Tuesday, June 16, 2009

Michael Porter on Business and Investing

Check out this article from last Friday. In it, Michael Porter provides another view on the current state of business and investing and talks about the damage being done by short-term thinking.

"With so much focus on the immediate value of stocks, and the resulting costs from short-term trading in and out of individual company shares, "the stock market now is a tax on the real economy."

"The financial sector is extracting value from the rest of the economy [through] fees, costs and expenses." 


To me, this take on the impact of today's prevailing investment practices is in many ways similar to the views stated by Munger, Bogle and Buffett (among others) in recent years. Here are a few quotes from previous posts that are consistent with what, I think, Porter is saying.

"And that's where we are today: A record portion of the earnings that would go in their entirety to shareholders - if they all just stayed in their rocking chairs - is now going to a swelling army of HELPERS" - Warren Buffett in the 2005 Berkshire Hathaway Shareholder Letter

"I will join Galbraith in coining new words, first,
'febezzle', to stand for the functional equivalent of 'bezzle' and, second, 'febezzlement', to describe the process of creating 'febezzle', and third “febezzlers” to describe persons engaged in 'febezzlement'. Then I will identify an important source of 'febezzle' right in this room. You people, I think, have created a lot of 'febezzle' through your foolish investment management practices in dealing with your large holdings of common stock.

If a foundation, or other investor, wastes 3% of assets per year in unnecessary, nonproductive investment costs in managing a strongly rising stock portfolio, it still feels richer, despite the waste, while the people getting the wasted 3%, 'febezzlers' though they are, think they are virtuously earning income. The situation is functioning like undisclosed embezzlement..." -
Charlie Munger speaking to investors at the Philanthropy Round Table in 2000

Note: Telling a group of professional money managers that they are the functional equivalent of an embezzler may seem brutal, but I think if you read the whole talk by Charlie you'll see he does a good job of thoughtfully backing it up.

"As stocks became entertainment, perhaps our greatest circus became our financial markets." - John Bogle from his 2005 book "The Battle for the Soul of Capitalism"

"When we should be teaching young students about long-term investing and the magic of compound interest, the stock-picking contests offered by our schools are in fact teaching them about short-term speculation." - John Bogle from his 2005 book "The Battle for the Soul of Capitalism"

"In other words, the burden of paying HELPERS may cause American equity investors to earn, overall, 80% or so of what they would otherwise ean if they just sat still and listened to no one." - Warren Buffett in the 2005 Berkshire Hathaway Shareholder Letter

Changes to prevailing investment practices isn't going to happen anytime soon. Today, what dominates is a high frictional cost approach with an emphasis on speculation, instead of a low frictional cost approach with emphasis on the magic of compounding.

A generation of investors seem to now have these habits and quite a lot of the money management industry's business incentives are built upon it. Tilting investor behavior toward low frictional costs and compounding would seem to be a wise move, but I don't expect it to happen soon.

At a minimum, as an individual investor you gain tremendously by going with this approach (Newton's 4th Law) in the long run. No need to wait for the rest of the world to come around to the Berkshire view of the world. What they do works. Buy durable businesses at a fair price...let high-powered compounding (i.e. by owning shares in high return on capital businesses) work.

As Porter says above, "the stock market is now a tax on the real economy". To me, that is measured both in terms of 1) direct fees, commissions and 2) an ever increasing tendency to attract the best future engineers, mathematicians, and scientists for largely unproductive activities and away from more productive areas. (BTW - I don't blame anyone for wanting to get rich at a hedge fund. As long as the incentives are there I expect them to do it. My inclination is to adjust the incentives so more want to use those talents creating new science and technology.)

"It's my guess that something like 5% of GDP goes to money management and its attendant friction. ...Worst of all, the people doing this are among the best and the brightest. Hundreds and thousands of engineers, etc. are going into hedge funds and investment banking. That is not an intelligent allocation of the brainpower of the civilization." - Charlie Munger at the 2005 Wesco meeting

Moving capital to the ideas that need it most is the purpose of a stock market...it's not meant to entertain us.

Adam

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