"The regulatory monkey on our back"

We strongly believe that entrepreneurial activity is the critical engine that drives healthy economies and that has distinguished the economic prosperity that America has enjoyed during all of its most vital economic periods.

Kudos, therefore, to independent journalist Sarah Lacy for her interview from last Friday in which she uncovers an important aspect of the current entrepreneurial landscape.

The important part of this video is at the very end (beginning at minute 4:13 in the clip), when venture capitalist Pascal Levensohn begins discussing the flip side of the issue that is discussed for the first four minutes of the interview.

At first, the discussion is about the discipline the current economic landscape is imposing and has been imposing on entrepreneurs and those who provide capital to them.

But then Mr. Levensohn introduces a very important point: the discipline side is good, but the increased regulatory burden imposed by the government has serious negative repercussions.

"The fact is," he says, "it costs three times more to take a company public now than it did" (5:42).

The actual dollar costs of the increased regulation (which mandate additional work from attorney firms and accountants, for instance) mean that the payoff formula for funding a start-up company is dramatically different -- so different that some companies will not get funded based on projected revenues.

Companies that it may have made sense to fund before the regulation enacted in the past seven years may never get funding today. The "regulatory monkey on our backs now" (to use the phrase Levensohn employs) thus means that an entrepreneur does not build a company into a successful business that adds value to customers and to the economy. It means that employees do not get hired who would have gotten hired. And it ultimately means, as Levensohn correctly points out, that capital goes other places (such as overseas) in order to find opportunities for funding business formation in a less onerous regulatory environment.

Very revealing.

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Beautiful Growth Companies

We have written before about the fact that the investment management philosophy we have followed for over fifteen years is directly descended from that practiced by the late Mr. Thomas Rowe Price, Jr. (pictured) and the late Mr. Richard C. Taylor.

A hallmark of this approach is the emphasis, in the words of Mr. Price, on directing the attention of the investor towards "the simplicity and soundness of the growth stock theory and away from the belief of most people that you have to play the stock market in order to be successful."

This week, as Wall Street attention and speculation focuses on the upcoming Fed meeting and various ways to "play" the dollar's continuing decline, or the eventual tightening that the Fed's current easing will necessitate, we would point to the simplicity and soundness of reacting to the current "crisis of the day" the same way that Mr. Price and Mr. Taylor weathered the crises of previous decades: by trusting in the ownership of growing businesses.

In his 1973 essay entitled "A Successful Investment Philosophy based on the Growth Stock Theory of Investing," to which we have also referred in the past, Mr. Price outlined the fundamental characteristics of a growth company which he had settled upon after over fifty years' experience in the fields of money management, investment counsel, investment banking, and brokerage.

"While no mathematical formula alone can be relied upon to aid in identifying growth companies," he cautioned, "certain fundamental statistical guidelines" that an investor must consider include:

1. A return on invested capital of 10% or better, and continued increase in capital from retained earnings.

2. Above average profit margin for the industry in question, and a favorable trend of improving the profit margins.

and

3. Compound annual earnings growth of better than 7%.

Although the names and the businesses have changed, there are still growth companies that meet these and the other criteria that Mr. Taylor and Mr. Price looked for in a previous era.

For instance, medical waste treatment company Stericycle* (SRCL), which last week reported its ninth consecutive quarter of double-digit organic earnings growth, measures nicely against the three statistical guidelines Rowe Price set forth above. ROIC is over 11% in the most recent quarter and for all the previous quarters in 2007. Margins are well above industry average, and management indicated that their ability to increase margins by 20 to 40 basis points sequentially "on the steady state" remains intact.

By these measurements, as well as other considerations about the business it runs that are less statistical but by no means less important, this company is a beautiful growth company!

There are plenty of uncertainties on the horizon today, as during any period of investing, not the least of which is the return of ugly inflationary signals (which we've also discussed before). But we firmly believe that the best way to weather these situations is to tie a portion of your investments to the kind of good businesses represented by the company described above, and others that resemble the businesses that classic growth pioneers Rowe Price and Dick Taylor sought for their own portfolios.

*The Principals of Taylor Frigon Capital Management own shares of Stericycle (SRCL).

for later blog posts dealing with this same subject, see also:

• "Beautiful growth companies, part II" 07/25/2008.

• "Drawbacks of sector rotation" 08/13/2008.

• "Ownership of businesses through multiple economic cycles" 09/04/2008.

• "The business of America is business" 10/16/2008.

• "Lessons from volatility, October 2008" 10/29/2008.

• "Stock market guessing" 12/01/2008.

• "Beautiful Growth Companies, part III" 05/14/2009.

• "The importance of a proper sell discipline" 05/27/2009.

• "Would you sell your successful local restaurant because of a debt hiccup in Dubai?" 11/30/2009.

• "Have you heard of this company? IIVI" 08/05/2010.

• "Have you heard of this company? CHRW" 09/21/2010.

• "Have you heard of this company? EZCH" 12/09/2010.

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The current investment climate

We recently published "The Investment Climate, April 2008" in the commentary section of the main Taylor Frigon Capital Management website.

Not long ago, we wrote a blog post which described the over-allocation of capital to real estate and mortgage-based areas, much of which was a reaction to the severe market correction of 2000 to 2002. Fueled by the Fed's excessively long period of low interest rates (which were also a reaction to the severe market correction of 2000 to 2002), investors from large to small acted as though the very real progress in technology for the sharing of data over the internet (including over mobile networks) had been a giant dead-end, and therefore the progress in that direction was put on "pause" for a few years while real-estate and related asset-backed securities got all the capital.

There are many indications that the "pause" button has been released, and that numerous new applications of the expanding ability to share all kinds of data (including video data) are taking off for businesses and consumers.

for later blog posts dealing with this same subject, see also:

• "The current investment climate, July 2008" 07/10/2008.
  

• "Don't fear the current recession drumbeat, revisited" 07/18/2008.
  

• "The long shadow of the Y2K bug" 08/22/2008.
  

• "It's a panic, not a Great Depression" 01/21/2009.

• "Managing Investments in the New Era" 02/18/2009.
  

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Brian Wesbury's Excellent Congressional Testimony

Brian Wesbury is a respected economist whose analysis we have learned to value highly over the years.

On April 9th, he delivered testimony before the House Committee on Financial Services that gives one of the clearest perspectives on the current economic situation you will find anywhere. Click here to read the entire transcript of Brian's testimony.

In it, he explains how things got to where they are (hint: misguided government policy was a primary culprit, as we touched on in this previous post and this previous post), outlines the reasons for the Fed's reaction and likely outcomes (which we have also touched on in previous posts, such as this one), and demonstrates why comparisons to Herbert Hoover and the Great Depression should emphasize (although they rarely do) that Hoover's turning to protectionism and higher taxes made what could have been a mild recession into a major calamity. This last point is very important, because there are growing rumblings today from many lawmakers for both higher taxes and greater protectionism, as we have noted with some concern in previous posts such as this one and this one.

If you want greater situational awareness of the economic scene, you would do well to consider Brian Wesbury's excellent Congressional testimony. Let's hope those in Washington who have a hand in steering the ship are paying attention.

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Complaining about hedge fund managers and their paychecks

Yesterday, the New York Times ran a much-remarked-upon story entitled "Wall Street Winners Get Billion-Dollar Paydays" in which they suggested, by their tone and choice of quotations, that income inequality poses a hidden danger to the economy.

To come up with their story, the Times used an article in a magazine called Institutional Investor's Alpha which estimated hedge-fund managers' paychecks for 2007 by looking at the reported performance of those funds and their stated fee structure and calculating what the Alpha article called "earnings" and the Times story called "the manager's pay."

Whether or not that translates directly to the managers' actual pay for the year, the real question is -- what is the problem?

Plenty, according to the Times and the sources they quote in the story. The story's author notes that, while the top 25 hedge fund managers all made $360 million or more in 2007, "the median American family, by contrast, earned $60,500 last year."

This inequality of income must be a harbinger of disaster, according to the Times. "Since 1913, the United States witnessed only one other year of such unequal wealth distribution — 1928, the year before the stock market crashed," the article says, citing research by a senior fellow at the Economic Policy Institute in Washington (a lobbying group of academics that bills itself as "a nonprofit, non-partisan" think tank but whose articles generally advocate against free-market policies). "Such income inequality is likely to impede economic recovery," the Times quotes the same source as saying.

The Times also quotes famous bond manager Bill Gross, who says that the widening income divide (widening because of the high pay of hedge fund managers) is a cause for worry:

"Like at the end of the Gilded Age and the Roaring Twenties, we are going the other way," Mr. Gross said. "We are clearly in a period of excess, and we have to swing back to the middle or the center cannot hold."

Why "the center cannot hold" is a mystery (it is also, of course, a literary reference to a line from W. H. Auden's poem "The Second Coming," published in 1920 and therefore written during the period that Auden was "a left-wing political poet and prophet"). Why does the ability of any American to make a paycheck of whatever size threaten the prosperity of anyone else?

The anger certain elements feel about the paychecks of others stems from either envy or (if we want to put a more charitable interpretation on it) the persistence of the erroneous zero-sum mentality, which we have discussed in earlier posts such as this one.

A perfect illustration yesterday of zero-sum thinking was radio talk show host Michael Savage, railing about the hedge fund managers' pay and citing the Times article, who said that it was obvious that three billion dollars didn't materialize out of thin air, and that for hedge funds to make that money, someone else had to lose it!

Those hedge fund managers did not coerce anybody to invest in their funds, and they publicized their fees to investors before they invested, so participation was absolutely voluntary. Investors voluntarily weighed the potential value that those hedge fund managers could bring versus the cost of participating in those funds, and those who felt that the value was justified invested and those who did not used their money elsewhere.

The manager with the pay cited prominently in the Times article and by commentators on the article, whose calculated revenues were $3.7 billion, achieved that number by making investment returns in 2007 of 590% and 353% on funds that he managed.

Clearly, such investment returns are considered valuable to some investors, who willingly pay those who can achieve such returns for them. Also obvious is the fact that, if you can return 590% on a sum in the millions or the billions of dollars, you can add more value than if you earn 590% on a smaller amount, such as on one dollar. Generally, when people earn a lot of money in a free society, it is because they add a lot of value in a way that others are willing to pay for (in other words, in a way that others will trade some of the value that they added by their work somewhere else). Of course, this argument concerns earnings that were not achieved through coercion or through fraudulent deception (for example, if the hedge funds held a gun to investors' heads and ordered them to invest with them, or if they said that their fees were going to be one thing and then they deceptively charged something else, but nobody is arguing that this is what happened).

The ability to make money by adding value wherever you most see fit to do so is the mark of a free economy. Not only is it not a threat, but it is vitally necessary. People like Bill Gross who say that rising pay on the upper end means that "the center will not hold" are mistaken: it is when governments come in and remove the ability of citizens to make more by adding more value that things fall apart.

If governments regulate against income inequality, it actually leads in extreme cases to forced labor. If pay were mandated to be equal for all work, and someone who ran a hedge fund or did brain surgery or jumped out of airplanes in the middle of the night into combat situations was mandated to have the same pay as someone who splits peas for a living, then there would be no incentive for searching out ways of adding more value. It would be necessary for the government to force people to do more dangerous, difficult, or unpleasant work, because there would be no reason to sign up for the added risk or difficulty. In fact, this is just what happened in communist countries such as China during the twentieth century.

The zero-sum mentality that is behind all the agitation against the paychecks of hedge fund managers, CEOs, or partners at investment banks is fallacious and ultimately dangerous to freedom.

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