We must get back to real investing

Back in February of 2009, in the very depths of the financial panic of 2008 - 2009, we published a post called "Managing Investments in the New Era" which discussed a video (above) of a talk that Gerry Frigon gave on January 26, 2009.  It was a very dark time -- the market would reach bottom less than a month later, on March 9 of the same year. The theme of the talk was the factors that had led up to the catastrophe on Wall Street, and what investors should focus on to move forward.  

Those two subjects are related.  We argued that the over-reliance by investment professionals on math-based systems advocated by "modern portfolio theory" had played a major role in setting the stage for the panic, and that the lesson for investors going forward should be on what we called "getting back to real investing," including a focus on businesses rather than on markets.  If you don't have time to enjoy the full 39 minute video above, at least forward to the 22-minute mark which gets down to what we mean by "real investing."

It's been over three years now since that video was published, and we would like to point out that our experience since that time has borne out the assertions that we made back then.  We said that we believed there were tremendous opportunities for investors who focused on companies providing real innovation, and we have highlighted some of those companies on this blog in the years since then (see for instance here and here).  A look at the performance of our client accounts managed in the Taylor Frigon Core Growth Strategy since that time is available here.

We continue to believe that the convictions articulated in that talk from January 2009 are as true today as they were then, and that re-watching that video can be very beneficial for investors going forward from this point as well. 

One other example of a tremendously innovative company was highlighted today at the "All Things D" D10 conference in Rancho Palos Verdes, California, discussed in this article entitled "OTOY takes movie production to the cloud".  Note at the bottom of that article that Taylor Frigon is listed as an investor in Otoy (which is a private company), alongside technology and innovation prophet George Gilder.
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Three quick hits

Above is a video clip of Gerry Frigon discussing the issues at the root of the problem in Europe.  

The points made will be familiar to readers of this blog, but bear repeating.  At the heart of the disagreement about the way forward for Europe is a truth which we believe is obvious, but which many evidently still don't accept, and that is that governments don't create growth through government spending and "stimulus."  For evidence from history see this previous post.  

Elsewhere in the news, here is an excellent article from Forbes publisher and writer Rich Karlgaard, entitled "Seven Reasons Why Facebook IPO was a Bust." 

Investors should carefully consider the points made in all three -- the article by Mr. Karlgaard, the previous blog post with its embedded video (be sure to watch the video), and the video above from Gerry Frigon.
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Innovation needs capital

Tomorrow, a new company will begin trading in public markets, one that is well-known to millions (around nine hundred one million at last count, to be more precise).  Having now announced that its IPO price will be $38 per share, Facebook will be valued at roughly $104 billion and will raise roughly $18.4 billion of capital from the offering*.

The offering is being hailed as the "largest internet IPO in history"  (and in fact the highest valuation by any US company at time of offering, according to the Wall Street Journal) and receiving non-stop media coverage, with pundits opining on the things that Facebook will have to do in order to justify its lofty valuation.  

Facebook and those whose vision and hard work created the company achieved this milestone through innovation: the creation of something new (from Latin novo, meaning "new" or "fresh").  In order to create future growth that will enable its earnings to grow into its IPO valuation, it is clear that further innovation will be required from the team at Facebook.

This brings up a very important point, and one that should be very clearly understood by all investors: innovation needs capital.   In order for innovators to bring new value to others, they need capital.  Many of those who will see a payout tomorrow in the IPO are those who provided the young Facebook with capital back when it was still just getting off the ground.  Without that capital, Facebook could not have built the computer infrastructure needed to power its product, or hired the engineering talent needed to write the code, or paid for the many other people and services that it needed along the way.

Every other company whose products people enjoy needed capital as well in order to turn an innovative idea into a reality.  Most of the time, a very innovative company will eventually need levels of capital that are larger than any one family can provide.  This capital can be provided by banks, by angel investors, by venture capital firms, and ultimately by Wall Street in a public offering.

There are many voices today which vilify "bankers" and "Wall Street" as something evil or nefarious.  At the same time, many of those vilifying the forces of capitalism are happy to enjoy the fruits of the innovation that creative individuals and teams created over the years, which was watered by capital that was provided by the mechanisms that "marry up" innovation and capital.  This is a very unfortunate turn of events.

In the free world, these mechanisms allow capital to flow to innovation by free choice.  In systems other than capitalism, capital only flows to those firms connected to centralized rulers.  This alternative does not work very well at all (see, for example, the ugly example of Solyndra).  Thus, we should not be to quick to vilify the mechanisms which in a free economy allow decisions about capital flows to be made freely by private individuals (nobody is being forced to buy shares of Facebook tomorrow, for example -- that is everyone's free choice).

We need to do a better job of educating our children of the fact that innovation is a very good thing -- in fact, that it is essential -- and of the equally important fact that "innovation needs capital."

* At the time of publication, the principals of Taylor Frigon Capital Management did not own shares of Facebook (FB).
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Growth is the Answer, May 2012 edition

Here's a brief media clip of Gerry Frigon discussing the latest developments in the ongoing European saga, including the results of the elections which took place in Greece and Spain over the weekend.

The need for pro-growth reform in the struggling southern European economies ties right back to the quotation we offered recently from Friedrich Hayek (he said it in 1960): "what is most urgently needed in most parts of the world is a thorough sweeping-away of the obstacles to growth."  It also ties back to a piece we published in 2010 entitled "Growth is the answer: the primacy of human creativity," and the quotation from George Gilder cited in that piece saying, "Only freedom can enable innovation and empower progress."

What is the upshot of all of this for the investor?  For one thing, it is looking as though the markets are less and less inclined to panic over every piece of news coming out of Europe.  This crisis has been a long time in the making, and it should no longer be a surprise to anyone.  It is not going to solve itself overnight either.  Pro-growth reforms have so far been offered by neither "the left" nor "the right" (which ties back to some of the things Friedrich Hayek was saying in the other quotations we cited from him in yesterday's post).  That's because the older definition of "liberal" policies that he advocated for were quite different from what is usually categorized as "left" or "right."

We believe that the lesson that investors should take out of the woes of Europe regarding their own portfolios is a similar appreciation for the primacy of growth and innovation -- not just for their "growth" investments but also for their "income" securities as well.  If you loan money to a company or government in the form of bond purchases, in expectation of gaining an income stream until your principal is returned, be sure to examine the growth potential for that company or that country's economy as well.

Meanwhile, while it is of course important to be aware of the developments in Europe, investors should also be careful not to let the ongoing sensationalized news reporting about the situation there become a reason for missing out on investments in companies that continue to go about their business in very successful fashion in all different parts of the economy.
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Birthdate of Friedrich A. Hayek

The eighth of May marks the birthday of Friedrich August Hayek (1899 - 1992), the great economist and champion of freedom, innovation, and the removal of the obstacles to economic growth.

He is perhaps most famous as the author of the Road to Serfdom, published in 1944 and written while World War II raged.  While it deals directly with the issues that led to that war, the same issues are vitally important today.  

In fact, it could well be argued that the debates between the vision of Hayek and the vision of Keynes during the 1930s ended after the war with the triumph of the vision of Keynes.  The implementation of Keynesian policies across most of Europe led directly to the slow-motion train wreck that has been taking place in the European Union for the past few years and which will no doubt continue for years to come.

In 1960, Hayek published The Constitution of Liberty, which some scholars believe to be his most important work (portions of which are available to read online via the link above).  In it, although he wrote against the evils of socialism his entire life, he draws a contrast between his position and that of the "conservatism" that is usually seen as the opposite of socialism.  He argues that simply being "conservative" in the sense of opposing change is a negative term -- he sought a position that was positive in terms of moving towards greater freedom, rather than simply resisting change for the principle of "conserving."  

He called this active advocacy of economic liberty by the old term "liberalism," while acknowledging that this term has some problems in that it has been used to describe many who do not stand for economic freedom and that it can for this reason cause some confusion.

On page 521 of that work, he says:
Since the development during the last decades has been generally in a socialist direction, it may seem that both conservatives and liberals [and here he means the older understanding of "liberals"] have been mainly intent on retarding that movement.  But the main point about liberalism is that it wants to go elsewhere, not to stand still.  Though today the contrary impression may sometimes be caused by the fact that there was a time when liberalism was more widely accepted and some of its objectives closer to being achieved, it has never been a backward-looking doctrine.  There has never been a time when liberal ideas were fully realized and liberalism did not look forward to further improvement of institutions.  Liberalism is not averse to evolution and change; and where spontaneous change has been smothered by government control, it wants a great deal of change of policy.  So far as much of current governmental action is concerned, there is in the present world very little reason for the liberal to wish to preserve things as they are.  It would seem to the liberal, indeed, that what is most urgently needed in most parts of the world is a thorough sweeping-away of the obstacles to growth.
We would argue that these words, written in 1960, apply with equal force around the world today, and not just in Europe (where the lessons of rejecting the wisdom of Hayek are perhaps most on display at the current time).

It is certainly appropriate, on this 113th anniversary of his birth, to reflect upon his genius and consider its continuing importance.
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A "blast from the past" highlights the success of Amazon.com

There's a very interesting discussion in a book called The Dark Side of Valuation: Valuing Old Tech, New Tech, and New Economy Companies, by Aswath Damodaran (2001).  

The book's timing was somewhat unfortunate, as its opening line asked, "Do the old rules still apply?" and "Can you value a company that has no earnings, no history, and no comparable firms?" just as the dot-com bubble was imploding and many of the investors who had decided that the old rules did not still apply were watching their vaunted "new economy" collapse.  

However, Professor Damodaran's book was no cheerleader for investing in companies with no business model -- far from it.  The book actually asked some very important questions about the appropriate ways to value technology companies, advocated solid methodologies, and reached many valid conclusions.  It is all too easy to criticize the book with the benefit of hindsight, as if it should have anticipated the dot-com collapse (when those critics probably did not either).

That said, we were flipping through our old copy of Professor Damodaran's book recently when we came across a paragraph which, with the benefit of hindsight, is almost knee-slappingly funny (as much, that is, as a discussion of valuation can be).  

In a section on cash flow estimation, Professor Damodaran discusses whether an analyst should capitalize SG&A expenses for certain tech companies (capitalizing an expense is appropriate when that expense is anticipated to provide revenues over a future series of time periods – for instance, a farmer might buy a tractor which is an expense all at once but which will help him to gather harvests for several years, and thus he might capitalize that expense over the expected number of future years that the tractor will be providing him with benefits).  He uses Amazon.com* for his example, and his discussion is useful for showing just how far Amazon has come:
We decided that selling, general, and administrative expenses should continue to be treated as operating expenses and not capitalized for Amazon for two reasons.  First, retail customers are difficult to retain, especially online, and Amazon faces serious competition not only from Barnes&Noble.com and Borders.com but also from traditional retailers, like Wal-Mart, setting up their online operations.  Consequently, the customers that Amazon might attract with its advertising or sales promotions are unlikely to stay for an extended period just because of the initial inducements.  Second, as the company has become larger, its selling, general, and administrative expenses seem increasingly directed toward getting revenues in current periods rather than future periods.  115 - 116.
As stated above, it's not fair to sit in judgment with the benefit of hindsight and make fun of someone's analysis from twelve years ago (and we generally like his book and agree with most of it), but when we read that paragraph it's hard to tell if Professor Damodaran is talking about the same company that is known as Amazon today!  Twelve years later, Amazon has crushed the competitors mentioned above (particularly Barnes & Noble and Borders, the latter of which filed for bankruptcy protection in 2011), and differentiated itself quite successfully from Wal-Mart*. But at the time those words were being written, Amazon had yet to turn a profit (it would not report a positive earnings quarter until the end of 2002).

Perhaps more important, however, is the discussion of the question of whether SG&A expenses are  geared towards generating revenues in current periods or future periods.  Professor Damodaran concluded that Amazon customers "are unlikely to stay for an extended period just because of the initial inducements" and that expenses are "increasingly directed toward generating revenues in current periods rather than future periods."  

He could not have known at the time about Amazon Prime, which has almost completely reversed the situation as he describes it, and thus the fact that his conclusions appear today to be "180 degrees out" should be seen as more of a tribute to the business savvy of the leadership at Amazon than to any shortfall on Professor Damodaran's part.

Here is an article describing the significance of Amazon Prime (from February of this year).  It notes that Prime was introduced in 2005, and membership has been growing at 20% per year, but still represents only 4% of the company's total customers.  It also points out that Prime customers on average spend 130% more on Amazon than regular Amazon customers (we'd call that a refutation of the idea that customers on Amazon won't stay around for an extended period).

These are very significant statistics.  Looking at Professor Damodaran's "blast from the past" helps to highlight the significance of the achievements of Amazon as a company since the year 2000, and the significance of Amazon Prime for the company's future. 

*  At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Amazon (AMZN) and did not own securities issued by Barnes & Noble or Wal-Mart (BKS or WMT).

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