The end of 2009



















A year ago at this time we wrote a blog post entitled "Taking stock of 2008." It is worth revisiting because the issues we discussed then are still swirling around as pundits from all directions take stock of 2009.

We believe that the events of 2009 have borne out the interpretation we offered back in 2008. Back then we said that the "spectacular implosion of Wall Street" could well have been avoided if the government had removed the mark-to-market rule, which we had discussed all the way back in March of 2008 before the collapse of Bear Stearns.

As we would later see, when Congress finally forced the revision of mark-to-market during the first half of March this year, the recovery was rapid and impressive. It has been so impressive, in fact, that many are now saying that the markets have come "too far, too fast" -- but we would challenge that view by asking "too far from what?" In other words, we would point out that the panic-induced lows of early March, 2009 were an extremely abnormal situation, and it is very much appropriate for prices to rebound rapidly from the ridiculously low levels that they had reached.

Another important point to note is that we stated way back in September of 2008 our concern that, as a result of the financial panic (which could have been avoided, but wasn't), "government will become even more emboldened to interfere with the free-market system, just as they did after 1907." This observation has certainly come to pass.

Throughout 2009, we have published our view that TARP and the other extraordinary measures enacted at the beginning of the crisis should now be dismantled. One of the earlier posts on this subject, still relevant today, was April's "Four-letter government words."

Finally, our post from a year ago ended with this exhortation: "At the end of 2008, our most important piece of advice to investors is exactly the same as it was at the beginning of 2008: entrust your long-term financial well-being to the ownership of well-run businesses that are positioned in front of substantial opportunities for future growth." Those words turned out to be good advice, as the innovative companies we owned for our clients performed very well throughout the year, handily outpacing the broader markets for the second year in a row.

We would offer the exact same advice to investors as 2009 draws to a close.

Happy New Year!

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Issues raised by the indictment of Raj Rajaratnam



















Today the Wall Street Journal ran an article entitled "The Man Who Wired Silicon Valley" full of colorful details from the career of former tech analyst and hedge fund manager Raj Rajaratnam, who has been accused and indicted by the SEC for profiting in the markets from insider information.

The Journal article's accompanying interactive graphic calls Rajaratnam's alleged web of Silicon Valley contacts "a far-reaching and complex scheme," but the story itself for the most part does not detail any actual criminal activity -- mainly it gives glimpses of Rajaratnam's history of aggressively asking for information at companies, along with descriptions of parties where "wealthy investors and executives swirled" around luxurious pools, "smoked cigars and hobnobbed with beautiful women" -- as if these scenes somehow indicate that all the wealth came from illegal or underhanded activity.

The one activity actually detailed in the report that may have been unethical, or even illegal, involved an employee of Intel* faxing prices and orders to Rajaratnam.

Let's be clear: at Taylor Frigon we do not condone trading on "material, non-public information" (which is illegal), nor do we condone the use of deceit or trickery in gaining information. We also do not personally practice an investment strategy based on short-term events such as the quarterly earnings performance that have become such a circus on Wall Street. We have explained many times that our strategy is built around the long-term ownership of good businesses, through many market cycles and short-term events.

However, we also believe that there is a tendency among many -- including some at the federal government -- to think that trying to find out everything you can about a business in which you are going to invest large amounts of capital should somehow be illegal. It may turn out that Mr. Rajaratnam did indeed cross a line between digging for information and doing something that the SEC defines as illegal, but the existence of such a line and where it is drawn are important philosophical questions.

There is a strain of thought which seems to believe that all investors should somehow be "equal" and that those who do no research should have just as much opportunity to make money as those who burn the midnight oil digging into the business details of a company and analyzing its future prospects. This misguided view seems to want to turn investing into nothing more than a roulette wheel, where everyone has an equal chance at winning and nobody has any more intelligence than anyone else.

We believe that this type of thinking is dangerous in that it undermines the important function of allocating capital to the best businesses. Investors should understand this misguided sentiment and be alert for it, and discuss these issues with their friends and families.
* The principals of Taylor Frigon Capital Management do not own securities issued by Intel (INTC).

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Some lessons from 2009



















Over the weekend, the New York Times published an article which brings up a few important points we've made at length and which are worth revisiting as investors consider the lessons of 2009.

The Times article notes that many investors underperform available investment vehicles. We have discussed this phenomenon previously, linking it to the situation we call "The Intermediary Trap."

The article also notes that many investors pulled out of the market and thus missed much of the powerful rebound that began in March. This reinforces the intermediary problem, as many of them pulled out based on the advice of an intermediary. It also raises another important lesson, which is the speed at which market moves take place. The Times article says, "History shows that market rebounds can be so quick that they are easy to miss."

This point cannot be repeated often enough. We ourselves made it in an article entitled "Don't get off the train" which we published on March 2, before the rally began.

Finally, the article ends with a good quotation about patience, tying it to patience with one's investment process. This kind of patience is easily confused with "buy and hold forever" type obstinacy, and this confusion leads investors to make serious mistakes. We discuss the distinction between the two in "Remaining calm without being blind or obstinate," "The importance of a proper sell discipline," and "Seeing beyond a huge false dichotomy," among other places.

The ending point about trusting one's investment process for long-term success is the most important one in that article. It ties all the lessons mentioned above together. The main problem with the intermediary trap is that it makes it almost impossible for investors to maintain a consistent investment process, and leads to a lifetime of jumping from one train to another, so to speak. We discussed this point in 2009 as well, in "The same thought process for 30+ years."

Investors would do well to consider these lessons as 2009 draws to a close.

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We get by in spite

























Over a year ago, we published one of our quarterly commentaries on the investment climate (dated October, 2008) in which we began with one of Richard C. Taylor's favorite phrases: "We get by in spite."

In that commentary, we explained that to Dick Taylor, "We get by in spite" was a kind of short-hand expression which meant that "in spite of the lunacy of government and its intervention in the free enterprise system, great businesses and the entrepreneurs who lead them find ways to profit and ultimately make money for their owners."

He would often use that phrase when government lunacy seemed to reach a fever pitch, and legislators were enacting laws threatening unprecedented intrusion into the right of the individual to be able to do what he wanted with his own private property (and his money).

We believe he would find occasion to use that phrase quite often right now.

The wisdom of his observation, "We get by in spite," is in its recognition that such intrusion and restriction of freedom has taken place in the past, but that great businesses have still found ways to deliver value, economic growth, and better living standards in the past, and that they will do so in the future.

Even now, there are momentous business opportunities for innovative companies. We touched on some of them in our blog post yesterday. This perspective is very important for investors to understand, especially during times when many in the financial world and media are being distracted by the political news of the hour.

Richard C. Taylor managed portfolios alongside Thomas Rowe Price, and his investment philosophy directly influenced the consistent process that the principals of Taylor Frigon Capital Management have employed for many years.

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Unstoppable Wave: Revisited




















Mary Meeker and the rest of her tech research team at Morgan Stanley* recently released a trio of research documents entitled the Mobile Internet Report.

They can be downloaded at the Morgan Stanley link above, and also read online in their entirety at ReadWriteWeb.

Meeker and her team are one of the first major Wall Street firms to delve into the enormous paradigm shift which we have written about in several places earlier, such as last January's post entitled "The Unstoppable Wave."

We would recommend that all investors understand the enormous wave that has already begun to radically transform the technology landscape and which will work its way through just about every other business during the next several years. It promises to be even more transformative than the tidal wave of technological change that hit the world in the 1990s, and may be even more rewarding to investors if they align their capital with the right businesses.

As we noted in the Unstoppable Wave, this is a paradigm shift that refuses to be stymied even by inept government meddling, of which there seems to be plenty these days.

Also, while they are now beginning to pay attention, this impending paradigm shift has been largely overlooked by the traditional investing voices, which have been distracted over the past two years (and, in fact, over the past decade -- see here).

Investors may wish to review some of our previous notes on this topic, such as:


* The principals of Taylor Frigon Capital Management do not own securities issued by Morgan Stanley (MS).

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The 97-pound weakling




















Who isn't familiar with the iconic and long-running ad campaigns for the bodybuilding techniques of Charles Atlas, featuring the "97-pound weakling" being bullied on the beach?

Becoming "fed up" with having sand kicked in his face, the former bag of bones bulks up and returns to the beach to put down the bully, restore order to the beach, and earn the respect and admiration of all the onlookers.

Lately, the US dollar has been playing the role of the "97-pound weakling," having sand kicked in its face daily by just about every other currency on the planet. Just as in the comic strips, this situation is a recipe for disorder and disharmony, and something needs to be done about it.

The problems with the current "bag of bones" dollar are numerous, as economist David Malpass pointed out last week in an excellent guest opinion piece in the Wall Street Journal. Having a disproportionately scrawny dollar floods other regions with capital that would not otherwise flow that way, feeding speculation and asset bubbles, starving more worthy business ventures of capital, and generally encouraging malinvestment that leads to disastrous boom-and-bust patterns and retards real progress that could otherwise take place.

Furthermore, when currencies fluctuate wildly from being strong to being weak, or vice versa, businesses must allocate more and more resources towards hedging currency risk. Businesses today actually staff entire departments devoted to this function, which really adds no economic value whatsoever into the economy. Those people and their talents, and the business resources they use in pursuit of this goal, could be directed towards creating other value, if currencies were stabilized.

While the recognition of these problems might lead some to call for a strong dollar that can dominate all the other currencies (somewhat like the end of the comic strips, in which "Mac" comes back and knocks out the bullies), what investors should really hope for is not necessarily a disproportionately strong dollar but rather a stable dollar.

Some businesses (both foreign and domestic) benefit from a stronger dollar, while others benefit from a weaker dollar. But investors should not be looking for companies (or other investments) that only make money because they receive a handicap one way or another from this or that government policy! Instead of tilting the playing field one way or the other, government policy should aim to provide equilibrium, and let the best business win.

We'd like to see the dollar put on some muscle and stop getting sand kicked in its face, but only so that order is restored to the beach, not in order to reverse the situation that is going on right now and simply create a new bully on the beach.

The lesson for investors is to search for companies that are able to make money by adding value, and not to be led astray by chasing after investments that are primarily successful because of the swings in the relative value of currency.

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What Rube Goldberg could teach us about economics




Rube Goldberg was a San Francisco-born American cartoonist and the genius behind a long-standing series of cartoons illustrating impractical humorous and endlessly-enjoyable contraptions. His name, in fact, became synonymous with "a comically involved, complicated invention, laboriously contrived to perform a simple operation." Some of his inventions can be found at the Rube Goldberg website, as well as elsewhere on the internet.

If someone were to actually build a device modeled on his illustration for automatically snapping a photograph or for automatically wiping one's mouth with a napkin after taking a spoonful of soup, he would put in a lot more effort than he would save with the machine, and what's more would have to constantly monitor the thing in order to replace the popped balloons, frightened dogs, flying birds, spilled cups of molten metal, and other components that would be used up with every iteration!

In spite of the obvious silliness of such machines, many people are under the misconception that the economy (and the business world that drives the economy) resembles some kind of huge Rube Goldberg device, always prone to breaking down unless the government hovers over it to adjust and regulate and repair it at every turn.

In the long-running debate over whether free enterprise and free markets tend to blow up without careful government supervision and restraint, or whether well-intentioned government regulation of free enterprise and free markets tends to lead to unintended consequences and even to economic disasters, many people today have been fooled into believing the first scenario is true.

Put a little differently, the debate is between those who see the economy as an elaborate Rube Goldberg contraption, always in need of tinkering to prevent a huge calamity, and those who see the government as the Rube Goldberg contraption, creating a problem where none really existed and inviting disaster with its well-intentioned, but ill-conceived, solutions.

This very issue is on display this week in the Supreme Court, which is considering a challenge to the accounting oversight board known as the PCAOB, or Public Company Accounting Oversight Board, created by the Sarbanes-Oxley legislation that was signed into law in 2002. Sarbanes-Oxley and the PCAOB built an enormous and unwieldy bureaucratic apparatus where none existed previously, and its supporters argue that without it the entire economic system will no doubt break down. In fact, the problems it creates far outweigh any dubious benefits (just like the humorous devices envisioned by Mr. Goldberg).

In a story discussing the PCAOB that aired yesterday on National Public Radio, the case facing the Supreme Court is framed as another attack on the New Deal legacy of creating unelected government agencies (the "alphabet soup" we blogged about in "Four-letter government words" and about which Milt Friedman once joked: "any three letters chosen at random would probably designate an agency or part of a department that could be profitably abolished").

That NPR segment concludes with a serious-sounding quotation from former SEC Chairman Rod Hills (1975-1977) who declares that the issue may be "a philosophical argument that's kinda fun, but it's too serious." In other words, attacking the constitutionality of these government agencies is dangerous. He states gravely, "What they are really trying to do, after all these years, would do far too much damage to our system," apparently referring to those who would dare to challenge the legitimacy of government bodies such as the PCAOB.

The first response to this argument is to note that it demotes serious constitutional questions to the status of frivolous, esoteric debates for philosophers (akin to the oft-pilloried debate over how many angels can dance on the head of a pin). Such arguments, while "kinda fun," must take a back seat to pragmatism: if we don't do this (never mind if it's constitutional or not), you businessmen will blow yourselves up, and take the rest of us with you!

The second response to this argument is that it is by no means a given that without Sarbanes-Oxley style regulation there would be irreparable "damage to our system." In fact, we would argue that such regulation often leads to disastrous unintended consequences.

Proponents of ever-increasing regulation point to the recent financial panic as proof positive of their position. The authors of the script for the NPR story, for instance, have reporter Nina Totenberg begin her comments the with the line, "sitting here today, as Congress debates what measures are needed to avoid a repeat of the financial institution failures of the last year . . .” -- as if it is obvious to everyone that more legislation from Congress is needed in order to keep the system from blowing up again. Invoking the recent catastrophe is a way of tilting the discussion that follows towards the concluding quotation from Rod Hills.

What is not mentioned, of course, is that it was a misguided attempt to pile up more accounting regulation (and remove flexibility) that helped cause the financial meltdown of 2008 in the first place. New mark-to-market accounting regulations that went into effect at the end of 2007 -- and which were the brainchild of another former SEC Chairman Richard Breeden (1989 - 1993), who argued extensively for such regulation in the early 1990s and whose cause was taken up by later SEC Chairmen -- contributed more to the financial implosion of 2008 than any supposed lack of government regulation.

We are not arguing here that there should be no accounting rules, and that markets should become the "Wild West," where anything goes. We have explained previously, such as in our earlier post entitled "Free enterprise vs. free markets," we acknowledge that markets absolutely require what we called "a series of rules and regulations in order to ensure smooth and orderly operation and the ability of all parties to evaluate and compare different capital investment opportunities, much the same way a game of basketball requires rules to enable the game to take place."

But fraud was already illegal before Sarbanes-Oxley. The idea that more and more regulation will somehow make fraud go away is a fantasy. Penalizing everyone to try to stop a few bad actors has an enormous cost -- and the bad actors typically figure out ways to try to go around the new regulations anyway.

Almost lost in the NPR story is a quotation from frustrated accountant Brad Beckstead, who notes that the onerous and sometimes arbitrary requirements of the Sarbanes-Oxley legislation created a serious obstacle to his clients, who were primarily small, entrepreneurial, start-up companies -- the very agents of the kind of innovation essential to economic health and economic growth!

While some might say this is just the price of safety, as Rod Hills in his quotation above seems to say, it can be argued that government regulation that goes beyond preventing fraud and violence actually can have other unintended consequences that can lead to huge disasters. The mark-to-market rule is one example.

Other well-intentioned government intrusion we have noted as partially culpable in the 2008 disaster include the CRA, the quasi-government entities Fannie Mae and Freddie Mac, and the Federal Reserve in its attempts to steer the economy instead of simply providing a stable currency with which individuals and companies small and large could transact their business.

The view that government must constantly tinker and regulate to prevent the economy from blowing itself up has enjoyed such a long period of acceptance, and is reinforced by so many voices in the media and in the classroom, that many investors are unaware of the arguments we have laid out here for the opposite view.

Implicit in the joke behind every Rube Goldberg cartoon was the clear common-sense understanding that those elaborate contraptions were entirely unnecessary and that left to themselves, people in general have no problem opening doors, wiping their mouth with a napkin, teeing up a golf ball, or sharpening a pencil. When government builds ridiculous contraptions that are totally unnecessary, it shouldn't surprise anyone when they break down. Rube himself in the video clip above acknowledges that "you can't get something for nothing," although the government often seems to try.

The recent financial disaster should actually cause people to reexamine the assumptions that have led to the kind of well-intentioned government regulation that contributed to the crisis.

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The best defense is a good offense!

























Recently, independent investment research firm BCA Research published a weekly bulletin (available by subscription only) with the subject of "Wealth Preservation."

In it, author Chen Zhao noted that he has found from his conversations with ultra-wealthy investors and their advisors that they are often "natural bears."

"As one gentleman put it," the bulletin relates, "their job is to be worried. They need to make sure that the family money is passed on to the next generation, hopefully with an expanded capital base. Many families have lived through wars and social upheaval over the last several decades, and they want to make sure their money is not robbed by people like Madoff, lost in financial crisis or confiscated by governments. Therefore, wealth preservation is always a big topic for this group."

The report notes that these wealthy families and their advisors are often looking for 5% to 6% returns without much volatility.

While this may seem like an "un-ambitious goal," the author correctly notes that it is actually very difficult to find such returns. We ourselves have long held that the decline in overall bond yields during the late 1980s and 1990s (and through the current time) from the double-digit yields that prevailed during the late 1970s and 1980s played a big role in the huge explosion in hedge funds, as investors with the mindset described above looked for someone who could give them the kinds of returns they could no longer obtain with a straightforward bond portfolio. The dismal performance of many of these hedge funds, especially during the recent financial panic, has caused investors to realize that they are often the wrong prescription for the kind of returns wealthy families seek.

We would also note that the desire among wealthy families for this kind of steady return no doubt contributed to the fraudulent practice of the aforementioned Bernie Madoff, who offered just such steady "un-ambitious" returns to his victims. We have discussed some important lessons for investors from the Madoff scandal in previous posts, such as this one.

The report also points out that bonds lately have not presented much of a solution either, with very low yields on governments, and very high volatility on investment-grade corporates. Junk bonds (or "high-yield bonds," as brokers often euphemistically call them) can provide even higher yields than investment-grade bonds but at risk levels that make them unacceptable for the goals articulated wealthy families and their advisors.

We believe this issue is a very important one to consider. We even agree with the general conclusion reached by the author from BCA, when he says: "In the end, the best defense is probably offense. I have found that many of these 'super rich' investors are highly entrepreneurial and extremely industrial. They have been involved in all kinds of very innovative projects and exotic ventures all around the world to extract returns."

However, he then concludes that "asset allocation has to become more imaginative and dynamic to obtain 'excess rent.' The trick to sustaining and preserving wealth is to take risks when the time is right." The remainder of the bulletin discusses whether it is time to shift capital from US equities to global equities, from small cap to large-cap, from dollars and yen to euros or other currencies or gold, from the debt of the US to that of other nations, and so forth.

We would argue that the author's observation about the fact that many wealthy investors are very entrepreneurial is right on -- in fact, we have noted many times before that most of the wealthiest families in America became that way precisely by being entrepreneurial (see for example here, and here, and here).

Given that important observation, however, why would one argue that they should now abandon investment in innovative and entrepreneurial companies and instead entrust their wealth preservation to an attempt to time the market moves of one sector versus another, one currency versus another, one style or capitalization band versus another, and so on? These kinds of guessing games, which we have previously classified under the broad heading of "sector rotation" (under which we could group countless variations and permutations), are more properly understood as speculation. While it may seem that they have superficial similarities, they are actually very different from the kinds of entrepreneurial activity mentioned as being so central to the stories of many successful and wealthy families.

We agree wholeheartedly that in the current environment, the best defense is a good offense, and that to achieve satisfactory returns (even "un-ambitious" returns of 5% or 6% per year), investors must expose themselves to investments that may be seen as more aggressive than the bond portfolios of past generations. We have discussed this very idea in previous posts, such as "Panning for gold in unfriendly business climates" and "Return of the 1970s, part 2," among other places.

However, we would argue that the proper prescription for the "good offense" is to allocate capital to carefully selected, innovative, growing businesses. While this may seem to be just as aggressive as the speculative strategies outlined above, the opposite is more likely true over time, as we have explained before. This "aggressive" capital can be balanced with more conservative strategies, including cash itself (accepting the lower returns it offers as the price of stability).

In spite of this point of disagreement, we believe that Mr. Zhao's discussion of "wealth preservation" and the issues he uncovers -- as well as his insightful comment that "the best defense is probably offense" -- are all incredibly important subjects for investors to consider and to understand.

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Would you sell your successful local restaurant because of a debt hiccup in Dubai?




















The Wall Street Journal reports that "the Dow dropped sharply Friday after Dubai World asked creditors for a six-month stay on repayment of $60 billion in debts" and that "Stocks were lower around midday Monday [today] as mixed Black Friday sales results sparked concerns about consumer spending and unease about Dubai World's debt headaches lingered."

To us, these debt problems of a high-spending, heavily-borrowing Middle Eastern emirate can serve as a helpful illustration for investors.

Imagine that you are the founder and owner of a successful little taqueria in your neighborhood. Perhaps many years ago you moved to California and noticed that there was no place nearby to get a particular kind of burrito or taco that you craved. Sensing a business opportunity, you began a restaurant to provide those special dishes, which became incredibly popular. Your restaurant became a daily lunchtime destination for all the workers in the area, from day-laborers to software developers to local doctors and CPAs.

While it had been difficult to start it up and build its reputation in the beginning, ten or fifteen years down the road the business is a well-oiled machine, providing a steady stream of profits, in good times and bad. Perhaps you receive occasional offers from envious businessmen to buy your restaurant, but you have no desire to sell for many more years, as you are proud and happy of your little taqueria, you view the employees as part of your family, and you have noticed that the profits are increasing every year and believe they can continue to grow for many years to come. You may even have plans to expand to other locations, or you may have already expanded to one or two nearby cities and seen accelerated growth with each new site.

It may seem like a slightly ridiculous question, but do you think -- given the situation described above -- that you would open the newspaper over the past weekend, notice that a far-away emirate in the Persian Gulf was asking for an extension in paying back its debts, and decide that you'd better sell your restaurant immediately and cash in your chips?

Of course not, unless for some reason you had loaned some sum of money to them and believed that you might go out of business if they failed to pay it back. If, as is more likely, your restaurant had had no dealings whatsoever with Dubai, you would probably flip to the sports pages and then head down to your taqueria to have a cup of coffee and see how things were going over there.

The purpose of this illustration is to encourage investors who own shares in businesses that they have carefully selected, businesses with innovative products or services and competent management teams, businesses whose profits are growing and which they believe have good prospects for continued growth, to keep the short-term "crisis of the day" being splashed across the headlines of the various media outlets in perspective.

We have written on this subject many times previously, such as in this important post. While the Dubai problem only concerns about $60 billion of capital (a large amount for that emirate but a small amount in the grand scheme of the global economy) and will probably pass from the headlines fairly soon, we would go as far as to argue that the same lesson can be applied to much larger news events as well.

For example, we have argued that the most recent recession was primarily caused by a financial panic that impacted banking and Wall Street, but that did not derail many innovative firms operating in other industries. Although the crisis may have set them back temporarily, selling out of them because of the panic would have been as foolhardy as the owner of the taqueria described above selling his shop this morning because of the Dubai headlines (or even because his sales hit a slight bump in 2008 and early 2009 as customers dialed back their lunchtime dining-out budgets for a while).

Of course, the difference between owning an innovative and growing local restaurant and owning shares in a publicly-traded innovative and growing company is that it is almost impossible to own the second one outright, and thus investors in publicly-traded companies must put up with the behavior of all the other owners of the company.

Since many of those other shares are held by large institutional investors who think nothing of selling their shares at any hint of an adverse headline, no matter how unrelated to the long-term business prospects of the company in question, investors who take a longer view must be prepared for short-term gyrations based on all kinds of interim events. This is why we feel it is so important that investors understand this issue.

Finally, we would add two caveats. First, investors must be very careful that they own truly innovative, well-run companies. We have written on this subject many times, such as here and here. Second, we would note that we are not saying that owners of any business (taqueria or otherwise) should never consider selling their ownership. We have discussed at some length the subject of selling one's ownership in a business in "The importance of a proper sell discipline," among other places.

However, in general we would advise investors that the next time some "crisis of the day" (or crisis of the week, month or even year) arises, they may want to visit their local taqueria, order a burrito, and carefully consider this important concept.

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Happy Thanksgiving 2009


















We'd like to wish all our readers a warm and happy Thanksgiving.

As we gather with family and give thanks for our blessings, we are mindful that for many around the world, conditions are still as dire as they were for those first ragged settlers who clung to existence after crossing the Atlantic to the New World in the 1620s.

What made such a difference in the annals of this country versus the situation that still prevails in much of the world? Upon reflection, we would submit that much of the answer lies in the word "Freedom."

While Americans are undoubtedly thankful for the freedom we enjoy, it is appropriate to go one step further, and ask where that freedom came from, as the Acton Institute did last year in a film entitled The Birth of Freedom (see clip below).





It also occurs to us that there is a connection between the common Thanksgiving symbol of the cornucopia (or "horn of plenty") and the concept of freedom. The cornucopia is a symbol of abundance -- in fact, it is tied to a mythical horn which produced an inexhaustible abundance of goods.

It strikes us that, as such, the cornucopia is the perfect symbol for the opposite of the "fixed-pie" view of the world. We've written several times before about the "zero-sum" or "fixed-pie" view which believes that there is only so much wealth available in the world, and that therefore any gain by one person must come at the expense of another person. It is not hard to see how such a view of the world can lead to tyranny, or at least the restriction of freedom.

On the other hand, the cornucopia -- unlike the "fixed pie" -- is a symbol of constant increase. Those who understand that, in a free society, the efforts and contributions of some people can actually increase the size of the pie for everyone can actually see that the cornucopia is not just a mythical concept! In fact, the history of America and the blessings we consider on Thanksgiving are proof of that.

While there are always things that could be better, we hope these thoughts will add to your thoughts and conversations around the Thanksgiving table this year.

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What about commodities? (part 3)



















We've written at least two times previously on the topic of commodities (see here and here). When commodities such as gold and other metals begin to skyrocket, gold advertisements begin to flood the radio stations and financial television shows, and investors inevitably begin to ask themselves, "What about commodities?"

Investors are understandably concerned about the precipitous decline of the dollar. We have been cautioning investors for some time that Fed "oversteering" is probably in the works, based on certain economic beliefs held by Chairman Bernanke which, in our opinion, are misguided (see for greater detail the discussions in "Stand still, little lambs, to be shorn" and "A Phillips-curve Fed?" among many other previous posts). When investors are worried about inflation, or the future of the dollar, gold is one of the first thoughts that enter their minds.

However -- and this may be a little bit counter-intuitive -- this is exactly why they should not rush into commodities without a full understanding of the way they work. The fact that the Fed's oversteering is responsible for gold's recent rise should cause investors to realize that it can tumble just as fast when Fed policy inevitably swings back the other direction.

Back in the middle of last year, with crude prices at $135 a barrel, we made the exact same warning (see here). At the time, as it always does when prices are rising sharply, it felt as though oil prices would never turn around. Of course, they subsequently tumbled below $40 a barrel.

The important point about commodities, which we made in those two previous editions of "What about commodities?" is that they can be quite volatile over time but don't tend to make much progress (see, for example, this chart of sugar prices going back to 1948). Therefore, the only way to make money in them is to attempt to trade the peaks and valleys, hoping to catch them at the right time.

While many believe that the same can be said of owning stocks, in reality owning innovative companies is quite different. Unlike the chart of a commodity that fluctuates back and forth without making real progress, a successful business is creating new value and -- although there will be ups and downs -- the overall trend of such a company tends to be upward over time.

As we've said many times before -- regardless of the economic environment -- owning innovative, growing, well-run businesses is the best foundation for long-term wealth preservation and wealth creation.

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The Dismal Science
















We recently attended a business conference where we heard an economist making extensive predictions about where the economy was headed. Our concern immediately turned to the many attendees who left the conference with a conviction that this particular view of the future was accurate (after all, they just heard it from an economist).

The problem is that most economics as it is taught in the halls of higher learning consists primarily of mathematics. Economists are comfortable plugging data into their models, which may do a fine job of extrapolating current trends into the future, but which are entirely unsuitable for predicting what will actually happen.

This is the exact same "quantitative" quagmire that has overtaken general finance theory. We have written before that no mathematical model can predict the next entrepreneurial development that will create new markets and drive economic activity in a completely different direction. For example, the iPhone has transformed the concept of mobile computing, and developed markets for the adoption of software applications that never existed previously. In turn, this has created wealth where it did not exist before. This radical change was not visible or predictable in an economist's model prior to its actual occurrence.

The problem lies in the misbegotten idea that economists have the wherewithal to truly "forecast" when in fact most are not suited or trained to identify important trends in economic activity when they are about to happen.

We would suggest that economists, in general, should not be a primary factor in the decision-making process of investors because it is at the most crucial inflection points that the economist is unable to identify what innovation will create new markets that drive economic activity beyond any level that his mathematical models suggest are possible.

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Anniversary of the end of the Berlin Wall



The night of November 9, 1989 saw the fall of the Berlin Wall at the hands of the people it had isolated for twenty-eight years.

In the famous speech (available here) that former US President Ronald Reagan gave at the Brandenburg Gate in 1987, he correctly declared that the Wall represented "the question of freedom for all mankind." Its downfall marks an important landmark in the triumph of freedom over political and economic oppression.

As we wrote on the anniversary of the Apollo moon landing, it is important to remember that there was -- and continues to be -- an ideological struggle between those who believe "that the best way to organize society and reach goals is through centralized government planning" and those who believe that the best way is "to enable individuals to make their own choices through free enterprise, the rule of law, and respect for private property." The tearing down of the Berlin Wall, as the Apollo moon landing, shows that the second choice is the right one.

Yet, amazingly, many voices even in countries that have benefited most from the freedom to choose and the ability to own private property do not understand this fact.

The Wall Street Journal yesterday noted that anchorman Dan Rather went on record saying, "Despite what many Americans think, most Soviets do not yearn for capitalism or Western-style democracy." City Journal contributor Daniel Flynn notes that in 1991, the LA Times stated "Ten months after the new Germany merged, women in the eastern sector are coming to the stunning realization that, in many ways, democracy has set them back 40 years." He also notes that in 1992, CBS anchorwoman Connie Chung declared, "In formerly communist Bulgaria, the cost of freedom has been virtual economic disaster."

These voices inevitably point out that capitalism and freedom can seem less secure than central planning, and are often blamed for poverty and inequality. Friedrich Hayek addressed this very issue in his landmark text The Road to Serfdom, first published in 1944. His remarks are appropriate on this historic anniversary. There, he said:

"What our generation has forgotten is that the system of private property is the most important guaranty of freedom, not only for those who own property, but scarcely less for those who do not. It is only because the control of the means of production is divided among many people acting independently that nobody has complete power over us, that we as individuals can decide what to do with ourselves. If all the means of production were vested in a single hand, whether it be nominally that of 'society' as a whole or that of a dictator, whoever exercises this control has complete power over us. Who can seriously doubt that a member of a small racial or religious minority will be freer with no property so long as fellow-members of his community have property and are therefore able to employ him, than he would be if private property were abolished and he became owner of a nominal share in the communal property? Or that the power which a multiple millionaire, who may be my neighbor and perhaps my employer, has over me is very much less than that which the smallest fonctionnaire possesses who wields the power of the state and on whose discretion it depends whether and how I am to be allowed to live or work? And who will deny that a world in which the wealthy are powerful is still a better world than one in which only the already powerful can acquire wealth?"

These truths are important for all members of society to understand. Please share them with your friends on this historic anniversary.

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Voting With Their Wallets!

















While much attention has been focused on the election results in Virginia and New Jersey last night, perhaps the bigger story is the election results announced in Michigan yesterday where Ford Motor Company announced a profit of almost $1 billion.* Ford, the lone of the Big Three Automakers to not accept government bailout money, is demonstrating that a private company, in the midst of a devastating recessionary environment in its industry, can find ways to make money. We suspect they are now making products people want to buy (like the beautiful red retro Mustang pictured), but also that consumers are standing behind the company that decided to "go it alone" and reject the government's offer of assistance.

We believe this is a signal to government that intrusion into the free enterprise system, and the cronyism that can result, is not acceptable to ordinary "car buying" citizens. It occurs to us that the success of Ford may have as much to do with voter/citizen backlash against the heavy hand of government as it does with their managing through a tough economic environment.

And while Ford is looking good right now with its breakout to profitability, storm clouds are hovering. Their counterparts over at the "U.S. Department of Automobiles" (GM and Chrysler, of course) are likely to be given preferential treatment when it comes to labor negotiations. This could spell trouble.

But perhaps Ford will have a trump card, as Economics Professor Dr. Mark Perry pointed out last December in his excellent Carpe Diem blog, Ford has built the most advanced auto production facility in the world...in Brazil! It would be a shame if the unreasonable position of the UAW (now aided by GM and Chrysler's new majority owner!) were to force Ford to abandon operations in the United States. However remote that possibility is, that may be what is in the future given Ford's obvious disadvantage in negotiating with the UAW.

As believers in the free enterprise system, while we would be disappointed to see such an event come to pass, we would support Ford wholeheartedly.



* The Principals of Taylor Frigon Capital Management do not own shares of Ford Motor Company.

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Special report on variable annuities


















We recently published a Taylor Frigon Special Report entitled "The Anatomy of a Modern Variable Annuity (in plain English)" in the commentary section of our website.

In it, we summarize some information about variable annuities and our opinions about these products.

Taylor Frigon Capital Management is a fee-only Registered Investment Advisor and does not sell variable annuities or insurance products of any kind.
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The moral case for free markets




















Today's robust GDP number may have surprised the majority of economists, but it did not surprise us here at Taylor Frigon and it did not surprise economist Brian Wesbury, who was predicting a strong rebound before almost anyone else.

Today, he posted a new installation of his "Wesbury 101" video series, entitled "The Conservatives' Big Mistake." We believe it should be "required viewing" for anyone who wants to understand where the economy is right now, particularly in light of the ongoing level of ill-informed economic commentary coming from all directions in the media.

The video above is also noteworthy for another reason. At about 3:44 into the video, Mr. Wesbury outlines what he calls "The moral case for free markets." It is a concept with an importance that far transcends the day-to-day ups and downs of the markets, or even the periodic recessions and recoveries of the broader economy. It is a concept that was eloquently championed by the late Milton Friedman and his wife, and yet one that seems to find fewer champions today.

In his video, Brian Wesbury says: "The moral case for free markets is very simple. Under a free-market system, where freedom reigns and entrepreneurship is allowed, where innovation and creativity create growth, what people do is they're able to find their own God-given best and most-productive use for their life, and if we don't have that there are lots of people who never fulfill what God in fact put them on earth to fulfill. [. . .] It's not government-directed -- it's individual-directed. It has a spiritual nature, and not just a government-bureaucratic nature."

We couldn't agree more, and we applaud Mr. Wesbury for championing the moral case for free markets and free enterprise at a time when so many seem to have lost that vision.

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Remember all the hype about "toxic assets"?



















Recently, concerns have arisen over the prospect that the government may force banks that received TARP money to raise capital in order to pay their way out.

Doing so would cause the banks to have to issue more shares of common stock, thus diluting the value of the shares currently outstanding, a prospect which yesterday prompted a sharp sell-off in shares of the larger banks.

The irony of this situation, and with the current discussion over the health of the banks, is that nobody seems to be discussing the status of the original "toxic assets" that supposedly necessitated the entire TARP program in the first place.

We have long held the position that the so-called "toxic assets" were really a kind of bogeyman created in large part by the well-intentioned but misguided mark-to-market accounting rules instituted in 2007.

Those accounting regulations caused banks to have to write down the value of assets -- such as mortgage-backed securities -- to whatever the market said they were worth at the time, which during the financial panic was next to nothing. We previously linked to this report from former FDIC Chairman Bill Isaac which gave an illustration from an actual bank which had to write down assets with face value of a billion dollars by a massive loss of $913 million, even though actual losses on the assets were only $1.8 million, with projections of losses of no more than $100 million.

The irony is that now, more than a year later and after the removal of that ill-conceived accounting requirement, those supposedly "toxic assets" have not imploded. In fact, current data would suggest that the main source of bank losses are from straight loans, not from the financially-engineered debt products that (in conjunction with a toxic accounting rule) caused such panic and led to the government forcing banks to accept TARP.

This recent article from Bloomberg shows that the real losses at banks have been from non-current loans that they wrote and kept on their books. As Louisiana State banking professor Joseph Mason says in the article, "While these aren't your giant banks, they are the guys your local strip mall and commercial real estate investors get their funds from." They are local loans that weren't securitized and packaged up into exotic structured products, but the kind of local development loans that have been hung out to dry by the recession.

It is also important to note that, just as in any other business, some banks were less wise in their business practices than others, and are now suffering the consequences. This is yet another reason why we do not advocate investing by "the whole sector" (whatever sector it may be), but rather advise investors to do their due diligence on the individual companies, and commit capital only to individual companies that meet rigorous criteria.

All this is not to say that we take a positive view of the financial engineering that went into the creation of the complicated debt instruments that played a starring role in the devastation of Wall Street in 2008. We have written many times that we take a dim view of the belief that investment risk can be engineered away with complex academic algorithms and theories.

However, the fact that these assets did not contain the level of losses that mark-to-market accounting was forcing firms to value them at raises significant questions. It is entirely possible that these banks never should have been forced to take TARP in the first place, and that the shotgun wedding of B of A and Merrill Lynch (for example) need never have taken place*.

Unfortunately, the repercussions of the over-reaction to the toxic assets that really weren't will echo through the financial system for decades to come.

* The principals of Taylor Frigon Capital Management do not own shares of Bank of America (BAC).

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"The Consumer"



















Investors who spend much time reading financial predictions or watching the financial media can't help but hear about the powerful entity known as "The Consumer."

This amazing being figures so prominently in conventional economic analysis because many analysts attribute superhuman powers to The Consumer. In their view, The Consumer moves the entire economy, or if not the entire economy, The Consumer moves so much of the economy that there isn't much value in focusing on anything else.

When the economy is moving ahead, in the eyes of these pundits, it is because The Consumer is lifting it. Normally, The Consumer is full of something called "Animal Spirits," causing the economy to grow almost singlehandedly (of course, even the believers do not allege that The Consumer does it all singlehandedly, but they say that 70% or even 80% of the work is done by The Consumer, which is almost the same thing*).



















Sometimes, however, The Consumer becomes weakened. The cause of this weakness is never precisely explained (possibly kryptonite), but it appears that The Consumer is prone to bouts of depression, or at least self-doubt, during which the economy either stops growing and stagnates for a time, or even slips backwards into recession.

You can hear or read the opinions of those who believe in the mighty role of The Consumer literally every day in the financial media. One recent example is found in the video clip below from CNBC, in which Harvard professor Niall Ferguson invokes The Consumer:






In the above exchange, particularly the segment beginning around 05:40 into the clip, Larry Kudlow -- concerned that the Fed is keeping rates too low, as we have opined previously -- asks Professor Ferguson, "Will the Fed drain cash, will the Fed raise rates, will the Fed move to an exit strategy? And, I guess -- heaven forbid, Niall -- will we ever stop this explosive borrowing coming out of Washington?"

To this flurry of questions, Professor Ferguson replies, "Well, I don't see any end in sight to the explosive borrowing. We're on a $9 trillion cumulative deficit over a ten-year timeframe and right now I think it's way to early to talk about exit strategy for the Fed. I don't buy the idea that this is a V-shape or even a 'W' -- I think it could be a flatline, given the condition of The US Consumer. So, I don't really see any reason why the combined forces at work here, a huge deficit plus easy money, are going to go away any time soon."

Later, Professor Ferguson adds, "I think they're too scared that this economy could go dipping downwards again and I think they've good reason to be. They also know there's no inflation risk -- you know, they could let the dollar go down another 30% or more."

The problem with this belief in the crucial role of The Consumer is that it is simply false. It is -- as we have playfully suggested in the above paragraphs and images -- a myth, a fable, a comic-book view of reality.

In fact, it inverts reality altogether. As George Reisman, Professor Emeritus of Economics of Pepperdine University, wrote in Capitalism: A Treatise on Economics, this inverted view of the world can be called "consumptionism," which he defines as "the doctrine that the fundamental problem of economic life is how to increase the need and desire to consume in the face of an ability to produce that exceeds them" (543).

In other words, the proponents of this inverted view of reality believe that man's need and desire to consume is fixed and constant, just like the other animals (presumably, dogs and horses do not sit around wishing they had big-screen televisions -- they are satisfied with having their basic needs met). However, because man is able to produce so much more than we need, we are always in danger of having an "output gap" of products and services that exceed the desires of The Consumer, whose desire to consume must then be stimulated somehow.

In this ludicrous view of the world, an endless supply of big-screen televisions can be taken for granted from the production lines of the world -- the real problem is somehow stimulating the lethargic consumer to actually desire a newer and better television than the one he has.

The reason this is an upside-down view of the world is that man, unlike animals, can and does always desire something better. If he secures a newer and larger television, it will not be long before he wants one with even higher definition, or with the ability to connect to his stereo wirelessly, or with the ability to connect to content that is delivered over the internet, in 3-D.

If the above television example does not work for your own particular consumption patterns, you can no doubt think of items for which the above pattern would hold true, whether it be food, housing, cars, surfboards, clothes, travels, or power tools. In short, the desire to consume does not need to be stimulated at all -- it can essentially be taken for granted!

However, the ability to produce goods and services is not automatic. The consumptionist mentality just assumes that goods and services will continue to be produced, often in excess of The Consumer's desire to consume them, regardless of how many obstacles to production are erected in the form of taxes on business returns or regulation of free trade or confiscatory government corruption. Unlike the desire to consume, the desire to produce can be completely squashed by foolish policy. For instance, if you lived in a country where the police did not stop looters from breaking into your store and taking all your goods, you would soon learn not to build a fixed store with inventories of goods and services. This is why in most countries without the rule of law, small-scale stands in open-air markets and bazaars are the norm, rather than larger permanent shops which can take advantage of economies of scale. Generally speaking, in those countries, scarcity is the norm, and sufficient quantities of goods and services to meet the basic needs of all those who desire them are not produced.

For this reason, Professor Reisman says that the consumptionist worldview is completely upside-down. "Instead of taking the need and desire to consume for granted and focusing on the ways and means by which production might be increased, the problem of economic life is now believed to be how to expand the need and desire to consume so that consumption can be made adequate to production" (544).

The problems with the widespread belief in the superhuman role of The Consumer are many. First, predictions about the future of the economy that are based on trying to take the pulse of The Consumer are usually inaccurate. Investors should be very attentive when they hear a talking head on the financial news shows begin to invoke The Consumer, because what follows will likely be driven by the mistaken belief that The Consumer moves 70% of the economy. The widespread nature of such mistaken views, however, has no doubt been responsible for much fear and doubt among the general populace in the past, and will continue to be in the future.

Another negative impact from this consumptionist view is the role it plays in misguided policy, from excessive monetary stimulus at the Federal Reserve to excessive spending out of Washington in its attempts to "stimulate" The Consumer.

The United States often elects consumptionist leaders who believe in the outsized power of The Consumer and miss the importance of the portion of the economy that is responsible for economic activity along the stages of production, and therefore craft policy that penalizes everything else in the interest of The Consumer. We have written previously about ways investors can gauge the degree to which production is being hindered in an economy by these policies, and how investors should adjust when this takes place.

This is a vital concept for everyone to understand -- please share this knowledge with your friends and family.

* The root of the widespread belief that The Consumer is responsible for 70% or 80% of economic activity lies in the way the so-called "Gross Domestic Product" or GDP of any nation is measured: because of the way it is constructed, the GDP formula purposely excludes intermediate goods used in the production of end products, thus artificially increasing the percentage of economic activity attributable to consumer goods. Additionally, GDP is simply one measure of economic activity; there are many more, such as Industrial Production, that give insight into the productive side of the economy.

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