Thursday, August 25, 2011

Gladwell on the Picasso Theory

It looks like the "Picasso Theory" is catching on.

A few years ago, I argued that owning a sports team is like owning a Van Gogh: you don't own it to make a profit, but, rather, for the ego gratification of ownership. Normally, an owner doesn't mind that much if he makes money, or even loses a small amount, because that's just the cost of the hobby of owning the team.

There's some evidence that supports that. For instance, teams that are making lots of money are more likely to be owned by corporations, who don't get pleasure and so insist on money. On the other hand, teams losing money are more likely to be owned by individuals, who are willing to pay the price to be real-life fantasy owners. (Read my previous post for the full argument. And, other posts on this topic here.)

Later, Tango dubbed that the "Picasso theory."

Now, it looks like David Berri and Malcolm Gladwell agree. Gladwell wrote about the "psychic value" of NBA team ownership on "Grantland" last week, and, today, Berri cites it approvingly.

Gladwell writes in the context of a possible NBA lockout, where the owners are complaining that they can't make money under the current salary structure. Read the whole thing, but here's two key paragraphs:

"The best illustration of psychic benefits is the art market. Art collectors buy paintings for two reasons. They are interested in the painting as an investment — the same way they would view buying stock in General Motors. And they are interested in the painting as a painting — as a beautiful object. In a recent paper in Economics Bulletin, the economists Erdal Atukeren and Aylin Seçkin used a variety of clever ways to figure out just how large the second psychic benefit is, and they put it at 28 percent.7 In other words, if you pay $100 million for a Van Gogh, $28 million of that is for the joy of looking at it every morning. If that seems like a lot, it shouldn't. There aren't many Van Goghs out there, and they are very beautiful. If you care passionately about art, paying that kind of premium makes perfect sense ... Pro sports teams are a lot like works of art ...

"The big difference between art and sports, of course, is that art collectors are honest about psychic benefits. They do not wake up one day, pretend that looking at a Van Gogh leaves them cold, and demand a $27 million refund from their art dealer. But that is exactly what the NBA owners are doing. They are indulging in the fantasy that what they run are ordinary businesses — when they never were. And they are asking us to believe that these "businesses" lose money. But of course an owner is only losing money if he values the psychic benefits of owning an NBA franchise at zero — and if you value psychic benefits at zero, then you shouldn't own an NBA franchise in the first place. You should sell your "business" — at what is sure to be a healthy premium — to someone who actually likes basketball."

Anyway, my comments, which mostly agree with Gladwell despite a couple of exceptions:

1. I'm not sure I'd phrase it the way Gladwell did, that you have to add "psychic benefits" to financial profit to get true profit. I think you have to talk about them separately. I'd say that, yes, the owners are losing money, but, that's because they're willing to accept losses to get the "psychic benefit".

There are psychic benefits to a lot of transactions. I like Tim Hortons coffee, and, a few years ago, I bought their stock. I get a very small amount of psychic benefit out of owning the stock, because I like the product so much. But if I sell the stock, would anyone expect me to adjust the amount of my gain or loss by my perceived Picasso value? I don't think so. That would be weird. Better to say, "yes, I lost $X, but I got some small pride from being able to say I owned it, so I'm not all that upset."

In the case of the NBA, I wouldn't phrase it quite the way Gladwell does. Rather, I'd say, yes, some of the NBA owners are indeed losing money, but, so what? That's the price they pay for all the fun and fame of owning a team. If they don't like the cost, they can always sell the team, perhaps for more than they paid."

2. Even if teams broke even, they'd still be a bad investment. Right now, the way the stock market is valued, you can buy good businesses at 15x earnings, or even less ... which means you'll make at least 7% on your investment. Safer investments make less, of course ... let's suppose an NBA team is more predictable than (say) Coca-Cola, and a 4% return is more appropriate.

If the Detroit Pistons recently sold for $420 million, and they only broke even, the owner would be forgoing 4% of $420 million, which is $16.8 million. That's the opportunity cost of owning a team that merely breaks even.

According to the NBA, "11 teams lost more than $20 million each." If your team lost $25 million, that's not as big a deal as it looks, since you're already choosing to give up $17 million to own the team.

In fairness, you have to take into account that the owners may not have the cash flow to flush $25 million in cash down the drain ... the $16.8 million is a paper loss, while the $25 million is cash that needs to be found somewhere.

3. Even after lots of total losses, you might argue that the team might still be a good investment.

The argument might go like this. Suppose it costs $40 million in opportunity costs to own a team. If there are enough billionaires around who love basketball, they might be willing to pay that, and more. Suppose the 30th most rabid basketball billionaire is willing to pay $50 million a year for the privilege of being an NBA mogul. Then he'd be willing to pay $625 million for the team. (That's because his $625 million purchase will cost him an annual $25 million in opportunity cost, and $25 million cash.)

So, even losing money every year, an NBA team can still be a good investment. But only if the Picasso Value -- the consumption, "psychic" value of ownership -- rises.

But, wait! It's not enough that the psychic value rises. It has to rise *more than expected*. Because expectations for future value are already built in to the purchase price. If owner X realizes that the psychic value will be $100 million ten years from now, he'll be willing to pay extra for the team now, knowing that in ten years, he can sell it at a hefty profit.

As well, value of the team goes down if the actual cash losses are higher than expected. If the 30th most rabid billionaire is willing to lose $50 million a year, and losses are $55 million a year ... then the team is valueless. Well, not really, because someone might buy the team in anticipation of locking out the players to restructure league finances. But, still, the amount of cash losses is very important. Owners are willing to bear a certain amount of loss, but not an *unlimited* amount of loss.

And that's why I don't see any reason that NBA owners shouldn't want to restructure their agreement with the players to keep their losses down. Even if an owner is actually getting good value even if he loses $25 million a year ... well, at the same time, the NBA's superstar players are getting good value for their talents even if they make $8 million a year instead of $12 million.

The point is not that the owners are wrong in wanting to pay the players less. The point should only be that it is not unacceptable for the owners to be losing money. The question is: *how much* money is it reasonable to ask the owners to lose? And *how much* money is it reasonable to ask the players to give up? I don't have answers to those questions.

And that is one point where I disagree with Malcolm Gladwell. He says,

"But of course an owner is only losing money if he values the psychic benefits of owning an NBA franchise at zero."

That's not true. The psychic benefits might be quite high, but the losses, both in cash and opportunity cost, might be even higher. If the owners are really willing to lock out the players, isn't that some evidence that we're getting close to the owners' "reservation price"?

"if you value psychic benefits at zero, then you shouldn't own an NBA franchise in the first place. You should sell your "business" — at what is sure to be a healthy premium — to someone who actually likes basketball."

But the owners don't value the psychic benefits at zero. If they did, they wouldn't have bought the team in the first place, as they would have made more money in other investments. They're just getting to the point where the financial losses are starting to come close to the psychic benefits.

If I had to summarize everything in one paragraph:

It is absolutely true that there are substantial psychic benefits to owning an NBA franchise. But those psychic benefits aren't infinite. Unless we can figure out the value of those benefits, we have no idea whether

(a) league finances are truly unsustainable, as losses are regularly higher than Picasso values;
(b) league finances aren't unsustainable yet, but headed that way, as the losses owners are being asked to bear are getting close to their Picasso value;
(c) league finances are still in favor of the owners, just not as much as they used to be;
(d) league finances are WAY in favor of the owners, who are pretending otherwise and blowing smoke.

You have to come up with some way of estimating "psychic values" to figure out where we actually are.



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