Panning for gold during unfriendly business climates

In our previous post, we discussed the "Four Pillars" of tax rates, interest rates, inflation and global freedom, and noted that there are some troubling signs cropping up in all four of those important areas (Global Freedom being perhaps the most positive of the four, with much of the world outside the United States turning towards freer markets and more free enterprise).

No doubt this raises some questions in investors' minds. What should an investor do, if there are potential storm clouds building on the economic horizon?

Does this mean that it's time to head to cash, or gold -- if not immediately, perhaps in the near future? Does it mean that investors should seek out new "alternative" vehicles that are designed to perform well when things turn sour, perhaps investing in "long-short" funds, or "absolute return" funds, or other exotic strategies?

We would answer that during difficult periods -- in which tax rates, inflation, interest rates, or levels of freedom are moving sharply in the wrong direction -- investors should become even more acutely aware of the importance of searching for innovation.

As we have asserted many times before, we believe that investors should always be looking to match their capital with innovation. This is the foundation* during any investment climate. During periods in which tax rates, interest rates, unstable currencies, and government intrusion serve to choke off a lot of potential innovation, the search for tiny nuggets of innovation must become all the more urgent.

A useful analogy might be panning for gold, as depicted in the above photograph from 1916.

During periods in which the climate is conducive to business growth -- in which tax rates are low, inflation is contained, interest rates to borrow capital are not prohibitive, and government restriction of freedom is retreating (all conditions which generally marked the period from the late 1980s through the 1990s) -- innovation and growth may be widespread throughout the business landscape. Investors can experience investment growth with big companies and small companies -- big gold nuggets are literally all over the place, and you have to be careful not to stub your toe on them (many investors may remember feeling that way in the 1990s).

During more restrictive periods, in which the investment climate conspires to restrict innovation, investors must screen for innovation using a much tighter and finer sieve -- similar to the gold miner who sifts through even the smallest pebbles and river silt in search of a few precious flakes.

During these periods, most large companies are not innovating (capital is expensive, due to high interest rates, government regulation and intrusion tangle up their avenues for new business growth, and the reward for marginal innovation success is reduced because the government will tax earnings more heavily). What innovation is to be had will often be found in much smaller companies, companies whose survival and future hinges on overturning the status quo in their market, rather than on preserving it (a very different outlook than the view typical among the larger players in an industry).

We have written before that the 1970s were clearly a period in which the economic landscape was unfriendly to businesses. Examining the Four Pillars of tax rates, interest rates, inflation, and global freedom show that all four were stacked against innovation. In that article, entitled "Return of the 1970s, part 2" we presented historical evidence showing that smaller companies outperformed larger ones during that period by a solid margin.

It is also notable that gloomy periods in which the deck is stacked against innovation often seem to incubate a few highly innovative businesses that completely change their industry and which become real home-runs for investors. Notable examples from the 1970s include Intel in the world of technology, and Wal-Mart in the world of retail**. This phenomenon only serves to underscore what we said above, that during periods when taxes, interest rates, inflation, and government intrusion are against innovation, innovation will likely be far less widespread and the companies where it can be found will be companies whose success is geared towards completely remaking their industry, or forging new ones.

While we believe that the current economic landscape is experiencing the positive effects of a rebound from a financial panic (see for instance the discussion in this previous post), we cannot deny that analysis of the Four Pillars give clear indications that conditions may not be good for widespread innovation and growth over the next few years.

In light of this, we would advise that investors:
  • Avoid the temptation to try to time markets by jumping in and out of cash, which is a very dangerous foundation for investment over long periods of time (see for example the discussion in this previous post and this previous post).
  • Avoid the products the financial industry is churning out to take advantage of the widespread feeling of discomfort, products such as "absolute return" funds or investment vehicles built on short strategies, almost all of which are focused on markets rather than on business fundamentals (we discuss the problem with such a focus here and here and here, among other places).
  • Become even more attuned to the importance of innovation, and to disruptive innovation in particular. We always believe that innovation is the touchstone to an investment discipline built on long-term ownership of growth companies, but during difficult periods the criteria you search for must become even more exacting, because many potential innovations will wither in a climate that is characterized by lower access to capital and greater government restriction and taxation.
  • Look for innovation among smaller companies, and be cautious of investing in larger companies, even larger companies that have previously been fairly innovative. We give some examples of this in our discussions on maintaining a proper sell discipline (see here and here).
These are the kinds of adjustments that we believe investors should understand whenever their close analysis of the indicators we discussed in "The Four Pillars" indicate conditions that may squelch innovation and business growth for a period of time. Rather than give up on looking for growth, they should take up the attitude of the old prospectors panning for gold, and become very focused in their hunt for the precious flakes of innovation, which can be found in almost any decade if you just know how to look.

* Unfortunately, much of the investment industry lost sight of this important truth during the advent of modern portfolio theory, which is why their response to difficult climates is to offer investors even more exotic forms of financial engineering.

** The principals of Taylor Frigon Capital Management do not own securities issued by either Intel (INTC) or Wal-Mart (WMT).

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1 comment:

  1. Well written as usual and thanks for making the case so well. (Of course we agree with you.)

    The S&P is a decent index so I do tell people, particularly individuals with limited capital to use it as a proxy for US stock ownership over mutual funds.

    Simple results are a good argument against it but I'd add that having a portfolio management process that is superior to how the S&P works. That's not hard to do at all. We use more forward looking projections which will identify companies before S&P does and also our own "Intrinsic Value" which gives us better portfolio weightings than the S&P. So there are several ways to prove that one can do better than the S&P.

    Why more investment managers don't do it is a mystery to me.