The "Budget Uncertainty Tax"

As the play-acting drama of the "fiscal cliff" negotiations continue -- a drama that would be ridiculous and laughable were it not so detrimental to the ability of individuals and businesses to plan for their immediate future -- we would like to offer several related observations.

First, we point out that the entire "fiscal cliff" scenario is itself the product of the inability of the elected representatives in Washington DC to agree upon a budget.  This inability is not new -- it has become a regular feature of political life over the past decade.  In fact, although the Congress did pass what is often called a "budget" in 2009 (and has not passed one since), the 2009 measure was only a temporary "omnibus spending bill" and to find the actual date of the most-recent budget passed into law in the US, one needs to go back to 1997 (now over fifteen years ago).

This inability of Republicans and Democrats to reach an agreement is compounded by the fact that the two sides cannot even agree upon what the problem is, let alone which measures should be taken to solve the problem.  In this case, some believe that government spending is the problem, while others believe that government spending is the solution, and some believe that low tax rates are the problem, while others believe that low tax rates are the solution.

But the problem is much deeper than that, as it is clear that even within the major political parties there are deep divisions over how to define the real problem.  Within Republican ranks, for example, it has recently become clear that there are deep divisions between those who are arguing that the main focus should be on the "debt ceiling" while others argue that the debt ceiling is a red herring and that the real focus should be on pro-growth tax reforms and regulation reform (see for example this article). 

The situation has become so divisive that an increased level of cynicism and pessimism among those who have to try to do business in a world that is impacted by the decisions of these "leaders" is entirely understandable.  We believe that it is reasonable to conclude that an era of budget uncertainty is here to stay for the foreseeable future, and that the real questions investors should ask are how it will impact them, and what they should do about it?

We believe that this government-induced "budget uncertainty" acts as a drag on business, because it creates additional uncertainty about where tax rates will be from one month to the next, causes business leaders to be more cautious than they would otherwise need to be, and generally saps economic growth and productivity as energies and attention is diverted away from primary business concerns and into all sorts of political analysis and tax-planning activities.  This drag on business activity caused by budgetary uncertainty is very similar to the drag on business activity that comes from misguided monetary policy that makes it  more difficult for businesses to predict the future price of raw materials or the future strength of  different currencies, and more difficult for lenders to provide capital to businesses that need it to expand (see here and here).

We might call the drag on business imposed by the budget follies of the past fifteen years a sort of a tax: the "Budget Uncertainty Tax."  It is not an actual tax in that it doesn't represent business activity that is taxed after revenues are made and employees are paid -- instead, it is a tax that is taken in the form of revenues that are never made in the first place.  In that sense, it is a "stealth tax" in much the same way that inflation can be a stealth tax.

So what should investors do when they perceive that businesses are likely to be facing a "Budget Uncertainty Tax" for the next several years?  Well, we don't believe that the answer is to run and hide, trying to escape the problem by not investing in businesses at all.  We believe that almost all investors need the potential growth that comes from participating in the success of well-run businesses over the course of many years, and that investment in growing companies has historically been one of the very best defenses against the loss of purchasing power caused by inflation and other destroyers of wealth (see here and here for example).

However, during times when the obstacles to business success multiply -- obstacles such as the ones described above -- the need to become more discriminating in the businesses to which one commits capital increases dramatically.  History appears to illustrate that during better business climates, the "rising tide lifts all boats" and investors can do fairly well by owning just about any group of well-run companies.  During such periods, the advice to "just invest in an index" becomes popular (during the 1960s, an early version of large-cap "indexing" called the Nifty Fifty strategy was popular).

During uglier periods, however, investors need to be more like the prospector panning for gold, keeping only what are true nuggets and discarding companies that might be worth considering in better times (companies that might turn into diamonds if given the chance, but may never get that chance in the more uncertain climate). 

We will continue to discuss this subject in future posts.

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AIER's essay on "A World of Persistent Inflation"

Last week, the venerable American Institute for Economic Research (AIER) published a clear and comprehensive study of monetary policy in the post-WWII United States, entitled "A World of Persistent Inflation," by Stephen R. Cunningham and Polina Vlasenko.  While somewhat long and involved, it provides an excellent discussion of an absolutely critical topic for investors, as well as some much-needed historical perspective to frame the shorter-term news that can monopolize one's attention in this "information age."

The essay's conclusions are stark and fairly straightforward:  increased government expenditures can be covered by increased taxes or by increased government borrowing, both of which can create increased public resentment. Most people understand how increased taxes can create resentment.  Increased government borrowing creates resentment by driving up interest rates on government debt, which then drives up interest rates on everything else, increasing borrowing costs for individuals, families, and businesses. By creating new money to buy up debt, however, interest rates can be kept low, masking the cost of borrowing. The study shows that this method has become the preferred method in the US since 1940.

By creating money in order to keep borrowing rates lower, however, the cost of those increased government expenditures are not erased, but transformed into a different kind of cost, one that can be less noticeable and cause less public resentment than exorbitant taxes or exorbitant borrowing costs.  As you might guess, this new cost is inflation, and it can be thought of as a sort of "stealth tax."  While extremely high inflation does cause widespread anger among the populace, steady but less elevated inflation rates can cost individuals just as much as taxes over the years (perhaps even more, depending on one's individual situation) without many people even noticing what is going on.

This subject is one on which the AIER has a long history of producing outstanding research, most notably in their essential study entitled "Stand still, little lambs, to be shorn."  We recommend that all our readers go back and revisit our comments on that essay, and the essay itself (which AIER has updated in the interim since we discussed it -- the latest version can be found here).

The newer "World of Persistent Inflation" essay is timely, as the Fed announced yesterday that it will continue buying mortgage securities at a rate of $40 billion per month, and that it will continue buying long term Treasury securities at a rate of about $45 billion per month.  Both of these measures had been enacted in order to keep interest rates lower, for the reasons described above.

Additionally, the Fed had previously been selling shorter-term securities in the same amount as it was buying longer-term securities (known as Operation Twist).  It announced yesterday that it will discontinue this selling, which marks a major step in further expanding its balance sheet.

While some investors may fear that these expansionary and accommodative policies by the Fed will lead to out-of-control hyperinflation, an understanding of the thesis of this latest AIER essay by Dr. Cunningham and Dr. Vlasenko points to a different conclusion.

As explained in that essay and outlined above, the cost of ever-expanding government spending can be passed on to the citizens of a country in three ways: it's a case of "pick your poison."  The cost can be passed on in the form of taxation (unpopular and acutely painful), in the form of higher borrowing costs (unpopular and acutely painful), or in the form of a long-term policy of inflation (much more difficult to detect, because the poison is subtle and slow to act, and when administered properly it causes some grumbling but after decades of such treatment the people generally accept it as part of the way things are supposed to be).

Based on this analysis, hyperinflation (which is unpopular and acutely painful) is less likely than a policy of persistent inflation, which is exactly what the authors titled their article, and exactly what the policies we see from the Fed are likely to create in the long run.

In other words, "Stand still, little lambs, to be shorn."

This subject is very important for investors to understand, as they weigh their strategies for the protection of their purchasing power into the future.  It is part of the reason why we recently reiterated our conviction that "we continue to believe that the best course for investors is to diligently seek out well-run, innovative companies in whose growth they can participate through equity ownership -- something that becomes all the more important during periods in which such growth is more difficult to find."

The search for growing innovative companies in which to invest is not a luxury in a "World of Persistent Inflation" -- it is a necessity.

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"Cornucopians" and "neo-Malthusians"

In our previous post (on Thanksgiving), we noted the prevalent symbol of the cornucopia, closely associated with that holiday.  

It is an appropriate symbol, for in spite of all the problems in the world today, we can all admit that there is much to be thankful for, and that while unending goods and services do not simply appear miraculously (as they do from a cornucopia), the innovation and hard work of countless men and women operating under the free enterprise system have in fact created an abundance of very good things.  Among those we might list are new medical treatments, semiconductors and networks and all that they enable, increasing harvests of food, and many other wonders.
There have certainly been those along the way, however, who have shaken their head at this increasing prosperity, called it illusory or even a dangerous fiction, and issued dire pronouncements which generally centered around the warning that production cannot keep up with consumption forever, and that "we" must take steps to limit demand -- usually by limiting population growth, or even by limiting population.  Some of those in this camp actually refer to those who do not share their zero-sum fixed-pie view of the world as "cornucopians," which they use as a term of derision.

Here is a webpage written by a current university professor who uses that term, and who clearly comes down on the side of the anti-cornucopians (although it is billed as an examination of the "perspectives" of both sides, the zero-sum arguments take up the majority of the essay).  Here is another one, also written by a (different) university professor, and also coming down against the assertions of the "cornucopians".  One wonders if anti-cornucopians celebrate Thanksgiving, and if so whether they have cornucopias as part of the decorations or not.

Fortunately, history has decisively proven the zero-sum paradigm to be bankrupt.  Those economic systems that have enabled people to innovate and create and produce have seen results in direct proportion to the degree that they have done so.  Those economic systems that tried to enforce a zero-sum view of the world (seizing what others produce, with the result that nobody wants to produce anymore) have generally collapsed, and sometimes they have even been replaced with systems that give their people more freedom to innovate and grow.

It is astonishing that many continue to espouse extreme zero-sum ideologies, to the point that the arrival of the seven billionth person on the planet last year was celebrated with a National Geographic site that asks "are there too many of us?" and with articles asking whether a world-wide "one-child policy" might be a prudent idea.

Students of economics and history will immediately recognize these lines of argument as "Malthusian," after the Reverend Thomas Malthus.  In fact, both of the university professor-authored papers cited above specifically use the term "neo-Malthusian" as the opposite of "cornucopian," and align themselves with the "neo-Malthusian" camp.  The neo-Malthusians are pessimistic about the idea human innovation will keep us ahead of ongoing demand placed on resources, particularly as populations continue to grow.

The counter to this argument, to which some of the neo-Malthusian authors do make reference, is the idea that it is a mistake to look at growing populations only as potential consumers of resources, rather than as the most important multipliers of resources, through their innovation.  In other words, each person is not just a potential problem but a potential solution, because human innovation actually creates new resources as if by magic (like a cornucopia!).

Innovation makes things in our natural world become resources that were previously useless.  For example, until cars, ships and airplanes could use petroleum products for fuel, petroleum was not a desirable resource.  It was the innovation of human inventors that made today's resources "turn into" resources in the first place!  Therefore, while future population growth will certainly create greater pressure on existing resources, the future innovation and inventions of some of those members of the future population will almost certainly "create" new resources that we don't even think of as resources today.

This is why, as investors and as believers in the free enterprise system, we are so convinced of the importance of growth and innovation -- and in the importance of providing capital to innovators and to innovative companies.  It is also why we are so convinced of the importance of keeping the obstacles to growth and innovation as low as humanly possible.

Ironically, as defenders and supporters of capitalism and free enterprise, we are on the more "cornucopian" side of the equation, rather than the "Malthusian" (or "neo-Malthusian") side of the equation.  In popular literature and movies, "capitalists" are often depicted as heartless Malthusians, one of the most famous being Ebenezer Scrooge in the Christmas Carol of Dickens, who makes a reference to helping the poor as being wrong, saying that it would be better for the hungry to hurry up and die, in order to "decrease the surplus population."

We would argue that the popular association of capitalism with Malthusianism is wrong, and that it is the proponents of free enterprise who understand that the pie is not necessarily a fixed pie but that it can be a miraculously growing pie, and that people cannot be "surplus" because it is people who make that pie grow!

Again ironically, the neo-Malthusians of today are often found in the halls of academia and the centers of government; both of which are centers of zero-sum thinking.

This is an important subject, and one that investors should understand.  It is one that has important bearings on investment, and one that points to the message which we have woven into our posts throughout the history of this blog, that growth really is the answer.
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Happy Thanksgiving, 2012!

As this previous post points out, we recently celebrated the fifth anniversary of this blog, which means that as Thanksgiving approaches for 2012 we already have five previous Thanksgiving posts to look back on from prior years.  You can re-visit them yourself by following these links: 
 All of those previous posts featured the image of a "cornucopia," a traditional Thanksgiving motif.  The cornucopia (or "Horn of Plenty") symbolizes abundance of blessings, in fact a miraculous super-abundance -- one which cannot be depleted and in fact never runs out.  It is a fitting symbol for a holiday that commemorates that feast celebrated in 1621 to give thanks for their first successful harvest by the pilgrims of Plymouth Bay Colony, joined by the Wampanoag Indians led by Massasoit (who actually provided much of the food).

Those settlers, who had experienced hunger and even seen loved ones and friends die of starvation, did not take food for granted, and Thanksgiving was established to remind successive generations that we should not take the blessings that we enjoy for granted either (noting that sufficient food is one of the most fundamental of those).

In our previous Thanksgiving posts, we have also pointed to the importance of economic production -- and a focus on the production side of the economic equation -- because increased production makes the "pie" bigger for everyone.  Many economists focus excessively on the consumption side or "demand side" of the equation, and by doing so fall into the error of viewing the world as a "fixed pie" or "zero-sum" situation, in which scarce resources must be divided up between competing populations and an increase in population necessarily means that someone will have to get less or even go without.  We have long rejected that view.

Fortunately, in this country, economic liberty has created an environment in which people are largely free to innovate, create, and produce, and that environment has attracted an influx of people from all over the world who have done just that -- with the result that production has been so abundant it really does at times resemble a cornucopia.
This Thanksgiving, we can be thankful for our freedom and belief in the value of every human being as well as each of our ability to be the real solutions to basic economic problems.

We wish all of our readers a very happy Thanksgiving 2012.

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Missing from the discussion of the fiscal cliff: GROWTH!

Here's a video clip of Gerry Frigon speaking on television yesterday, November 13, 2012 about the "fiscal cliff" and the larger issue of economic growth.

Yesterday we wrote that the hype about the fiscal cliff should spur lawmakers on both sides of the issue to tackle some real and fundamental tax reform, doing away with the rat's nest of exemptions in order to support a lower, flatter tax. 

In the above clip, Gerry reiterates a belief that is at the heart of our investment philosophy: that growth is the answer to solving the economic problems that the US -- or any other country -- faces.  Any suggestions for changes to the tax code are only valid to the degree that they promote human freedom and economic growth.  Budgetary problems such as those surrounding the fiscal cliff can ultimately only be alleviated by economic growth.  Even the problems in Europe cannot be solved by "austerity" in the long run -- they can only be solved by a vibrant, healthy and growing economy which supports business formation.

Previous posts on this subject include:
It is our view that this is an issue that all can agree on, regardless of politics. 

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How to fix the fiscal cliff: let go of the sacred cows!

Now that election week is behind us, Wall Street and markets around the world are focusing on the looming  US "fiscal cliff," which is dominating the talk in the financial media and which is in fact a very significant topic.

In case you are still a little hazy over the exact size and shape of the fiscal cliff towards which the US budget has been speeding since passing the "Budget Control Act" in 2011, this CNN Money article published in August of this year contains a fairly good rundown of the specific cuts to spending and the specific increases in taxation which will go into effect in January unless lawmakers and the president sign new legislation before the New Year.

This Wall Street Journal video also does a decent job of explaining the current budgetary mess, along with some cool "high-speed whiteboard drawing" footage and some footage of actual cliffs with sheer drops into yawning gorges coursing with icy mountain streams.

While the politicians are already posturing over which taxes will be raised or which programs deserve to be cut, we'd like to offer a solution which we believe should be welcomed by everyone, no matter what their political affiliation: let go of the sacred cows!

By "sacred cows" we are referring to the "loopholes" or tax exemptions granted to various business and investment activities, presumably as some kind of incentive for behavior that the government wants to encourage (in which case these tax breaks could also be labeled "social engineering").  In many cases, these tax exemptions benefit one industry at the expense of others, by making the purchase of that industry's products less costly than they would be otherwise -- thereby making some members of those industries wealthier than they would be otherwise (which is why these industries are often referred to as "special interests," especially when they pay for lobbying aimed at keeping or increasing the favorable tax treatment that their industry receives).  

We are fully aware that, as investment professionals and members of the "financial industry," we are part of an industry with more than its share of such tax shenanigans, but we are arguing that these should be eliminated, along with the rest of them.  By getting rid of these sacred cows that have heretofore been considered untouchable, we believe that the government would be able to enact lower, flatter tax rates on everybody.  That should make everyone happy.

Of course, if you think that it is better for the general public to pay higher taxes so that your special industry can sell a product that provides buyers with a tax loophole, then you might not like our list of sacred cows that should go away.  However, if you believe that these loopholes are unjust, then you might agree with us that these special interest loopholes should be thrown out, even if you (like us) are part of an industry that benefits from such loopholes.

We can start by naming a few products that the financial industry sells which are made more attractive by the special tax treatment they receive, such as IRAs and 529 college savings plans.  How many people would really put their money into 529 plans if those plans did not have special tax treatment?  The answer is, "next to nobody."  Those 529 plans are an example of a product (in fact, an entire sub-industry) that would not even exist without the current tax code.

Another member of this category is a much older species of sacred cow, the tax-free municipal bond.  For generations, investors have deployed capital to municipalities to which they would never have considered loaning their money if it were not for the tax-free status afforded to these bonds. 

Why should muni bonds get special treatment versus any other investment?  The reflexive answer is, "because municipalities need the money!"  That's probably the argument that was used to get the entire muni-bond racket started in the first place, and to get politicians to carve out a special tax exemption for muni bonds which other investments do not enjoy.  However, a moment of reflection will show that getting rid of the tax loophole for muni bonds would not mean that municipalities would not be able to borrow money -- it only means that municipalities would have to pay interest at market rates on the money that they borrow, rather than getting a special deal given to them by politicians, which other investments do not enjoy.  Imagine how much more fastidious government officials might be if they had to compete with every other borrower, on a level playing field, for the dollars they spend!

We believe that every potential investment should have to compete equally, on its own merits, rather than getting preferential treatment because politicians have decided that one investment is more "socially desirable" than another (or because one industry group is a bigger friend to those politicians than another industry group).

Into this same category, of course, we would put all the insurance products that receive special tax treatment, including annuities (another product which, like 529 plans, would be immensely less attractive to investors if they had not been given special tax treatment by the rules of our arbitrary and convoluted tax code).  For the record, we believe insurance policies are a very important part of wealth allocation planning, but that's exactly why we do not believe it requires any special tax laws to help "nudge" people into buying more of it than they might otherwise purchase.

While we're making some of our readers either dismayed or angry (there's enough loopholes here for us to anger or alienate everybody!), what about the tax deductions on real estate loan interest?  Why should home-buyers (both first and second home-buyers) be given tax incentives to take out home loans?  We also believe that tax laws that incentivize people to purchase new real estate with the proceeds of real estate sales without having to pay taxes on the gains (the "1031 exchange") should also go!  Unless, of course, you want to make ALL capital gains tax free...but we'll leave that for the details. 

We realize as we write this post that no politician of either party dares to address such "sacred cows" of the American tax code, but we believe that both sides of the aisle should really address the inherent unfairness (and actual injustice) that these special-interest loopholes represent, long before they go raising tax rates in other areas (such as on income or payroll).  Democrats are always talking about "change," and Republicans are always talking about "free markets" (we believe they should really say "free enterprise") --  what about getting rid of these sacred cows as a first step towards real change and real market pricing?

While members of the financial industry, insurance industry, and real estate industry might initially revolt at our recommendations, we believe that is the wrong way to look at it.  We actually believe that real estate and insurance offer value to those who choose to invest in them (we might even say the same thing about municipal bonds, if they ever get rid of their politically-engineered tax loophole).  In other words, we believe that members of the real estate industry and insurance industry (and financial industry) should be proud of the products that they sell, and should not feel that they need the government's help in selling them by way of tax exemptions (which only drive up the tax rates somewhere else).

In fact, it can be shown that historically the US government takes in taxes that are roughly equal to 20% of the GDP at any given time, regardless of the different ways that legislators fiddle with the various aspects of the tax code.  Given this fact, we believe they should be able to get to 20% without all the complexity and special-interest loopholes and deductions that only serve to favor one industry over another, shifting the tax burden onto those who aren't able to wiggle through all the available loopholes.  

We believe that the government could get to 20% of GDP with lower and flatter rates on everybody.  And that would make everybody happier.

Thus, as the "fiscal cliff" haggling proceeds in the US over the next several weeks, we'd like to see leaders emerge on both sides who are not afraid to tackle sacred cows such as muni bonds, insurance tax exemptions (grandfathered going forward, perhaps), and even real estate's favored tax status, as well as low, FLAT tax rates that are in line with what government collects as a percentage of GDP.  But, we're not going to hold our breath.

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Fifth anniversary of this blog!

It's hard to believe, but it was five years ago today that we started the Taylor Frigon Advisor as a way to have a conversation about the classic "Growth Stock Theory of Investment" and the principles and convictions that guide our investment management process, as well as to discuss some of the current events of the day from a perspective that might be slightly different from what you hear in the news media.

How time flies!

The world in many ways is a very different place than it was on November 09, 2007 when we published our first post.  However, the foundational principles that we discussed in that post are just as true today as they were then.  

In that post we referenced a paper that Mr. Price wrote in 1973 discussing the principles and convictions that guided his investment philosophy, and although the world had changed dramatically between 1973 and 2007 when we were discussing them, those principles were still just as valid as they were when he wrote them in April of 1973.  

For that matter, in his essay Mr. Price writes that he formed those convictions "in the early 1930s, after ten years experience in the investment business."  While the investment and business landscape of the country had changed dramatically between the early 1930s and the early 1970s, he clearly believed that those investment principles, which he articulated in that text, remained true.

This is an important lesson, and one that we believe all investors should carefully consider.  Today, on the fifth anniversary of our blog, we invite readers to pause and revisit that first post from five years ago.  As the saying goes, "The more things change, the more they stay the same!"

Even as businesses and technologies and geopolitical realities change dramatically, we believe the timeless principles of investing remain the same, if they are true.  Investment fads, unfortunately, come and go as well, but we believe that those that have stood the test of time should be shared, which is what we try to do through our writings here on this blog.  Thanks for coming along!
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US election, 2012

The voters in the US have spoken, and investors are weighing the outcomes and asking themselves what the future may hold.  

We believe that the likelihood for continued growth in government is high -- something that we have previously stated has characterized the past three presidential terms (two under George W. Bush and one under the current president) and will most likely mark the upcoming term as well.  This continued growth in government may lead to slower economic growth than might otherwise have taken place.

As professional investors, we can observe a previous four-term period of bipartisan government growth and slower economic growth -- the 1970s (technically, Lyndon Johnson was not really president during "the 1970s," as Nixon was elected in the 1968 election and took office in January of 1969, but he certainly presided over a significant expansion of government and can be grouped with the other three presidents shown above for purposes of this discussion).  If you were a professional investor at the beginning of the 1970s knowing what you know today, what kinds of investments would you seek out?

We have discussed this very question in two previous posts, each published about four years ago, entitled "Return of the 1970s?" and "Return of the 1970s, part 2."  Each of those posts are still worthwhile for our readers to revisit and consider.  In those posts, we noted that the 1970s were marked by excessive taxation, increased government intrusion into the private sector, and misguided and excessively easy monetary policy which led to inflation and the massive destruction of purchasing power.  We also observed that such an environment made it more difficult for companies to grow and to innovate, and  therefore more difficult for investors to find innovative and growing companies in which to invest.

More difficult -- but not impossible.  While fewer than perhaps would otherwise have been the case, there were innovative and well-run businesses that "changed the world" in their respective fields that  came out of that difficult period of the 1970s.  In the first of the two articles linked above, published in August of 2008, we wrote:
Furthermore, it turns out that while the 1970s were marked by economic stagnation caused mainly by excessive taxation and inflation, they were also a tremendous time for some companies. In fact, maybe the 1970s weren't that bad after all. As we have written many times before, we emphasize owning businesses, not owning markets. In any economic environment, some companies grow faster than others. During the 1970s, companies not listed on the NYSE but listed on the NASDAQ began the transition from being outcasts to being important companies. Think of owning companies such as Intel, which had its IPO in 1971*. In fact, the 1970s were a golden age for small-cap investing as described in this July Forbes article, although most investors are unaware of that fact.
During difficult economic times, smaller growing companies can get a premium, because growth is generally so hard to find.  That has been true in the four years since we first published the above paragraph, just as it was during the 1970s.

As we position ourselves for the future, we will certainly look to make adjustments as necessary in light of the recent election and the prospects for increased government interference in the economy, as well as the likelihood of eventual inflation from excessively loose monetary policy.   But we continue to believe that the best course for investors is to diligently seek out well-run, innovative companies in whose growth they can participate through equity ownership -- something that becomes all the more important during periods in which such growth is more difficult to find.

This is the philosophy that Mr. Thomas Rowe Price articulated in 1973 (and which was followed by his disciple, Richard C. Taylor) based on his assessment of the situation at that time. It is a philosophy that we have discussed in many previous posts in the Taylor Frigon Advisor, and it is the philosophy that we will continue to apply going forward.

We would also note that one result of the election was a continuation of the divided Congress -- in fact, the Congress became slightly more divided with this vote.  To the extent that a gridlocked government can function as a check to government spending, we believe that is a potential positive sign.  In fact, since the mid-term elections of 2010, government spending as a percentage of the economy has come down.  Should this trend continue, as we think it could, we would view that positively.

Finally, the enormous size, strength and innovative capacity of the American economy dwarfs the impact that politics can have on the system.  After all, we survived the 1970s!

At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Intel (INTC).
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Latest Taylor Frigon "Investment Climate" Commentary

Here is a link to the latest Investment Climate commentary from Taylor Frigon Capital Management, which we send out to our  clients each quarter.

As always, we emphasize the importance of taking a longer view amidst all the turmoil of  the varying economic and political events that are taking place around us -- and certainly right now is a period in which economic and political focus is reaching a fever pitch (especially in the US, with elections right around the corner).

We include above our long-term performance record for our Core Growth Strategy through the end of the most-recent quarter, to emphasize our conviction that taking the longer view of focusing on investing in good businesses (rather than trying to "time" geopolitical events) is a valid philosophy for investors.  Full performance data, along with Global Investment Performance Standards (GIPS) disclosures can be found here.
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Growing the economy, part two: Fix the bad fiscal policy

Above is the full video of the press conference held by Fed Chairman Ben Bernanke held last week -- Thursday, September 13, 2012 -- as he announced yet another in a long line of "unprecedented levels of policy accommodation in recent years" (0:01:46).

In our previous post, entitled "Growing the economy, part one: Get off of a 'War Footing' with monetary policy," we argued that the Fed's unprecedented levels of accommodation over the past four years were inappropriate and in fact harmful. We also promised to discuss why the Fed continues to take this approach, and because the Fed really went "all-in" on that approach last week, it becomes even more important to understand what is behind their actions.

As Mr. Bernanke explains in his opening remarks at the press conference in the video above, the Fed has in its job description something called the "dual mandate," which is to use monetary policy to ensure both price stability and maximum employment.  With government measurements of unemployment still stubbornly above 8%, the Fed is compelled by this second part of their dual mandate to take additional steps to try to reduce unemployment.

In this regard, Mr. Bernanke and the Fed can hardly be criticized: their job description includes taking steps to ensure full employment, and unemployment remains at 8.1%, well above "maximum employment."  Never mind the fact that their control over the tools of monetary policy gives them precious little in the form of tools that can actually create employment -- it is in their mandate, so they have to do something with the tools they have, as inappropriate as that may seem.

To fix that mandate, lawmakers should get rid of it, by amending the Federal Reserve Act (in fact, the dual mandate was only added by Congress to the Federal Reserve Act as recently as 1977).  We have previously published our view that the dual mandate should be abolished (see this previous post, for example).

In his opening remarks, Mr. Bernanke makes reference to the fact that what is really needed in this situation are not monetary tools but rather fiscal tools, and we agree.  All the monetary accommodation in the world will not induce businesses to hire and expand if misguided fiscal policy (set by policymakers in Congress, not the Fed) imposes enormous burdens to hiring and expanding, by increasing the costs of employee health insurance, increasing the regulatory burdens and penalties aimed at businesses, increasing government activity in areas that were previously addressed by private businesses, increasing the taxes on business activity or making the threat of increased taxes seem more likely, and increasing government's spending to the point that future taxes seem even more likely.

Therefore, in order to unleash economic growth (and improve the employment picture at the same time), we need to fix the broken fiscal policy coming out of Washington lawmakers.  As distinguished economist  Dr. Walter Williams points out in his most recent syndicated column, fiscal policy (the power to tax and spend) is the responsibility of the Congress, not the responsibility of the Fed, and also not the responsibility of the President.

In the video below, Brian Wesbury (another economist with whom we agree), explains why he believes the Fed's action yesterday can be called "QE3," why it is misguided, and why it is the fiscal policy that must be fixed if the economy is going to grow:

He also provides some additional thoughts on the reasoning behind the Fed's incredible new tactic of telling the public that interest rates would remain essentially at zero until at least the middle of 2015 (this is what the Fed now calls "forward guidance"), while initiating additional balance sheet activities (often called "quantitative easing" as explained in this previous post) that it will continue until levels of unemployment fall.

At about the 2:30 mark in the above video, Mr. Wesbury points out that -- in addition to trying to fulfill their dual mandate -- the Fed officials may also be trying to correct the difference between the current rate of nominal GDP growth and the rate of nominal GDP growth that had prevailed before mid-2007.  However, as Mr. Wesbury insightfully observes, that is a terrible mistake!  That would be, in Mr. Wesbury's words, "trying to get GDP back to where it was in a bubble time!"  

This brings us to our final point for today's post.  The bubble to which Mr. Wesbury refers was primarily a bubble in housing prices and housing activity, and it was a bubble that was almost entirely created by . . . misguided monetary policy after the previous recession and bear market!  

All of this shows the folly of trying to use monetary policy to "steer the economy," as the 1977 dual mandate  requires by law, and as yesterday's Fed announcements clearly indicate the Fed is trying to do once again.  We have written about the dangers of such "Fed steering" many times in the past

As Mr. Wesbury argues beginning at about 1:30 in the above video, the biggest deterrent to economic growth right now is "bad fiscal policy: too much spending, too many regulations, fears about future regulations [. . .], and fears about future tax hikes -- all of that is holding back the economy, and its not a lack of money that is the problem."

We couldn't agree more.
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Growing the economy, part one: Get off of a "War Footing" with monetary policy

As investors return from a three-day Labor Day weekend in the US, much of the talk in the financial media centers around the activity of the central banks, particularly the European Central Bank and the US Federal Reserve. 

Many interpret Fed Chairman Ben Bernanke's comments at Jackson Hole last week as indicating that the Fed is preparing to "do something" at the upcoming Fed meeting on September 13, possibly including the formal declaration of the intent to keep US short-term interest rates at zero through 2015 (rather than through 2014, as the Fed has already pledged to do).

Why does the Fed feel the need to "do something," and why do many investors and pundits continue to argue that the Fed needs to "do something"?  The answer is pretty obvious to anyone who has been paying attention to economic matters at all, which is that unemployment remains stubbornly high and economic growth remains stubbornly low, and many assume that central bank action is part of the solution to these woes.

In this first installment of a short series of posts about how to fix the economy, however, we will make a different argument.  We would argue that when it comes to monetary policy, the best way to allow the economy to experience more robust growth with more jobs is to pursue a stable monetary policy and (equally important) a normal monetary policy.

Unstable monetary policy creates unpredictability and uncertainty that creates obstacles for businesses.  If your business requires purchasing components or ingredients and you don't know whether the prices for those components or ingredients will be going up rapidly over the next few weeks or months, it makes it difficult to plan.  When prices fluctuate wildly, businesses end up spending money trying to hedge against future price fluctuations, and time and talent that could be spent more productively doing something else is instead spent trying to analyze and predict price fluctuations and to plan strategies to lessen the impact of the price volatility.

Unstable monetary policy also creates obstacles to the critical function of supplying businesses with the capital that they need to grow and expand.  If central banks allow massive inflation, for example, lenders may be worried about loaning capital that will be repaid to them later with less-valuable dollars.  To guard against this danger, they may have to charge higher and higher interest rates, or they may become much more reluctant to lend.  Either way, capital can become less available to innovative businesses -- not because those businesses are not promising but because monetary policy is unstable.

Just as important as having a stable monetary policy, however, is having a normal monetary policy. This fact is something that commentators often overlook (especially those who continue to clamor for the Fed to "do something" next week).  The US Federal Reserve has kept short-term interest rates effectively at zero since December of 2008!

A zero interest rate is not a normal interest rate: it is an emergency interest rate, akin to going on a "war footing."  The dramatic cuts to the fed-funds rate that were enacted in 2008 were seen as emergency measures necessitated by a potential liquidity crisis.  Whether the actions taken in 2008 were appropriate or necessary can be debated, but four years later we are no longer in the middle of a financial panic and a potential liquidity crisis.  Why are we still on a "war footing" with regard to interest rates? 

US GDP has been growing at an average of 2.2% annual since the recovery officially began in mid-2009, and at 2.3% in the past year (as economist Brian Wesbury explains here).  While these are not stellar growth rates for GDP, they do not call for a 0% interest rate.  Many economists believe that interest rates are inappropriately low and monetary policy overly loose when they lag below real GDP by even a fraction of a percent.

Keeping interest rates this low may well be contributing to the slow economic growth, and it is certainly inviting dangerous inflation.  The Fed has enormously beefed up bank balance sheets by its emergency actions since 2008 (for an explanation with diagrams of what this means, see this previous post), which certainly alleviates any possibility of a liquidity crisis.  But, as central planners typically do, they are "fighting the last war."  It is no longer 2008!  All that excess money on bank balance sheets has not found its way out into circulation for a variety of reasons, but it certainly could do so and it could do so very rapidly.  If it did, that would have the potential to be enormously inflationary.

Finally, there is an aspect of "self-fulfilling prophecy" in this continued "war footing" mentality.  The US economy acts like it is still in an emergency mode because the Fed continues to enact an emergency monetary policy (and has said that it will need to do so through at least 2014).  

To allow the economy to return to healthy growth, it is time to stop fighting the last war and get rid of these unnecessary -- and harmful -- emergency monetary gimmicks.  A crucial aspect of a healthy growing economy is a stable and a normal monetary policy.

All of this begs the question: "Why is the Fed taking this approach?"  We'll tackle that in our next installment in this series.

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Have you heard of this (boring) company? APH

From time to time, we publish a brief highlight of a company that we own on behalf of our investors, in order to provide an example of the investment philosophy that we practice and that we try to explain to the world in the pages of this blog. In the past, some of the companies highlighted have included:

These short overviews are meant to provide some concrete examples of the investment principles we follow, and to counteract some of the incorrect understanding of "growth stock investing" that began in the 1990s and persists to this day (for more discussion of our understanding of what we might call "true" or "classic" growth stock investing, see previous posts such as this one and this one).

This time, we'd like to briefly discuss a company that may not fit the stereotype of a "hot growth stock" as portrayed by the often-unhelpful financial media, but a company that we believe fits the definition of a true "Taylor Frigon growth company," and that is electronic-equipment manufacturer Amphenol Corporation, of Wallingford, Connecticut*.

Founded in 1932, Amphenol is one of the largest manufacturers of electronic connection products in the world, including fiber optic connectors, busbars, backplanes, specialized cable assemblies, and other parts that enable the ongoing demand for electronics and automation in industrial equipment and automobiles. Many of their parts are designed for harsh environments and the rugged use-cases encountered in the aerospace, mining, and defense industries, often involving waterproofing, vibration-resistant connections, and the ability to withstand high pressure, extreme temperatures, and corrosive materials.

Many Amphenol products (some of which are pictured above) may not be as sleek-looking or ultra-modern in design as the consumer devices that many investors think of first when they hear the words "high-tech," but Amphenol components are critical connections inside many mobile connected devices, fully 50% of which contain Amphenol products in the form of antennas, microphone and speaker connectors, camera sockets, battery connectors, charger connectors, and so on.

Furthermore, Amphenol is a leading provider of electronics solutions that connect the "guts" of the communications networks that make those mobile devices possible, with products that go into cellular base-stations, wireless routers, cellsite antennas, and fiber-optic backhaul interfaces.

And, in case you think that the industrial-strength connections that Amphenol has successfully manufactured for decades are getting ready to be replaced completely by wireless RF connections, Amphenol offers a complete line of RF products which enable connection of devices through wireless RF technology. In fact, Amphenol engineers invented RF technology in the 1940s in conjunction with the US military.

Amphenol has a long history of steady earnings growth (interrupted by periods of earnings declines in 2001-2002 and 2008-2009, each period of decline lasting for about five quarters), and their most recent 5-year operating earnings growth has been at a compound annual rate of 13.3%. Their most recent 3-year operating earnings growth has been even faster, at a compound annual rate of 26.7%. The company's current return on equity (defined as current earnings available to common shareholders divided by common equity) is 21.8%. The company also instituted a modest dividend in 2005, which continues to the present and has grown at an annual rate of about 42.6% in the past five years.

In short, Amphenol may seem on first glance to be a somewhat "boring" company, involved in the unglamorous business of manufacturing the connectors and components that undergird the modern electronic world. In reality, the company is a textbook example of what the late Dick Taylor would call a "stable grower" and what Thomas Rowe Price might have described as a "successful business enterprise which continues to grow and prosper over a long period of years."

We believe that Amphenol exemplifies the kind of company that investors should consider as a destination for investment capital (as part of a well-rounded investment strategy constructed in conjunction with their objectives and constraints), and we highlight it here in order to illustrate the application of some of the general investment principles that we discuss here in the Taylor Frigon Advisor.

Perhaps most importantly, it serves to demonstrate that a "growth stock" may look very different from the companies that you hear being breathlessly ventilated night and day in the financial media.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Amphenol Corporation (APH), EZchip Semiconductor (EZCH), Panera Bread (PNRA), Tractor Supply Company (TSCO), and ResMed Inc. (RMD).
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Who is right, Bill Gross or Jeremy Siegel? Answer: George Gilder

Recently, the venerable bond-house money manager Bill Gross of PIMCO published his August Investment Outlook beginning with the attention-grabbing opening sentence: "The cult of equity is dying."

Headlines in the financial media immediately began to proclaim that Bill Gross was ringing the famous "Death of Equities" bell (here's one from the Wall Street Journal, and here's another from CNBC).

The phrase "The Death of Equities" has become legendary in investment circles ever since it was featured on the cover of BusinessWeek on August 13, 1979 (image below).  You can take a trip down memory lane and re-read that cover-story from August 1979 here.

Part of the reason that 1979 declaration of the death of equities has become so famous over the years, of course, is the fact that the stock market of the 1980s and 1990s produced such tremendous returns for many investors, prompting stock-market advocates to pull it out as a warning to all those who would ever dare to call the "death of equities" again. 

The current commentary from Bill Gross is no different, especially because his August investment commentary takes specific aim at the premise of Professor Jeremy Siegel's iconic 1990s investment text, Stocks for the Long Run and its thesis that -- over long periods of time -- stocks outperform all other asset classes.  Many who are rushing to refute the arguments of Mr. Gross and defend the arguments of Professor Siegel are invoking the 1979 cover story, but we think that by doing so they may be missing an even more important point.

Our reading of his Investment Outlook notices two main arguments: 
First, he argues that -- although the long-term real return for stocks is 6.6% when you look at 100 years -- the more recent rate of return for stocks for shorter periods has been far below that, and in fact this is a return to something like a "new normal" because that 6.6% return was the product of an anomalous period of time, "a historical freak, a mutation likely never to be seen again as far as we mere mortals are concerned."

This first argument is the one that makes equity bulls angry, and the one that has them digging up the 1979 BusinessWeek and rushing to the defense of Professor Siegel.  However, in doing so many appear to have missed his second point, which he tells us is the real point of his article (in the first sentence of the section entitled "Got Bonds?").  

His second point is that the long-term returns quoted for bonds are probably just as illusory for future investors, arguing that the long-term bond return has been boosted by the anomalous decades we just went through in which yields for newly-issued bonds fell from ridiculous highs in the 1970s and early 1980s to today's nearly-invisible bond yields.  Based on that fact, and the even more important probability that profligate governments are going to be forced to inflate their way out of their problems, he issues a stern warning to anyone buying bonds that could be remotely categorized as longer term right now.

This point brings him to his conclusion, made in the final sentence of his newsletter: "The cult of equity may be dying, but the cult of inflation may only have just begun."  Inflation of the currency is devastating to the wealth of savers, as we have discussed in numerous previous posts, such as "Stand still, little lambs, to be shorn." 

To be fair to Professor Siegel, he is in agreement with those who point out the damaging effects of inflation, and the likelihood that future inflation could be ugly.  That's why he recommends equities as the only asset class that enables investors to stay ahead of the wealth-destroying effects of inflation.  We agree with him in general, which is why we have linked to his arguments in many of the posts in which we discuss this problem.

Mr. Gross argues that the faith in a long-term real return of stocks in the realm of 6.6% is misguided. He argues that the long-term growth of the US GDP has been about 3.5% over the same period of time that stocks have returned 6.6%.  "If an economy's GDP could only provide 3.5% more goods and services per year," Bill Gross asks, "then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers, and government)?"

This phrasing points to a major flaw in Mr. Gross' understanding of economics.  He is phrasing the question in a zero-sum fashion, as if the gains of one group are always at the expense of someone else, which is the classic formulation of the fixed-pie or zero-sum paradigm.  It isn't that the returns enjoyed by one segment are at the expense of the returns of the others:  government, for example, does not lose-out to the private companies that make up the stock market -- those companies pay for the government and make its budget possible in a very real sense.  Mr. Gross also spends a good deal of his essay arguing that stock returns have somehow been stolen from "laborers," which is another manifestation of zero-sum thinking.

George Gilder explodes this false view in a recently published excerpt from his new prologue to his classic text Wealth and Poverty, entitled "Unleash the Mind."  There, he argues that:
Far from being a zero-sum game, where the success of some comes at the expense of others, free economies climb spirals of mutual gain and learning.  Far from being a system of greed, capitalism depends on a golden rule of enterprise: The good fortune of others is also your own.
George's masterful argument should be read in its entirety, so that the finer points that support this argument can be appreciated.  However, it is clear enough that the growth of the business reflected in a stock return does not come "at the expense" of the laborer as Mr. Gross declares, but rather that the good fortune of the business enables the good fortune of the laborer, whose job and wages are as dependent on the continuing success of the company as they are on the existence of the company in the first place. 

When he raises the specter of inflation, Mr. Gross does not offer any real way out.  Having "dissed and dismissed" both stocks and bonds, he basically tells investors: "If financial assets no longer work for you at a rate far and above the rate of true wealth creation, then you must work longer for your money, suffer a haircut on your existing holdings and entitlements, or both."  In other words, "stand still, little lambs, to take a haircut."

But we also believe that the faith in "the market" and "stocks" championed by Professor Siegel and his defenders is too simplistic.  Just as there are sub-sets of the overall economy that produce greater returns than the economy as an aggregate whole, there are sub-sets of the overall "stock market" that produce greater returns than the stock market as an aggregate whole.  We have never believed those who argued (based on their reading of the long-term charts) that you should "just index" and everything would always be fine.

This is where George Gilder's insights are so powerful and so revolutionary.  In his essay "Unleash the Mind," he argues that it is not markets that are the source of wealth and growth, but rather innovation, creativity, ideas: the mind.

He argues, "Capitalism is the supreme expression of human creativity and freedom, an economy of mind overcoming the constraints of material power," and "Creativity is the foundation of wealth."

This creativity and innovation is where investors must place their hope for escaping the scenario described by Mr. Gross.  And, while we believe that it is always important to seek out innovative companies, it is even more important to do so during periods in which the obstacles to creativity and innovation are more numerous (such as during the economically misguided period of the 1970s, and indeed during the period since roughly 2000).  This is where the criticism of Mr. Gross of the simple faith in "stocks" and "the market" is on target, especially as we appear to be in a period in which such obstacles will continue to abound.

We have produced evidence that belief in "indexing" tends to fall apart during periods of greater economic stress and malaise, including the 1970s as well as the past several years.  

We believe very strongly that long-term inflation requires ownership of shares of companies in order to stay ahead of inflation, but that just any companies will not do.  Investors must seek out exceptional businesses, creative businesses, innovative businesses -- well-run businesses in front of fertile fields for future growth.

This is a very different message from those offered by either Mr. Gross or Professor Siegel.  We would recommend that all investors check out George Gilder's new book as soon as it is released.

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Milton Friedman

Today is the 100th anniversary of Milton Friedman's birth, born on July 31, 1912.  He was a true champion of human economic freedom, and one of the clearest voices on behalf of the individual's right to choose that the world has ever known.

We have written many times in the past about the importance of Milt Friedman and his arguments for economic freedom, including:


We have also linked to many of his films and videos, and above is a link to the beginning of his superlative 1980 television series, "Free to Choose," which is well worth watching in its entirety.

Today, there is a powerful essay on the impact of Professor Friedman written by Stephen Moore of the Wall Street Journal's editorial page entitled, "The Man Who Saved Capitalism."  In it, the author notes that there are many who have recently "tried to tie Friedman and his principles of free trade, low tax rates and deregulation to the global financial meltdown in 2008."

However, as we wrote in 2008, that crisis was "A failure of government, not of private enterprise."  Ironically, that quotation -- "a failure of government, not of private enterprise" -- came from an essay that Dr. Friedman and his wife Professor Rose Friedman wrote in 1979 about the Great Depression, in which they noted that the tragic misreading of the Great Depression as a failure of the free enterprise system (when in fact it was a failure of government) led directly to the rise of tyrants such as Hitler and Mussolini (and later Mao as well).  It also led, they wrote, to the conviction among many intellectuals that capitalism was inherently unstable and needed the active and constant intervention of government.

That debate continues to rage to this day, and it is a critically important one that affects us all.  We believe that Milt Friedman was right on this crucial subject, and that the events of the 20th century provide conclusive proof that he was right -- as do the events of the 21st century thus far.

Milt Friedman was truly a champion of human freedom and one whose voice is as important as ever today, one hundred years after his birth.

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Roger McNamee on "time horizons"

Here's a thought-provoking video of venture and private equity investor Roger McNamee being interviewed a few months ago and discussing some of the things that he looks for in an investment. 

As interviewer Emily Chang brings up beginning at 10:15 in the video, Mr. McNamee is a very focused investor -- his first fund at Elevation Partners had $1.9 billion in assets and invested in only eight private companies.  He calls diversification "the bane" and argues that "it minimizes your returns and it raises your risk."

While this is contrary to the conventional wisdom most investors have heard from Wall Street and the financial media, it is actually a point we agree with and one we have written about in the past (see for example the post on "Deworsification").

Another important subject Mr. McNamee touches on can be found in the discussion that begins at around 15:00 in the video.  While he is ostensibly discussing the development of negotiated buyers and sellers of private (not listed) shares in a company that has not yet gone public, the general heading that we would put on this discussion would be "time horizons."  

The subject of time horizons for the investor is extremely important.  In his discussion at this point, Mr. McNamee explains that there were venture investors who were pushing for a sale of Facebook at a valuation of about $1 billion, when the company was still private, and were only over-ruled in this effort by the veto of CEO Mark Zuckerberg (this discussion takes place around 15:26)*. 

Mr. McNamee notes that negotiated private sales enabled those investors who wanted to sell to do so, and buyers (in this case Mr. McNamee's fund and another fund) to buy, which had the effect of moving "a lot of that stock into the hands of people whose time horizons were much closer to the management team."  In other words, he means the new investors had an investment horizon that corresponded more closely to the longer-term horizons of the management team, not the shorter-term time horizons of the venture investors who wanted a payout now and were less interested in the future of the business.

This is a critical point for investors to consider, and one we have written about many times in the past (see for example the post entitled "Wise words from Reid Hoffman").  While investors may not always have the opportunity to invest in innovative private businesses, and while even those who do may not wish to do so with all of their investment capital, it is at least important to "think like a private investor" in some ways, and particularly like the type of private investor that Mr. McNamee is describing who has a longer-term horizon focused on the business success, and not the shorter-term horizon focused on getting a quick return or payback.

The biggest problem with the landscape of Wall Street is that it is increasingly dominated by a short-term mindset interested in quarter-to-quarter time-frames (and even shorter periods than that, down to day-to-day or even minute-to-minute).  Investors of all levels have not helped this environment either, as the mindset of investing for many years has become more rare.  The decrease in a longer-term focus is somewhat understandable, given the constant short-term focus of most of the commentary coming out of  both Wall Street and the financial media since the dawn of the 24-hour news cycle.

The key distinction we believe that investors should take away is that between a focus on business and a focus on markets.  We believe that Mr. McNamee's comments reveal an intense focus on business, and that he brings out some of the real problems with the short-term market focus that prevails in many parts of the investing world today. 

By carefully considering these insights, investors can put themselves in the position to benefit from widespread short-term focus, just as Mr. McNamee and his fund were able to benefit by purchasing shares from those whose time horizons were much shorter, in the illustration that he cited above. 

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Facebook (FB).
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