, in different locations, you can sell a similar product at a different price and make a profit from it.

This forms the fundamental basis of global trade between countries and economies today.

Conditions leading to arbitrage

What is more interesting is not so much arbitrage in the traditional sense.

It is the arbitrage of conditions that allows profits to be made.

For example, China has been regarded as the world’s factory from the 1990s to the early 2000s.

Due to its sheer population size, high productivity and efficiency, many global consumer brands set up manufacturing hubs in China to enjoy economies of scale before exporting to global markets.

From there, they enjoy the fat profit margins. This unfortunately, is a form of arbitrage as well.

It is at the expense of meagre labour costs or a low-wage model that exploits the labour force in developing or poorer nations.

In this case, the arbitrage in value comes from lower labour costs compared with setting up a manufacturing hub in a developed country such as the United States. That is why allegations of sweatshops exist.

Of course, with greater awareness and increased advocacy for labour rights, sweatshops are being phased out although manufacturing hubs continue to move to other countries where production costs remain relatively low, such as Vietnam, Indonesia and Pakistan.

A different but widely acceptable form of arbitrage is knowledge itself.

The arbitrage of knowledge helps build super-normal profits.

This gap in knowledge is what sets companies, economies and countries apart.

The biggest global companies today often have their own proprietary knowledge or technology, more commonly known as their “secret sauce”, to excel.

In the consumer fast-moving consumer goods (FMCG) space, the formula for shampoo, toothpaste, body wash or soda is often kept in a black box.

While they outsource the packaging function of the business to countries with lower manufacturing costs, they keep the formula to themselves.

The difference in knowledge is what separates a generic FMCG product from a branded one.

Good examples would be Colgate, Dove, Coca-Cola versus generic brands.

Technology is the great equaliser

The advancement of technology disrupts many things.

It changes the status quo and normalises unequal conditions.

In short, technology is the great equaliser that eradicates value differences and closes the gap on arbitrage.

Today, research and development, which has traditionally been more advanced in developed economies, is witnessing the gap shrink as developing economies catch up.

Take the automotive industry. German automotive engineering has been a world leader for more than a century.

German brands like Volkswagen, Porsche, Mercedes Benz, BMW are all leaders, commanding a premium over rivals.

Volkswagen hit a record 10.1 million units in global sales in 2016, with an 11.1% global market share.

Today, the global leader is Toyota, at 11.3 million units, with China behemoth BYD at 4.6 million units in global sales. In 2016, BYD sold only 100,000 cars. How did a China upstart grow so exponentially in the past decade?

It was through the adoption of new technology – battery electric vehicles versus internal combustion engines.

Knowledge drives innovation, and innovation spurs change and disrupts the status quo.

When you cannot beat your competitor at their game, you innovate and adopt a new way of playing the game.

Creation of value is more sustainable

There is no doubt to first make a breakthrough it is necessary to hustle and grind. Finding your arbitrage is possibly the fastest and most efficient way to make your first pot of gold. Beyond that, relying on smarts to arbitrage would not suffice anymore.

To get to the next level or to join the big boys league, it is all about creating value.

This value must be about bringing good to the people around you, community, society or even the nation.

The value must be of demand otherwise it is only a feel-good factor. Monetising the value in the long run is more sustainable rather than just arbitraging the short-term difference where the gap will eventually close.

Case in point, hardware stores, fixed-price retailers and cheap goods merchants are now all suffering the brunt of cross-border eCommerce onslaught through the likes of Pinduoduo, Temu, Shein which disrupted the old business model of price arbitrage due to geographical location.

This is why the biggest difference between some evergreen tycoons versus businessmen lies in value creation and constant innovation. Whoever creates the most value that is in demand over the longest duration of time will enjoy longevity of success.

There is no doubt that, to make a breakthrough, it is necessary to hustle and grind. Finding your arbitrage is possibly the fastest and most efficient way to make your first pot of gold.

Beyond that, relying on smarts to arbitrage would no longer suffice. To get to the next level or join the big boys’ league, it is all about creating value.

This value must be about bringing good to the people around you, the community, society or even the nation.

The value must be in demand; otherwise, it is only a feel-good factor. Monetising that value in the long run is more sustainable than simply arbitraging short-term differences, where the gap will eventually close.

Case in point, hardware stores, fixed-price retailers and cheap-goods merchants are now bearing the brunt of the cross-border eCommerce onslaught from the likes of Pinduoduo, Temu and Shein, which have disrupted the old business model of price arbitrage based on geographical location.

This is why the biggest difference between some evergreen tycoons and businessmen lies in value creation and constant innovation. Whoever creates the most value that is in demand over the longest period of time will enjoy longevity of success.