Burgess COMMENTARY

Peter Burgess

Reinventing Our Economy: Part III — Long-term Focus on Value CreationOctober 25, 2013 Ownership is an important value, but it’s clear that ownership doesn’t guarantee a properly functioning economy. Many people have equity through mortgages and stocks, but these markets are subject to a high level of speculation. We need another core value: long-term focus on value creation. This is perhaps easier to understand when we consider its opposite: short-term focus on wealth extraction, which is basically the definition of speculation. It’s easy to lambast Wall Street as the culprit of all speculative investing. But Wall Street has simply perfected a technique that our broader society has come to accept. bull The speculative mentality can be found in many places. One obvious example is the mortgage industry. We can easily blame bankers for the financial meltdown, but home buyers are equally guilty. Everyone was operating under the speculative assumption that home prices always go up. Conventional wisdom says, “Let your money work for you.” It seems like the responsible thing to do, right? Be frugal, save money, and set up an investment fund? Many people invest in stocks through their 401(k)s, but how many people actually know what companies they have invested in? Most people don’t really care what companies they’ve invested in. They just want the value of their investments to go up. Publicly-traded corporations feel this pressure every day. Corporations are criticized for their lack of sensitivity toward social values and environmental concerns. But perhaps we should also put the blame on shareholders who are completely disconnected from the day-to-day workings of the business. What is Speculation? At the heart of the speculation problem is a flaw in our perception of what investment means: We purchase the investment. The value of the investment goes up. We sell the investment for a profit. If this is the process, it’s easy to see that the goal is to (1) maximize the price change and (2) shorten the time between buying and selling. This is exactly what Wall Street strives to do. Marjorie Kelly, in her book Owning Our Future, describes how the need for speed took hold on Wall Street: The phenomenon of high-frequency trading was taking shape, at speeds that made the blink of an eye seem slow. Velocity leaped far beyond the capability of any auctioneer’s human utterance, coming to be measured in thousandths of a second (milliseconds), even millionths of a second (microseconds). The metamorphosis occurred because traders developed ingenious new strategies for financial alchemy. One was latency arbitrage, vacuuming up the tiny price differences that occurred in the infinitesimally small time lags between the sending of an order from one trading platform and its arrival at another. Again, we shouldn’t blame Wall Street exclusively because they are simply acting on assumptions that are widely held. The problem is the idea that we should use money to make money. Restoring Dividends What is money? Money represents a claim on other people’s time and effort. The work that people do is the real value. Money is only a claim on that value. So when we use money to make money, we are trying to extract value out of the system and increase our claim on others’ effort without contributing anything. It’s theft. Contrast this with the concept of inheritance described in the previous section. The farmer knows that his land has the capability of producing a return year after year. If he takes care of the property and rotates the crops, etc., the returns will continue for an indefinite length of time. So if he owns the land, why would he ever want to sell? If circumstances permit, he will hold on to this property for his entire life and pass it on to his children. At one time, the value of a stock was a function of the company’s expected dividends. Dividends are the regular distributions of profits to shareholders. They are the industrial equivalent of the annual harvest that a plot of land produces. Today, dividends are rarely mentioned. Dividend yield has fallen out of favor, and emphasis on price appreciation has taken its place. This has reached the point where price appreciation is practically the only form of investment return that really matters. To reinvent our economy, we need to restore the importance of dividends. We also need to encourage people to hold on to investments longer. Clayton Christensen has an interesting idea related to tax rates on capital gains: We should instead make capital gains regressive over time, based upon how long the capital is invested in a company. Taxes on short-term investments should continue to be taxed at personal income rates. But the rate should be reduced the longer the investment is held — so that, for example, tax rates on investments held for five years might be zero — and rates on investments held for eight years might be negative. The Problem with Growth Price appreciation is a reflection of company growth. So, if we start with capital in the form of assets and produce a return, we may actually end up with a surplus. That surplus can be used to invest in additional capital. This is a good thing. But how fast should companies grow? A slow, organic growth rate provides for increased output as the population grows, and it allows us to live a more comfortable life. The Slow Money movement is dedicated to this idea of slow growth. Problems happen when growth becomes the goal. Today, startups are encouraged to have an exit strategy. That’s because the initial angel investors and venture capitalists don’t intend to hold on to their investments forever; they want to cash out after a few years. They can only cash out if the company is bought out or if it goes public. The investors are gambling. They know that most startups fail, so they’re hoping that the successful ones really make it big – to make up for all the failed investments. The pressure to have an exit strategy runs counter to the mission of companies that care about sustainability. That can make it difficult to obtain capital. The experience of one Vermont company is likely a common occurrence: One thing that needed to happen was the infusion of about $800,000 in capital to get on a serious growth trajectory. Attending a forum of angel investors in Vermont, Stearns and Davis quickly realized they were in the wrong place. Every other business presenting at the forum had a PowerPoint slide that was an exit strategy — the sale of the company resulting in big returns for all involved. High Mowing had no exit strategy because Stearns and Davis never wanted to sell. The culture surrounding startups is all about expectations of making it big and getting rich fast. Everyone wants to be the next Bill Gates or Mark Zuckerberg. It’s a glamorous world of cool kids, VCs, and big money. This culture tends to attract young people. For them, the term lifestyle business is practically a pejorative. They place an inordinate emphasis on the technology sector and a premium on fast growth. But this kind of growth is not helping society. It’s pushing us toward a virtual world filled with addictive apps that we don’t need. startup Investor Chamath Palihapitiya says the tech world is at an “absolute minimum in terms of things that are being started.” He says we need to start trying to solve big problems instead of creating trivial web apps. Clayton Christensen has pointed out that the best kinds of innovation, the empowering innovations as he calls them, take longer to develop – five years or more. Instead, we seem to be focused on finding the fast track to IPO. But the very act of going public seems to fuel speculation and overvaluation. Marjorie Kelly points out: . . . publicly traded companies often have higher valuations than privately owned firms. The difference is something that economist Paul Samuelson tried to calculate in the bull market of the 1990s. He estimated that a company was worth about three times the value of its annual gross output if it was privately held and five times the value if it was publicly traded. One of the measures used to sniff out overvalued companies is the price-to-earnings (P/E) ratio. Price refers to a company’s market capitalization based on share price – in other words, what people are willing to pay for the company. Earnings refers to the company’s actual net income. A “normal” P/E ratio, in my opinion, is 10. That means that investors could potentially get their money back through dividends in ten years. When Google went public in 2004, its P/E ratio was 80.5. When Facebook went public in 2012, its P/E ratio was over 90. It’s clear from these high valuations that there is huge expectation for future growth. This speculative demand for future growth is a real obstacle in our quest to reinvent the economy. It forces us to try to create something out of nothing. It allocates resources to all the wrong places. What if people realize that maybe they shouldn’t spend all their time on Facebook? Facebook investors want to recoup their money, so they will push for growth. They will try to make it work, even if it’s not good for society. Debt Fuels Speculation It could be argued that debt is a form of speculation. Debt focuses on future expectations. Interest demands growth. It doesn’t care where the growth comes from, or whether the growth is natural or artificial. Paul Grignon, in his Money as Debt series, argues that all of our money is based on debt. He points out certain mathematical inevitabilities: When the money supply is fixed, usury will eventually lead to defaults. Therefore, debt can only be paid back with more debt. Those who use money to make money (using debt) will eventually gain control of all the assets in the economy. Debt forces us onto the economic treadmill. Once on, it becomes very difficult to escape. Debt causes us to always be seeking for something extra. From Grignon’s second Money As Debt video series: It stands to reason that for each added interest charge in the system as a whole, something extra is demanded of the system as a whole to pay for it. This affects everyone – producers, governments and consumers. For producers, that something extra must be raised through higher prices or more sales. However, competition for more sales usually requires lowering prices, necessitating even more sales and leads to overproduction and saturation of the market. The end result can mean job losses, plant closures and bankruptcies. For governments, that something extra is raised by increasing taxes. But increasing taxes drains money from the productive economy, resulting in a reduction in the collective ability to pay taxes, which then necessitates increased government borrowing and additional interest charges. For consumers, something extra can mean getting an additional job, or borrowing to pay past debts, or paying off debt over longer periods of time. And, of course, borrowing to pay off past debts is like trying to fill a hole with more hole. And that is the situation we find ourselves in today. Uncomfortable Truths It’s clear that getting off the economic treadmill is no easy task. We have to face the facts of our situation. The problem is not just debt. The problem is using money to make money. It’s the disconnect between money and real value. So what do we do? Stop investing? Investing is good, so long as it’s an equity investment in productive assets. But still, if the investor is trying to cash out quickly, then he/she is using money to make money and is therefore accumulating wealth. If we allow this to happen on a widespread basis, that means that those who have capital will eventually get more capital, while those who lack capital will continue to struggle to keep up. This divergence between the haves and the have-nots is the difference that we see between the 1% and the 99%. The only way that we can escape this pattern is to be willing to let go of our surplus. This might be an uncomfortable truth for those who believe that they have earned what they have. We have to put our capital to good use and allow others to share in the ownership of the economy. Instead of letting our money work for us, we should work alongside our money. In my opinion, it’s not productive to complain about the super-rich. Neither is it helpful to force them to pay their fair share. Forced redistribution would stifle our freedom to achieve. Why should we complain, when the majority of us still have an attitude of speculation? Most of us want to be on the other side of the fence. We want to be getting something for nothing. We want the price of our house to go up. We want to make money on the stock market. We want that easy credit. When someone owes us money, how many of us are willing to cancel that debt? We can only escape if we look inward and make the conscious decision to do things differently. It’s not enough for one person to do it alone. In the next section, we’ll discuss how to leave the treadmill as a group. Reinventing Our Economy Series Part I — The Need For Core Values Part II — Alignment Through Ownership Part III — Long-term Focus on Value Creation Part IV — Local Self-reliance Part V — Summing Up Images by herval and Heisenberg Media