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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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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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:
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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Still in thrall to the Phillips Curve?

In response to the recent nomination of Janet Yellen to become the next Vice Chair of the Federal Reserve (replacing retiring Vice Chair Donald Kohn), economist Larry Kudlow has written an article entitled "Yellen is spellin' future inflation."

Kudlow states that "Ms Yellen is a distinguished economist who unfortunately subscribes to the Phillips-curve model that trades off unemployment and inflation."

Although he does not cite hard evidence that Dr. Yellen subscribes to the Phillips curve model, she has in the past cited texts that support the Phillips curve view, including the 1996 paper authored by her husband, Nobel laureate and UC Berkeley Professor George Akerlof (along with co-authors William Dickens and George Perry). She has also stated that some inflation is good in order "to grease the wheels of the labor market" -- in other words, to increase employment, a clear tenet of the Phillips curve view (and the conclusion of the 1996 essay authored by Akerlof et al).

We have previously discussed the problems with the Phillips-curve view of the world, as well as evidence that Fed chairman Ben Bernanke is "still in thrall to the Phillips curve," as Steve Forbes wrote back in June 2008. For those previous discussions, and what this means for investors, see "The Fed drops the mask," "Who are you going to believe . . . ?" and "The Fed's oversteering and the wreckage of the past decade."

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March 9 anniversary

There are plenty of stories out today about the one-year anniversary of the bull market, and in one sense we'd like to simply ignore it, because we often emphasize that investors should focus on businesses rather than markets (see here for instance).

However, the return of March 9 -- the day that marked the pit of the most ferocious bear market in nearly seventy years -- is a good day to actually re-emphasize that very lesson.

There are plenty of investors who, stunned by the precipitous drops in the market, were ready to jump off at the absolute bottom of the ride -- and many who actually did. We ourselves know of some whom we "talked back from the edge" and of others who actually sold their portfolios, following the (awful) advice of their "financial advisors" (now their former financial advisors) in March of 2009.

We have written a series of articles about the Dalbar studies that show this same deadly pattern destroying investor returns over and over -- and noted that the Dalbar data implicates "financial advisors" as part of the problem (see here and here).

The advice of focusing on the underlying business rather than the market helped investors during those dark days of March, 2009 -- because (as we have written many times) the panic of 2008 and 2009 was primarily a financial panic caused by Wall Street-specific issues, and those who owned shares of good, well-run businesses did not need to sell them at fire-sale prices because of the happenings on Wall Street, as we explained in this post.

We are not just saying this with 20-20 hindsight, either. On March 2, 2009, for example, we wrote an important post entitled "Don't get off the train" which cautioned investors against stepping out of the market and being left behind.

Now that things have gotten better, and investors can view the dark days of last year from a bit of a distance, it is important to revisit these lessons, and resolve to focus on businesses and less on the twists and turns of the markets, bear or bull.

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Have you heard of this company? DLB

In previous posts, we have discussed some of the characteristics of a Taylor Frigon growth company, and have highlighted some examples -- most recently Tractor Supply and Resmed.*

With Oscar weekend approaching, and plenty of buzz in Hollywood about 2009 being the "year of 3-D," we thought we would highlight another growth company, Dolby Laboratories.*

While most consumers are familiar with the name Dolby, because the company licenses their technology to manufacturers of consumer electronic equipment, many do not realize that Dolby equipment is also used by almost every professional studio in the production of music and movies and other professional media content (such as the Dolby-E encoding equipment pictured above).

And while moviegoers may have thought that 2009 was the year of 3-D, with the blockbuster success of James Cameron's Avatar (featuring Dolby 3D) they may not be aware that seventeen more big-name 3-D films are set to hit the screens in 2010, including another edition of Shrek, another Friday the 13th, a third Toy Story, and the return of Tron in Tron Legacy, as well as several others. Many will feature Dolby 3D, in addition to all the Dolby technology that is used in other aspects of movie production.

The dawn of modern 3-D may well transform the home theater as well, with Sony recently announcing a $200 3-D blu-ray player and Philips announcing 3-D LCD televisions to ship this summer.** Remember that Dolby technology is licensed by many consumer electronics manufacturers, who see Dolby as an essential partner (Dolby long ago decided to license their technology rather than make consumer electronics gear themselves, opting for the role of partner rather than competitor to the consumer electronics companies).

We believe that focusing on the fundamentals of well-run businesses in front of fertile fields of growth is important for investors in all economic environments, and that they can be reminded of that concept the next time they hear the media talking about the business of entertainment.

* The principals of Taylor Frigon Capital Management own securities issued by Tractor Supply (TSCO), Resmed (RMD), and Dolby (DLB).

** The principals of Taylor Frigon Capital Management do not own securities issued by Sony (SNE) or Philips (PHG).

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Avatar and long-term inflation

Every now and then, a fact or illustration arises which vividly reveals the long-term corrosive impact of inflation, that insidious force which usually remains invisible and all-but-unnoticed.

The following chart (from IMDb data) shows estimated US box office records for the all-time biggest movies. Note that while the current box office champion, James Cameron's 3-D science fiction adventure Avatar, recently became the all-time worldwide box office champion by overtaking Cameron's Titanic in total ticket sales, when adjusted for inflation of ticket prices it is only ranked number fifteen (this list shows domestic ticket sales because, when adjusting for the inflation of the US dollar, US box office figures are used rather than world-wide figures).

1. Gone with the Wind $1.538 billion
2. Star Wars $1.355 billion
3. Sound of Music $1.084 billion
4. ET $1.080 billion
5. Ten Commandments $997 million
6. Jaws $975 million
7. Titanic $977 million
8. Dr. Zhivago $945 million
9. Exorcist $841 million
10. Snow White $829 million
11. 101 Dalmations $760 million
12. Empire Strikes Back $747 million
13. Ben Hur $746 million
14. Return of the Jedi $715 million
15. Avatar $708 million so far

In other words, much of the credit for Avatar's record-breaking box office figures can be attributed to inflation of ticket prices -- which is to say, to the declining purchasing power of your money over long periods of time. Because much smaller amounts of money purchased so much more back in the day when Gone with the Wind was in theaters, its sales figures (which seem small by today's standards -- only $198 million) still make it the all-time box-office champ in the US ($1.53 billion in today's dollars).

Even when inflation is "relatively low," it cuts the purchasing power of everyone's money over the decades. At a 3% annual rate of inflation, money loses fully half of its purchasing power in about 23-and-a-half years. The most recent Dalbar study of investor behavior (2009) showed inflation averaging 2.89% over the past 20 years.

In spite of its ravaging power, it is easy to overlook the impact that inflation has on a family's long-term wealth and estate over the decades. Little illustrations such as the disconnect between Avatar's sales in current dollars versus its standing when adjusted for inflation can serve as valuable reminders of this slow decay over time.

We have written several times about the subject of inflation, and why the best defense against its effects over time has been ownership of growing companies (and not commodities such as gold). For readers interested in reviewing some previous discussions on this subject, we would recommend:

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One of the best explanations you will hear of the financial crisis and its aftermath

This remarkable video from economist Brian Wesbury is one of clearest explanations you will hear on the financial crisis and its aftermath.

It is entitled "TARP was a mistake."

One of the hardest-hitting points that Mr. Wesbury makes in the video is the fact that, to this day, the view that Congress needed to somehow use taxpayer dollars to buy up troubled mortgage-backed assets is not challenged by members of either side of the political aisle in Washington. Nowhere can we find a politician brave enough to say that the very idea of buying back troubled assets was mistaken.

Mr. Wesbury also points out that at the time, he was arguing that changing mark-to-market accounting rules would have fixed the problem, rather than spending taxpayer dollars. He cites this video from September 2008 in which he made that argument (and he was also making that argument in writing in many places leading up to September 2008).

We have noted before that we are also on record saying that mark-to-market was a big part of the problem (as early as this post from March 2008). We also publicly stated in April 2009 that it was time to retire TARP (and since then have argued that we certainly don't need to compound it by continued TARP-like "stimulus" or "jobs" bills).

We have long believed that a crucial component of investment is the ability to sort out the real situation from the "conventional wisdom" in various matters large and small. We believe that having a correct understanding of the Financial Panic of 2008-2009 will be extremely important to investors for many years to come.

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