Investing as an Entrepreneurial Endeavor

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"Entrepreneurial
judgment cannot be bought on the market. The entrepreneurial idea
that carries on and brings profit is precisely that idea which did
not occur to the majority. It is not correct foresight as such that
yields profits, but foresight better than that of the rest. The
prize goes only to the dissenters, who do not let themselves be
misled by the errors accepted by the multitude. What makes profits
emerge is the provision for future needs for which others have neglected
to make adequate provision."

~
Ludwig von Mises, Human
Action

For
the typical investor and his adviser, Mises' insight about the origin
of profit must seem out of touch with present day reality. It is
commonly thought that the U.S. economy reaps the benefits of an
entrepreneurial economy and its stock market is merely along for
the ride, providing participants double-digit returns as far as
the eye can see. Stock ownership has in recent years come to the
masses, who fully expect to profit not from their own unique vision,
but because "stocks always go up in the long run," or
so they are told.

Was
Mises wrong? Can the multitudes profit in the investment sweepstakes?
Is capitalism, in fact, democratic? Are we entitled to all get rich
together?

Looking
at the great bull market from 1988–1999, the answers appear
to be "yes". The S&P 500 returned 19.0% per annum
with dividends reinvested. Even if the 2000–2002 bear market
is included, stocks gained 14.2% annually for the 1988–2004
period.

Unfortunately,
the typical investor did not achieve these returns. First, he was
late to the party. In 1989, at the onset of a decade that saw the
Dow Jones Industrials Average quadruple, just 31.6% of households
owned stock. By 2001 stock ownership had swelled to 51.9%. Second,
investors chased momentum to their detriment, in essence navigating
the markets through a rear-view mirror. According to a recent study
by financial research firm Dalbar, from 1984-2002 the S&P 500
returned 12.2% annually, yet the average stock investor earned a
meager 2.6% per year.

How
can Austrian economics in general and Mises' wisdom about entrepreneurial
profit in particular improve an investor's returns? We think in
several ways:

  1. Invest
    in market entrepreneurs with a margin of safety (sustainable
    businesses, reasonable valuations, and solid balance sheets).
    A rising tide makes it more difficult to identify true entrepreneurs,
    at the same time lowering investment returns by driving up valuations.
    Better to wait for the tide to ebb, exposing those "swimming
    without a bathing suit," as value investor Warren Buffett
    suggests. Avoid political entrepreneurs (e.g. Enron) who attempt
    to circumvent the whims of the consumer and the vagaries of
    the competitive marketplace by convincing government to grant
    them some sort of privilege or protection.
  2. Look
    for investment opportunity in foresight apart from the consensus.
    Stock prices already discount the collective expectations of
    investors. It is the unexpected that moves markets. The
    larger the crowd, the more emotional and irrational, and more
    likely to be wrong in its assessment of the future. An investor
    does not need a crystal ball to succeed, just a more accurate
    glimpse of the future than the rest.
  3. Avoid
    the economic errors of the crowd. The typical investor is
    unaware that 1) central bank induced credit expansions create
    artificial booms (bubbles) inevitably followed by painful waste-removing
    busts, 2) increased government spending plus tax cuts equals
    an irresistible temptation to inflate, 3) unrestricted trade
    is a blessing, and 4) economic law ultimately prevails despite
    government attempts to interfere in the process.

Just
as a forest fire provides plenty of sunlight and nutrients for renewed
growth, economic busts create an ideal environment for entrepreneurs
to emerge. During the 1930s and 1940s, great growth stocks like
3M, Eastman Kodak, and IBM performed admirably, though they went
largely overlooked. During the 1983–1989 technology stock bear
market, hundreds of companies disappeared, only to be replaced by
a new breed of saplings. This is when the next wave of growth companies
like Compaq, Cisco Systems, Microsoft, and Dell Computer went public.

During
the dot-com bubble of the late 1990s, Michael Dell commented on
how the landscape for startups had changed since he took his company
public a decade earlier. A true entrepreneurial company must deal
with adversity and scarcity, he reasoned. The problem with Internet
startups was that they were spoiled, showered with venture capital
funds, and highly unlikely to build a corporate culture of thrift
and long-term profitability. Prophetically, the survival rate for
the Class of 1999 turned out to be miniscule compared to that of
1989.

The
interplay of wealth creation (entrepreneurship) and destruction
(government intervention) is constantly at work; it is the focus
and mood swings of investors that change. During the late 1920s
investors turned their attention to the positive — the wonders of
new technology such as autos, electrification, radio, and the telephone.
Meanwhile, the negative — government goosing of the money supply
in the name of maintaining a stable price level — went either largely
unnoticed or celebrated by mainstream economists as a powerful force
to prevent any serious downturn, both for the economy and the growing
crowd of stock investors. The "New Economics" of 1929
was followed over time by similar flights of fancy regarding government's
ability to manage an economy: the U.S. "New Era" (late
1960s), "Japan Inc." (1989), and a global "New Economy"
(2000).

In
contrast, major stock market lows are often set when the failures
of the state are exposed and become engrained in the public psyche.
Depression (1932), world war (1941), expected return to depression
(1949), inflation (late 1970s), and deficits (late 1980s) created
the best buying opportunities for investors of the past 75 years.

How
can an investor profit today? Asked another way, how does the future
— viewed through the lens of an Austrian economist — differ from
the outlook of the typical investor? The greater the disparity,
the greater the potential for profit. (This may sound dangerously
close to forecasting, an exercise Austrians know is impossible with
any degree of precision. Investors must avoid this trap, instead
assigning probabilities to various scenarios in an uncertain future
— what entrepreneurs do all the time.)

From
all appearances, investors today are optimistic. The most recent
Investors Intelligence poll of investment advisers shows 56.3% bullish
and just 17.7% bearish. Equity mutual fund managers hold just 4.7%
of their portfolios in cash, down from 9.4% in 1988. Equities account
for nearly 50% of the assets in pension funds and insurance company
portfolios, up from 28% in 1988.

Goldman
Sachs strategist Abby Cohen sums up the consensus view: "What
matters most is that investors are confident of the sustainability
of economic growth." Few doubt that tax cuts, increased government
spending, and the most aggressive Fed easing in its history will
have the intended effect. There is a palpable belief that Greenspan
& Co. will pull all the right levers. Inflation is thought to
be low and expected to remain so. Interest rates are seen drifting
upward at a "measured pace," though not enough to make
record debt levels unmanageable.

Residential
real estate lending is aggressive and standards increasingly lax.
A local banker told us that five years ago the mortgage payment/pre-tax
income ratio on any home loan could not exceed 28%; today it is
not uncommon to see ratios above 40%. In Orange County, California,
a first-time home buyer recently secured a $360,000 mortgage with
nothing down and a ratio of 50%. Nearly everyone is convinced "real
estate always goes up" and that a worst-case scenario is a
slowing in home price increases.

Are
investors justified in their optimism? From an Austrian perspective,
there appear to be several likely events, in order of their unfolding:

  1. The
    economic recovery will derail once the credit drug wears off.
    Since early 2001, thirteen rate cuts by the Fed (with plenty
    of help from the world's central banks and GSEs) stimulated
    little more than the accumulation of debt. From 2000 to 2004,
    total personal debt/GDP climbed from 66% to 83%. Personal debt
    payments/disposable personal income increased from 12.44% to
    13.22% over the same period, despite interest rates (as measured
    by the 10-year Treasury) dropping from 6.28% to 4.44%. By interfering
    with the healthy unwinding of the tech/telecom/Internet bubble
    of 2000, the Fed helped foment the current much larger housing
    and consumption bubble.

    Investors
    should sell real estate in the most speculative markets: southern
    California, Florida, New York, and Washington, DC. They should
    avoid stocks of mortgage lenders, mortgage insurers, banks, credit
    card companies, homebuilders, consumer discretionary items (autos,
    appliances, furniture, and restaurants), and luxury goods purveyors.
    There will be few safe havens. Perhaps stocks in consumer staples
    (food, tobacco, alcohol, and utilities), oil and gas, discount
    retailers, and manufactured housing will hold up relatively well.
    For the more daring, short selling or buying put options on the
    most egregious extenders of mortgage credit (such as Fannie Mae
    and the sub-prime California-based lenders) should provide speculative
    profits.

  1. Inflation
    will return with a vengeance. The government's deficit is
    expanding and the Fed is on a mission to print money. If the
    stock, bond, and real estate asset balloons break, this new
    money will have nowhere to go but into goods and services. Foreign
    investors (mostly Asian central banks) have soaked up much of
    the new credit creation since 2000. Should they ever slow their
    appetite for dollars or actually begin selling dollars, gasoline
    would be added to the current smoldering inflation fire.
  2. Year-over-year,
    money supply (M3) is +7.0%, import prices are +4.6%, gold is +8.8%,
    and even the statistically challenged Consumer Price Index is
    +3.1%. Investors should sell bonds and dollars, and buy gold,
    commodities, and short-term government notes in select foreign
    currencies.

  3. The
    long march of global capitalism will continue. As billions
    continue to extricate themselves from the abyss of socialism,
    they will greatly expand the global division of labor. Countries
    like China and India will require more commodities, especially
    energy, as living standards improve. They will increasingly
    put global capital to productive use, making it more difficult
    (and more expensive) for Americans to attract capital merely
    for consumption.

Investors
will eventually wake up to the reality that the U.S. is no longer
the center of the universe. With less than 5% of the world's
population and 21% of its GDP, the U.S. commands 45% of its
stock market capitalization (up from roughly 30% in the late
1980s) and 69% of the world's foreign exchange reserves. Though
there will surely be short-term setbacks, investors should keep
an eye on Asian stocks (including those in Japan), commodities,
and stocks in commodity-based countries over the long haul.
They should also diversify their cash and fixed income holdings
away from dollars.

Market
entrepreneurs tend to be optimists, finding solutions where others
see only obstacles. In fact, their optimism often gets them into
trouble, falling for the false signals of an artificial boom that
inevitably lead to a cluster of errors. Entrepreneurial investors
must instead be skeptics and realists, not allowing their judgment
to be clouded by overly rose-colored or opaque glasses.

Can
the concept of entrepreneurial profit be applied to a political
cause, such as the pursuit of a free society? We believe so. If
"profit" is measured in added credibility or new members
enlisted to the cause, opportunity is maximized by dissenting, not
camp following. If the opposition is spreading lies to the gullible,
exposing the truth can hardly be expected to make one popular in
polite conversation, yet the exercise will pay the greatest dividends
once the truth is revealed.

The
greatest chance to advance the cause for freedom is where government
is most powerful, accepted by the masses, arrogant, and thus vulnerable.
These areas are easily identified because they are surrounded by
the most outrageous lies and myths: the imperial presidency (Lincoln,
Wilson, FDR, and recently Reagan to a lesser extent), the war on
terror, and the seemingly omnipotent and omniscient institution
of central banking.

Investing
is an endeavor in which the most succulent fruit is reserved for
the contrarian. As the size of the crowd and level of group-think
increase, so does the opportunity for profit. For both the entrepreneurial
investor and promoter of the free ideal today, this is welcome news
indeed.

July
13, 2004

Kevin
Duffy [send him mail]
is a principal of Bearing Asset Management.

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