Wednesday, April 29, 2009

Back to the old drawing board!

























Back in January, we published a post in which we noted that "financial advisors" and other intermediaries were "reeling" and that they (and their clients) were probably at a point at which "they know that something needs to change, but they have not been equipped to know exactly what."

Now comes a story in today's Wall Street Journal confirming our assertions from that earlier post, and providing examples and quotations from intermediaries who are trying all kinds of new ideas in the wake of 2008, from leveraged ETFs to managed futures to computer algorithms designed to tell them when to get into and out of the market.

As the old saying goes, they have decided to say, "Back to the drawing board!" (a reference to an old pre-computer technology called a "drawing board," shown above). One wonders how many times they have said this before, and how many more times they will go "back to the drawing board" in the future.

We have previously pointed out that this kind of inconsistent investment philosophy -- this willingness to completely re-work the entire system of what principles govern where and how to invest -- is a common feature in the modern financial landscape, dominated as it is by intermediaries who do not actually manage money themselves but instead spend their time evaluating third party managers and telling their clients when to switch from one manager to another.

In fact, in January of 2008 we wrote a post entitled "Can your advisor answer this question?" in which we noted the deleterious results that such activities can have on investor returns over a twenty-year period. We believe that data from numerous studies showing poor long-term investment performance by investors should be linked to this kind of "back to the drawing board" behavior by their "advisors."

The Journal story referenced above also fails to point out that the kinds of "alternative investments" that advisors mention in the article, such as "currencies or managed futures that they believe will rise when stocks fall", are exactly the kind of "diversification" that caused catastrophic problems for many investors in 2008, as we noted in this post from November. That post also linked to a Journal article, entitled "No place to hide," which revealed that following the advice of "investment pros" who recommended moving into foreign funds, currency bets against the dollar, and commodity speculation during the first half of 2008 had resulted in many investors doing far worse than even the plunging U.S. equity markets by the second half of the year.

Another misconception in the article is that jumping in and out of markets is "actively managing clients' money" (see the third paragraph from the end of the article) and that anything else is a form of "buy-and-hold." Both of these assertions are incorrect.

Active management is a term used to distinguish between following a "passive" or index-based approach, and an approach based on the belief that one can find companies that will outperform the broader market over time (see for example the discussion in this previous blog post). "Buy-and-hold," on the other hand, is one form of investing that does not try to time markets, but by no means the only form. While we do not believe in timing market cycles, we also do not believe in holding a single company forever, the way "buy-and-hold" advocates might. The subtleties of that distinction are explored in a post we published entitled "Remaining calm without being blind or obstinate."

The article also notes that some advisors are turning to computer models to help them time market cycles, saying "We trust the computer." We would point out that such "black box" methods, in which an investor relies upon a computer algorithm to tell him when to buy or sell a stock, or when to get into or out of the market, are directly related to the kind of financial engineering and trust in computer models that helped cause the financial sector's disastrous meltdown in the first place, as we explained in "Beware of the witch doctors of modern finance."

We do believe that the events of 2008 should cause investors and advisors alike to consider going "back to the drawing board" and rethinking their entire approach to investing. However, it is clear that many are gravitating towards the same ideas that have been repudiated by the events of the past year.

Instead, we would offer a return to the kind of investing that was much more common prior to the dramatic spread of "modern portfolio theory" after 1974. We recommend investors think about investing as providing capital to businesses -- a concept which is entirely absent from the article referenced above.

Doing so is the best way to go "back to the drawing board" and to design a foundation for investing that will stand the test of time.

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Thursday, April 23, 2009

Look for paradigm shifts, part 2










As companies report their results from the first quarter of 2009, investors are noticing a divergence between companies reporting surprises that strongly beat expectations, and companies whose results can be seen as confirmation of the economic recession.

For example, today's Wall Street Journal calls attention to extraordinary earnings from Apple, which beat analyst estimates on continued strong sales of iPhones, while at the same time noting that "United Parcel Service, which is often seen as an economic bellwether, said its first-quarter net fell 56%, and projected second-quarter earnings short of analysts' estimates."*

Many times in the past (going back, in fact, to our very first blog post) we have quoted the assertion of Mr. Thomas Rowe Price in which he declared, "When selecting growth stocks, the most important requirement is capable, dynamic management operating in a fertile field of future growth."

We would note that in the examples from the Journal story above, the difference between the two companies might be expressed in terms of "fertile fields of growth." We have explained that one way of assessing fields of growth is to look for paradigm shifts, which open up new fields of growth as individuals or businesses change to a new way of doing things that adds new value.

In the case of the iPhone, it is clear that the rise of the smartphone (a category that the iPhone revolutionized upon its introduction in 2007) creates a fertile field of growth, the beginning of a paradigm shift that will eventually make traditional cellphones obsolete. In the case of UPS, it is clear that while they helped create a paradigm shift away from reliance on traditional postal service, that paradigm shift has largely penetrated most of society, and they are today much more tied to the cyclical ebbs and flows of the economy.

In our previous study of the difference between the broad investment periods of the 1970s, 1980s, and 1990s ("Return of the 1970s, part 2") we suggested that during periods of strong economic expansion (such as the period from 1984 to 1999), companies which had already grown to dominate their industries often did well, growing their sales and benefiting from strong liquidity and commanding balance sheets. During that period, and during the 1960s as well, large stocks generally performed well, as did index funds favoring large stocks such as the S&P 500 or the 1960's "Nifty Fifty" (a sort of large-cap index popular at that time).

During the economically rocky 1970s, however, there was a serious divergence between the performance of larger companies and smaller ones. Larger companies, whose businesses were less likely to be exploiting a new paradigm shift and were thus likely to be more tied to the ups and downs of the overall economy, lagged significantly. Smaller companies, which were more likely to be dependent upon some new field of growth for their opportunity to make money, considerably outperformed during that decade and into the early 1980s, in spite of the vicious 1981-82 recession.

We would suggest that there is evidence that the same phenomenon may be starting to take place today. Investors should therefore be thinking carefully about where there are fields of growth, or paradigm shifts, and what companies can best pursue them.

As we stated in our previous post on paradigm shifts, "a paradigm shift can take place from the creative application of almost any new and more efficient business model, whether it uses some new technology or not." In other words, the field of growth can arise from a very subtle trend.

For example, Quest Diagnostics, which just reported 20% growth in earnings over the results of the same quarter in 2008, is taking advantage of a variety of trends that point towards greater use of lab testing. One trend is that lab test usage increases with age, and the demographics in the US and other countries are such that we will witness an aging population in the decades ahead. Another trend is toward greater use of diagnostic testing sooner, in order to provide physicians with greater situational awareness on a more timely basis. Related to this trend is a growth in esoteric testing, laboratory tests which require greater human analysis from trained personnel and which are often used to detect less common health issues. These tests are often more expensive and carry higher margins for lab test providers such as Quest Diagnostics.**

These types of paradigm shifts are perhaps less obvious, but represent the kinds of fields of growth that well-run businesses may be able to follow for many years. Investors should carefully consider this concept, especially at a point in time where there may be an increasing divergence between companies that meet the definition of "capable, dynamic management operating in a fertile field for future growth," and those that do not.


* The principals of Taylor Frigon Capital Management do not own securities issued by Apple (AAPL) or United Parcel Service (UPS).

** The principals of Taylor Frigon Capital Management own securities issued by Quest Diagnostics (DGX).

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Wednesday, April 22, 2009

'Earth Day' investment lessons

























Our most recent post contains a discussion of the dangers of zero-sum thinking and notes that many international organizations, such as the UN's Population Fund (UNFPA) are clearly coming from a zero-sum worldview when they support assertions such as: the "solution to climate change and food security must tackle population growth."

Sadly, children in schools around the world today will be taught "Earth Day" lessons replete with messages that humans are rapidly depleting the planet's scarce resources. Readers who doubt the level of rhetoric that has been directed at the upcoming generation on this front can peruse the book reviews offered last week by the Wall Street Journal's children's books columnist Meghan Cox Gurdon, who lamented the heavy-handed "eco-propaganda" directed at children in a piece entitled "Scary Green Monsters."

As we have pointed out in a previous post, there are serious economic consequences to proposals for "sweeping global goals" designed to force individuals and economies to "curb energy use and greenhouse gas emissions," such as those called for in a NY Times blog that we cited in our post from 2007.

Most basically, it is by no means settled that human activity is causally related to global climate, as the talk given by Professor Noah Robinson of the Oregon Institute of Science and Medicine linked previously explains.

Further, even if one were to grant a causal relationship, it does not necessarily follow that the best response to such a causal link would be to impose government restriction of free enterprise. On the contrary, it can be demonstrated using empirical data that economic freedom and the corresponding increase in wealth, productivity, and technology that it brings about is the very thing that enables greener and cleaner societies and improvements in the health of the environment.

For example, as economics Professor Mark Perry of the University of Michigan's Flint campus demonstrates in his excellent Carpe Diem blog yesterday, various measures of air quality in the US have improved dramatically over the past twenty to thirty years (a 28% decrease in particulates over the past seventeen years, a 76% decrease in carbon monoxide levels over the past twenty-seven years, and a 91% decrease in lead levels over the past twenty-seven years), despite the fact that the US population has increased by 50.25% since 1970 and the number of miles driven has increased by 159% (see "Earth Day 2009: Air Quality's Better than Ever.")

Professor Perry links to other examples that support the fact that free enterprise and rising prosperity are the best prescriptions for environmental health, such as this article by John Tierney in Monday's New York Times.

Government interference can not only smother the kind of innovation and economic value-creation that help improve air quality and other measures of environmental health, it can also act to artificially direct capital towards projects that are wasteful.

Normally, capital flows towards innovation based on rational decisions made by those who provide the capital based on their potential rates of return. However, when governments artificially tip the playing field, capital can flow into areas that it normally would not, a phenomenon properly termed "malinvestment."

For example, the government gives out subsidies for the use of solar technology in order to make it appear to be more economically viable than it actually is. Unlike the profits earned by an unsubsidized business, which must demonstrate value to customers who then voluntarily trade their money for the products or services of the business, these subsidies come from taxes which are taken from taxpayers using the force of law.

Venture capitalists and other investors will allocate more capital to solar start-up companies than they normally would, and those solar start-ups can make profits they otherwise would not be able to make. Thus, capital flows towards solar which might otherwise be more profitably employed towards a technology or innovation that would be able to stand on its own merits. It should be noted that there are plenty of recent examples of government-induced malinvestment, such as the real estate bubble, in which the government encouraged more home lending than would otherwise have occurred.

The argument that government should encourage home ownership is exactly parallel to the argument that government should support solar energy, and the results of the malinvestment in residential housing should be a warning to those who assume government should be tilting the playing field and encouraging capital to flow where it otherwise would not.

While individual investors cannot do much about the government's decisions to encourage capital to flow towards "green" initiatives (or the use of their tax dollars to subsidize such initiatives), they can make sure that they don't fall into the same trap when they are making the decisions about the allocation of their own investment capital.

While the areas that receive huge inflows of capital due to malinvestment appear to flourish for a while (think of real estate related investments during the period from 2003 to 2006, for instance), artificially-induced bubbles inevitably deflate. As we have written several times before, investors should remember that investing is ultimately about "providing capital to businesses" -- and if those businesses are making profits in large part because of government subsidy, they may not be a very wise place to direct your capital.

Ultimately, we would argue that the best lessons investors can contemplate on "Earth Day" are the importance of free enterprise, and the importance of allocating their own investment capital to the very best enterprises that they can find.



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Monday, April 20, 2009

The dark side of zero-sum thinking
























Zero-sum thinking is often explained using the metaphor of a "fixed pie" view of the world: there is only so much wealth out there, and the more people there are competing for any given portion of it, the less there is for everyone else to squabble over.

Those who have a fixed-pie or zero-sum view of the world naturally see others as potential competitors for resources, and even support measures to reduce the addition of other people whom they view as making everyone's pie even smaller.

For instance, the United Nations Population Fund (UNFPA) uses the euphemistic term "population issues" to refer to the "link between population and poverty" -- as if additional human beings are always a burden who decrease the resources available to everyone else.

In their advocacy of this zero-sum viewpoint, they participate in various "global and regional forums" such as this one which they link on their website, which declares that the "solution to climate change and food security must tackle population growth." At that forum, from December of last year, the UNFPA's G. Giridhar, "speaking on behalf of UNFPA," praised the benefits of "lower fertility, smaller families, and slower population growth, thus reducing the burden on the environment."

We have written about the problems with such zero-sum thinking many times in the past, such as here and here. The biggest error those who hold such a "fixed-pie" view make is in their failure to realize that every single person is a potential producer as well as a potential consumer -- every single person has the ability to make the pie bigger. The pie, in other words, is not "fixed" in its size.

When individuals and groups of individuals think of new ways to add value to others (which translates into making money for themselves, in exchange for the value they add), the pie grows. You can probably think of dozens of things that you use today that did not even exist ten years ago -- iPods, cellphones with video cameras and GPS capability, high-definition television sets -- and that is just scratching the surface of consumer goods, to say nothing of medical breakthroughs, manufacturing breakthroughs, and other business innovations that we don't usually notice on a daily basis.

The zero-sum fallacy sees people as liabilities rather than as they truly are: potential contributors to the prosperity of everyone else, because to the extent that they contribute to the economy, they actually enlarge the pie.

In an essay we have linked previously, first published in 1964, economics professor George Reisman of Pepperdine University wrote that this erroneous focus leads to the fear "that the work performed by machines leaves less to be performed by people, that the work performed by women leaves less to be performed by men, that the work performed by children leaves less to be performed by adults, that the work performed by Jews leaves less to be performed by Christians, that the work performed by blacks leaves less to be performed by whites, and that the extra work of some leaves a deficiency of work available for others."

It is appropriate to revisit the dangers of the zero-sum mindset, especially because tomorrow is Holocaust Remembrance Day, established to commemorate those murdered by people subscribing to thinking that is clearly linked to what Professor Reisman describes in the paragraph above.

Nevertheless, the news continues to provide examples of despotic leaders from countries with closed economies built upon zero-sum thinking who have taken their zero-sum thinking to violent and racist levels, such as Iran's leader today at the United Nations.

In the aftermath of an economic crisis, it is extremely important to understand the dangers of such thinking, because history has proven that such crises can cause a retreat into just such fixed-pie behavior. Thirty years ago, writing in an edition of the Journal of Portfolio Management that we have mentioned before, Rose and Milton Friedman observed:

"The spread of the Depression to other countries brought lower output, higher unemployment, hunger, and misery everywhere. In Germany, the Depression helped Adolf Hitler rise to power and paved the way for World War II. In Japan, it strengthened the hold of the military clique dedicated to creating the Greater East Asia co-prosperity sphere. In China, the aftermath of the Depression destroyed the monetary system, weakened the ability of the Nationalist government to resist the Japanese and then the Communists, and fostered the final hyper-inflation that sealed the doom of the Chiang Kai-shek regime and elevated Mao to power."

We feel that it is important to understand the connections between economic ideas and political events, and that it is critical that everyone be able to recognize zero-sum thinking, and able to explain why it is so fallacious and so dangerous.


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Wednesday, April 15, 2009

Four-letter government words







Milt Friedman once declared, "Given our monstrous, overgrown government structure, any three letters chosen at random would probably designate an agency or part of a department that could be profitably abolished" (cited in this Wall Street Journal obituary written about him the day after his death on November 16, 2006).

To the "three-letter" agencies of that quotation, we can now add a few "four-letter" government programs, notably TARP, TALF, PPIP, and the ARRA of 2009.

Scholars will debate for decades to come whether or not the bailouts enacted at the height of the market panic during the end of 2008 were necessary to save the financial system. What is clear at this point in time, however, is that continuing bailouts are no longer necessary.

In fact, as the video clip above indicates, banks are rushing to give the TARP money back, in order to escape the onerous interference that comes along with having the federal government as a part-owner of your business. In that video, First Niagara Bank CEO John Koelmel says that his bank is doing the same thing that Goldman Sachs is doing -- raising capital on their own and giving back the capital from the Treasury.*

We would argue that at this point, further extensions of TARP are not necessary, especially now that the boot of mark-to-market accounting has been removed from the throats of financial institutions. We would say the same about TALF (the "Term Asset-backed securities Loan Facility") plan, which established a credit facility by which the Federal Reserve Bank of New York would lend to financial institutions in order to support student loan activity, small business loan activity, car loan activity, and credit card loan activity, at a time when the disruption of markets for securities backed by such loans threatened to bring such lending to a halt.

Nevertheless, there are some who want to keep right on extending TARP's reach, including expanding it to include troubled insurance companies. Larry Kudlow disagrees in this well-argued recent post from his blog, and we are with Larry on this issue.

We would argue that the best thing the government could do now would be to eliminate further expenditure of tax dollars through TARP, as well as the more recent PPIP (the Public-Private Investment Program, designed to help banks by buying up their "toxic assets" or "legacy assets" using a consortium of selected private buyers partnering with the government). It should be clear at this point from the video above, for instance that PPIP is not necessary.

The testimony that former FDIC chair William Isaac gave before the House Subcommittee on Capital Markets, Insurance, and GSEs on March 12 presents a masterful case illustrating that these so-called "toxic assets" were being made toxic by the misguided 2007 accounting rule that forced them to be valued at well below their actual cash-flow value.













Using an anonymous example from an actual US bank, he illustrates in the graph above on a billion dollars in securitized mortgages. The purple bar on the far left, totaling $1.8 million so far, shows the actual losses that the portfolio has sustained, while the blue bar in the middle is the estimate of the maximum losses over the lifetime of all the mortgages in the portfolio, at $100 million. The green bar on the right shows the losses required to be marked against the portfolio of loans by the accounting rule in effect before the change: $913 million or over 90% of the value of an asset currently receiving payments on 98.2% of its assets.

In other words, it is quite clear that the reason those assets were so "toxic" to banks was because of the poisonous accounting rule. We have explained this problem several times, and have included links to Bill Isaac explaining this problem before, such as in this post from November. We would advise all investors to read his entire Congressional testimony linked above.

Particularly on the day that Americans remit their taxes to the government, it is appropriate to examine the case against continuing further "emergency" measures. The government has already taken significant steps to end the causes of the emergency, by addressing mark-to-market and the uptick rule and by flooding the economy with money.

We have argued that the problem was a financial panic, not a "depression," and because of this maintain that continued stimulus beyond addressing the technical factors at the heart of the panic is not necessary. In fact, we have given several reasons why government "stimulus" is harmful, rather than helpful.

While it is not likely to happen, Congress should realize that the technical factors at the heart of the panic have been addressed, and draft legislation to stop the "stimulus" spending in the American Recovery and Reinvestment Act of 2009 that has not yet taken place, and instead allow the massive monetary stimulus that the Fed has unleashed to do its job.

The remainder of ARRA, TARP, TALF and PPIP are "four-letter" government activities that, in the words of the late Professor Friedman, could be "profitably abolished."




* The principals of Taylor Frigon Capital Management do not own securities issued by First Niagara Bank (FNFG) or Goldman Sachs (GS).

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Monday, April 13, 2009

Don't get off the train, revisited




















Just over a month ago, we published a post entitled "Don't get off the train," on March 2, 2009.

In it, we suggested that market moves are often like a "bullet train" and that jumping on when it decides to make a rapid move is very difficult.

"The train is currently backing up and moving forward, backing up and moving forward," we wrote then at the beginning of March, but added that when it starts its move, "jumping on is a lot harder than people think it is."

The past month has borne that out. The day we published that post, the Dow Jones Industrial Average closed at 6763.29, the S&P500 closed at 700.82, and the Nasdaq Composite closed at 1322.85. As of the end of last week, those numbers stood at 8083.38 for the Dow, 856.56 for the S&P, and 1652.54 for the Nasdaq -- a gain of over 19%, over 22%, and over 24% respectively.

If measured from a week after that "Don't get off the train" posting, the increases through the end of last week were even larger -- a gain of over 23%, over 26%, and over 30% for the Dow, S&P, and Nasdaq indexes, respectively, since March 9th.

Those who got off the train and are now thinking it is a safe time to step back on have thus lost a significant amount of ground in just one month, illustrating the incredible difficulty of timing the market's sharp bursts -- in either direction.

Of course, there are plenty of pundits out there now saying that this is a "sucker's rally" and that the market has yet to reach a true bottom.

For example, colorful commodities advocate Jim Rogers was on Bloomberg today saying that he is not participating in stocks because he thinks commodities are a better place to be. Of the recent rally and the market bottom on March 9th, he said, "Is it the bottom? I don't think so, Bernie. I think we're going to see more bottoms in the next few years."

As we have emphasized over and over, we do not advise investors to try to figure out market bottoms, or to make the unpredictable moves of the market their focus, nor do we make such predictions ourselves.

Those investors who are being scared off by commentators predicting that the market will plumb new lows below those set on March 9th would do well to consider the little-known but very instructive case of famous Columbia professor and author Ben Graham, who advised one of his students not to invest in 1951 because the Dow was at 250 and he might be better off waiting until it went below 200.

Had that student (who turned out to be Warren Buffett) taken that advice, he would still be waiting, because the Dow never visited 200 again.

The upshot of all this is that the events of the past month provide yet another powerful example that it is far wiser to spend your energy and analysis finding and owning good businesses than trying to predict when the market will suddenly make its next wild gyration one way or the other. When the market is closest to its extremes, those gyrations become almost unbearable, but that is when it is most important to remember the saying, "Don't get off the train."

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Thursday, April 9, 2009

The Investment Climate: April 2009

























We recently published "The Investment Climate: April, 2009" in the commentary section of our website.

In it, we summarize the current situation and provide some perspective on where we stand today.

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Tuesday, April 7, 2009

Wise words from Reid Hoffman



Towards the end of 2008, we wrote: "We continually try to draw people's attention back to the fact that investing is about providing capital to businesses, whether you are investing in common stock or whether you are searching for yield through ownership of bonds, preferreds, or other income securities."

In light of the tremendous importance of seeing yourself as an investor in the role of one who is providing capital to businesses, the above video conversation between three venture capitalists and an "angel investor" contains some useful insights from individuals whose entire work and livelihood centers around the concept of providing capital to businesses.

A venture capitalist provides capital to entrepreneurs or "start-up" companies, typically in exchange for a share in the business. If they provide a million dollars to a start-up, at an agreed-upon valuation for that company of ten million, then they would expect to receive a share of 10% of that company. If that company becomes more and more successful and is later acquired by another company for a hundred million dollars, or sold to the public through an IPO for five hundred million dollars, for example, then the ten percent ownership of the capitalist investor would be worth ten million dollars or fifty million dollars, a tenfold or a fiftyfold increase in this scenario.

An angel investor does the same thing, although usually acting alone using his own personal money, as opposed to the venture capitalist who typically works at a venture capital firm and uses capital pooled together from wealthy investors looking for exponential returns.

An environment in which there are structures and institutions for channeling capital towards entrepreneurial activity is critical for long-term economic success in any country. As McGill University economics professor Reuven Brenner points out in his insightful work The Force of Finance, "countries prosper when better matches are made between capital and talent. And the corollary is also true: they become poorer and fall behind when the two are mismatched, and the mismatches persist" (10).

In America, one of the most dynamic intersections between talent and capital takes place in California's Silicon Valley. There, institutions such as the start-up culture, the venture capital culture, the angel investing culture, the entrepreneurially-focused Stanford Business School, and discussion forums such as the Churchill Club where venture capitalists and entrepreneurs and other members of the community can discuss entrepreneurial topics have created an environment that has made it one of the most fertile entrepreneurial regions in the world's history.

In the above Churchill Club dinner event from March 16 of this year, venture capitalist Jeff Yang of Redpoint Ventures, venture capitalist Matt Murphy of Kleiner Perkins Caufield & Byers, angel investor Reid Hoffman (founding CEO of Linked-In), and venture capitalist Jay Hoag of Technology Crossover Ventures discuss "Trends and Strategies 2009."

The entire clip is over an hour and a half long, but Reid Hoffman makes a very important point for all investors at about fifteen minutes and twelve seconds into the video (slide the progress bar to 0:15:12).

He says: "I think one of the things that's always interesting in these conversations is: We're actually all in the business of -- and differentially -- but all in the business of longer time-frames. So, you know, one of the things that I was mulling about with a few early-stage venture guys about a year ago was that my average number of years to liquidity as an angel investor is about seven, right? That's seven years out in the future from where you are now. And so, overly predicting based on what the market is this year for what's going to be going on in seven years strikes me as something of a fool's game. [. . .] I actually think that the current market has very little to do with what you're planning on other than intermediate rounds of capital, and questions of appropriate valuation."

This strikes us as a very important point at this juncture in time, when investors are still reeling from a bear market plunge unlike any in the past sixty years, and at a time when brokerage firms and other members of the financial industry are cranking up their advertising with offers of investment strategies calculated to sound soothing and attractive to people in a state of maximum fear and confusion.

Instead of rushing into guaranteed products, or "diversifying" into commodities (which, incredibly, some advertisements are offering as a wise "non-correlated asset," less than a year after the commodities index plunged 47% in nine months), investors would be wise to consider themselves as being in the business of making "better matches between capital and talent," in the words of Professor Brenner.

They would also be wise to consider, in the words of Reid Hoffman, their "number of years to liquidity" -- how long they are allocating capital to those businesses -- and if the number is less than seven, they may want to reconsider their time horizons (for more on that topic, see the Taylor Frigon commentary, "What Hasty Investors Could Learn from an Ent").

We would strongly agree with Mr. Hoffman that "overly predicting based on what the market is this year for what's going to be going on in seven years" is something of a fool's game. Instead, investors should adopt more of the mindset of a benevolent capitalist, searching for innovation and maintaining a flint-like business focus. Doing so is the best prescription for investors going forward.

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Friday, April 3, 2009

Government interference, unintended consequences, and Wall Street bonuses
















World leaders are now gnashing their teeth over bank bonuses, and discussing ways of getting involved in dictating compensation at banks and other firms.

This story, which aired on NPR yesterday, seems to think that would be a good idea.

Making a parallel with professional basketball and players whose compensation may be tied to their individual scoring statistics, the announcer declares, "A selfish basketball player can cost his team a shot at the playoffs; but bankers who play for themselves can put the whole economy at risk."

The outrage centers over the heavy use of enormous bonuses in the compensation of those who work at banks, particularly at Wall Street investment banks. As one member of the Institute of International Finance said on the NPR broadcast, "Banks' profits were illusory, but the bonuses were real."

At yesterday's G20 confab, President Obama said he wanted to use the government to change compensation structures "so that executives are compensated for sound risk management and rewarded for growth measured over years, not just days or weeks."

Far be it from us to defend Wall Street bonuses: we have written before in criticism of the short-term mentality at Wall Street firms which allowed the pursuit of short-term profits (and the short-term cash bonuses associated with short-term profits) to sacrifice the long-term good of their shareholders. Our opinion is firmly with those who believe that Wall Street ruined itself and caused significant collateral damage with its profligate bonuses.

However, with all this high-level criticism of these bonuses among politicians and the media, a very important fact is being deliberately ignored -- the role that government interference played in creating this infamous bonus structure in the first place.

This insightful article published in Forbes on February 04 of this year explains how 1990s agitation against large salaries for executives led to severe limits on how much executive salary could be deducted for tax purposes.

Normally, a company pays taxes on what it earns -- after it pays its employees and other expenses. But IRS revenue code rule 162(m) said that publicly-traded companies could only deduct $1 million of the salary paid to each of the top five executives at the firm. If a firm payed the CEO $2 million in annual salary, then it would be taxed on the second million dollars as if those dollars had gone through to the bottom line instead of payed out as a cost of doing business.

Note that this interference is analogous to the government telling you how much you are allowed to spend on your children's birthday presents. It is really outside of the boundaries of government to be dictating what citizens do with money that they earned in the private sector.

Additionally, unlike birthday presents that private citizens choose to buy for their children, salaries that businesses pay to their executives are not given in order to be generous: they are given in order to obtain the kind of talent they feel is necessary in order to obtain profits in the extremely competitive and complicated corporate world, where other firms are actively trying to put their competitors out of business.

As Professor Emeritus of Economics for Pepperdine University George Reisman has noted, if you needed brain surgery someday, you would want your surgeon to be the best one that money could buy. From the perspective of a corporation, including a Wall Street firm, their executive is as critical as a brain surgeon. The success or failure of their business in the competitive arena has a huge impact on their lives and the lives of every single employee and shareholder at those firms.

Predictably, the attempt to tell companies how much they could pay did not actually lead to a freezing of executive salaries, as the Forbes story explains, but rather to an increase in the use of other forms of compensation for critical executives, including stock option grants and the now-infamous bonuses.

In other words, the social engineering intended by the legislators only led to consequences that they did not foresee. As the article explains, the increase in stock option use may also have led to a general decrease in dividends by companies that use stock options as compensation -- yet another unintended consequence lost on the legislators who enacted the limits in the first place. Additionally, as the NPR radio program correctly points out (and as we pointed out last year), the use of cash bonuses may also have played a role in creating incentives for short-term behavior that was detrimental to the long-term health of those firms.

It is extremely important that people understand the role that government meddling (in areas of private economic activity in which it had no business meddling) played in creating these unintended consequences.

The news media is completely ignoring this enormous story. Similarly, politicians are not rushing to the microphones to admit the blame that their own political legislation played in creating the bonus structure that has infuriated people around the world.

Because this link is not understood, we now face the prospect of even more government interference, which is what caused the problem in the first place! As we have written before, "economic ignorance hurts."

For later posts related to this same subject, see also:

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