Don't squash innovation

We've been sounding a note of optimism recently, to remind investors that although government intrusion into business produces negative results, we still believe that the best investment plan is to search for ways to match investment capital with innovative and well-run businesses.

However, as we have said many times before, government actions do have an impact on the risk vs. reward decisions investors make when considering an investment (see for example the discussion in this post from over two years ago, particularly the eighth paragraph in that post which discusses a venture capital investor as an example).

Two weeks ago, Senator Christopher Dodd of Connecticut unveiled a bill entitled the "Restoring American Financial Stability Act of 2010."

While the purpose of the bill is heralded by proponents as "ending 'too big to fail'" and "ending bailouts," thoughtful observers point out that the bill contains language which would change the laws regarding individuals and investment funds that invest in entrepreneurial start-up companies. For details, see the excellent discussion by Scott Edward Walker in Venture Beat's "Ask the Attorney" column, entitled "Will Senator Dodd's new bill destroy angel investing?"

We have previously noted the importance of angel and venture investing, and have recommended that investors might benefit by thinking more like an angel/venture investor whenever they invest capital in any company, whether it is a start-up or a major public firm (see for example this post).

Interfering with the ability to match capital with innovation at this most critical and vulnerable stage in the economic recovery is a grave error, and one that would throw salt over the fertile fields of entrepreneurial innovation that have given rise to so many innovative American companies.

Of course, cutting off capital from those who are trying to create companies that can do things better, cheaper, or both better and cheaper than existing companies will help existing companies survive longer and make more money, but in the long run this aid to the incumbents will come at enormous cost.

Lawmakers should understand that these kinds of measures are very harmful to those they represent -- and that they have a wider negative impact on the rest of the world, which depends heavily on American innovation in many industries, from software engineering to medicine.

Hat tip to Steve Waite and Kris Tuttle of Research 2.0 for pointing out this problematic legislative development to us.

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The often-underestimated strength of the free enterprise system

Over the weekend, two important articles appeared on the opinion page of the Wall Street Journal.

The first, by the editors of the opinion section, noted the accounting write-downs which public firms are making to their earnings based on their estimates of the costs of the newly-passed healthcare legislation.

That the additional government taxation and regulation will carry a business cost comes as no surprise, and many pundits are reacting to the new law as the sign of the inevitable close of the American free-enterprise system.

However, the second noteworthy piece, an interview of Nobel laureate economist Gary Becker by Hoover Institution fellow Peter Robinson, sounds a note of optimism. Entitled "'Basically an optimist' -- still," the interview is well worth reading.

Professor Becker, a longtime economist of the Chicago School and colleague of Milton Friedman (whose own note of optimism from the depths of the 1970s we pointed out to readers of this blog last week), argues that the amazing power and resilience of the free enterprise system is repeatedly underestimated because people "have a hard time seeing how this pursuit of profits can lift the general standard of living. The idea is too counterintuitive."

We share Professor Becker's belief in the often-underestimated strength of the American free enterprise system. Even in periods in which government interference has increased, innovative men and women have found ways to create new value and solve the world's problems.

This belief in the strength of the free enterprise system (which other countries are also adopting, as Mr. Becker points out in his interview) is fundamental to the growth stock philosophy of investing that we articulate in this blog. This does not mean that we think investors can put money into whatever companies they want and "everything will be all right" -- far from it.

However, it does mean that we still believe there are opportunities for well-run companies to add value, and that investors should not underestimate the long-term resilience that the free enterprise system has shown, including through decades with challenges every bit as serious as those that concern investors today.

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For later posts on the same topic, see here:

• "Glenn Beck is an economic butterbar" 11/04/2010.

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Time For Another Dose of Milton Friedman

Almost exactly a year ago, we published a blog post entitled "Don't despair," which is a remarkably relevant post for investors to read again in its entirety today.

In it, we linked to an interview with Milt Friedman from December, 1975 in which he discusses the increasing government interference in personal life which took place during that decade, as well as two important notes of optimism which Dr. Friedman struck during the interview.

We concluded our post from last March with our observation that, "Government intrusion may be on the rise, but we believe as Milton Friedman did in 1975 that there are important elements in the American economy and the American character that will prevent government from growing to the point that it destroys the entire system."

We would advise investors to continue looking for innovative, well-run businesses for the investment of their capital, just as we have argued before is the best formula for long-term wealth preservation and wealth creation. We have discussed this advice in greater detail in another post from a year ago which is worth revisiting as well, "Return of the 1970s, part 2."

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For later posts on the same topic, see here:

• "Glenn Beck is an economic butterbar" 11/04/2010.

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Great minds think alike!

We would urge our readers to check out Andy Kessler's March 10th piece published in the Wall Street Journal entitled, "Lessons of a Dow decade."

In it, he points out the historic connections between massive capital misallocation -- from the infamous "South Sea Bubble" of the early 18th century to the dot-com bubble of ten years ago and the financial implosion of 2008-2009.

Contrary to the popular narrative that unrestrained capitalism causes such excesses, Mr. Kessler correctly declares: "Misallocation of capital is everywhere and anywhere a fallout of bad government policy." He then calls for a return to investments that create real productivity improvements and new capabilities that don't exist now.

We couldn't agree more. In fact, we have made the exact same case several times. Previously published posts that Mr. Kessler's assertions in this article reinforce include:

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

• "Managing investments in the new era" 02/18/2009.

• "Wise words from Reid Hoffman" 04/07/2009.

• "The hard-money real-estate sinkhole" 09/17/2009.
  

It's good to see reinforcement of these convictions from a source we respect as much as Andy Kessler. We guess this is a case in which we can say with a smile, "Great minds think alike!"

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The financial services timeline, 1977 to present, and what it means to you

As we survey the past three decades or so from an investor's perspective, it occurs to us that the Baby Boom generation has had to endure one financial innovation after another. It also occurs to us that their patience must be starting to wear thin.

As the chart below illustrates, the peak year for births in the United States during the Baby Boom was in 1957, when there were 4.3 million babies born (this figure would be finally topped in 2007, when 4.32 million babies were born, although to a population that was much larger and hence the rate of births per 1,000 women was much lower, as illustrated by the second line in the chart).

























As members of that population entered their peak earning years, the financial industry began a series of major innovations and transformations, ostensibly improvements to previous ways of investing, but which we believe were of dubious value at best.

Prior to the arrival of the 1970s, investment in stocks and bonds was seen as the exclusive province of the ultra-wealthy, as we illustrated using the popular TV series Gilligan's Island in "Invest Like Mr. Howell" (May 18, 2009). The vast majority of investments were directly into individual stocks and bonds. Brokers still called themselves "brokers" -- the terms "financial advisor" or "financial consultant" would come later.

Towards the end of the 1970s, however, some significant rumblings of change began to take place. Brokerage firms began introducing accounts which could hold stocks but also sweep idle cash into money market mutual funds -- a seemingly small innovation but one which heralded the future blurring of the lines between brokerage firms and banks (and later, insurance companies as well).

This innovation, which quickly spread throughout the financial services industry, pointed towards the shift that would see the traditional concept of the "broker" fade away, to be replaced by a new concept, that of the "financial consultant" or "financial advisor."

As depicted in the chart at the top, this transformation was accompanied by the introduction of major new product categories, from the limited partnership craze of the late 1970s and early 1980s, to the exponential growth in mutual fund assets, followed by the idea of the "fee-only account" or the "wrap account" (in which clients would pay an annual fee rather than individual trading commissions), and finally to the rapid introduction of a host of new investment products that took off in the late 1990s and especially 2000s, from ETFs to "alternative investments" of every variety.

For the most part, investors have gone along with each of these foundational shifts they have been asked to make in the way they invest their money (the steep growth in total assets in each new category of investment vehicle attests to that).

However, there are signs that the financial panic of 2008-2009 -- during which many who were counseled to commit capital to exotic international funds, foreign exchange bets, commodity tracking vehicles, and other "alternative" strategies saw their asset values drop even more precipitously than the broad US market indexes -- was the "last straw" for many who had been going from one innovation to another for the past years and decades. We have previously pointed to articles indicating that investors -- and their "financial advisors" or "consultants" -- realize that something was seriously wrong (see here and here).

We have often stated our strong conviction that the most important ingredient for long-term investment success is consistent adherence to the same investment philosophy for many decades. The modern history of the financial services industry described above has, unfortunately, worked against such consistency for a large number of investors.

The moral of this story is that, in the aftermath of the recent meltdown, investors who are approached with yet another "new way" that will "be better than the old way" should ask how long this new way has been in effect, and how long it will be before it is discarded for yet another idea.

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