The Greatest Time To Build A Fortune Is Now

From Is Value Investing Broken? by Geoff Gannon:

There’s a tendency for people – people of any time – to see the time they live in as unique, dangerous, different, unlike any other age. In some ways, they are always right. Some things really are different this time from all other times. But, mostly, they’re wrong. And what they are wrong about is reading a golden age of stability into the past. I was talking with a value investor once and this value investor said that sure Ben Graham’s ideas worked in Ben Graham’s times. But Ben Graham invested in simpler times.

Here are the times Ben Graham invested in: the 1910s through the 1950s. He invested during Two World Wars, the start of the Cold War, the atomic bombings of Nagasaki and Hiroshima by the U.S. and then the testing of nuclear weapons by other countries, The Great Depression, a big explosion (reportedly a terrorist bombing) on Wall Street, and the longest shut down of trading in Wall Street history that I can remember at least (right as World War One started). People talk about political risk today. Political risk in Ben Graham’s time meant Marxists and Fascists. Investors saw hyperinflation in Germany after the war and then they saw deflation after the 1929 crash. These were not simple times. If you go back and read the newspapers from the time – you can see how not simple they were.

Now, yes, they were different from today in some ways. Much of the period investors and economists in the U.S. study were more regulated than today. So, you either had the Gold Standard or Bretton Woods. You had much greater belief in planned and insular economies in a lot of countries. With the benefit of hindsight – and seeing the entire sweep of history – many of these decades seem simple to us. They rarely were. Try to find a decade without too much inflation, too much deflation, too much war, the mania of some bubble, or the bursting of that bubble. At any point in that past, people could have believed value investing was dead. And yet, buy and hold investors – business owners and the like – have been compounding fortunes in the U.S. from the 1800s through today. If there are companies that can make founders and their families billionaires – there are companies that can make shareholders very rich if they buy and hold.

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Sorry, The Economy Is Officially Closed

One way to describe what I do for a living is “capital allocation.” Really, I am like an internal strategic consultant to a family business (a family of which I am a part) so there is more to it than that, but thinking about where to put our capital is one of the primary functions I serve.

One interesting problem to have when one owns things of value is receiving bids on those things from people interested in buying them when you’re not sure you want to sell. The further above your own estimate of “fair value” their bid goes, the stronger the temptation to take advantage and sell your asset. It seems like a pretty straight forward problem to solve.

The only problem is the market context of the potential sale. Generally, if you’re in a position to get more than fair value for what you’re selling, you’re going to have a hard time finding another asset to buy where the seller isn’t facing the same dynamic. In other words, you can potentially sell one asset at an inflated price and buy another at an inflated price– you’re probably better off just holding on to what you have because there’s no arbitrage in that and it could very well cost you money in terms of frictional costs like brokerage commissions and taxes on imaginary capital gains.

One thing you could do is sell your asset at an inflated value and sit and wait in cash for a better buying opportunity. The problem with that is that cash is, currently, a seemingly barren asset. If you stuff your haul into T-Bills, you’re lucky to earn a few basis points every 90 days– it might as well be zero, and when you factor in the effect of inflation and those damned capital gains taxes once again, it probably is. You could go further out on the yield curve and buy some 10YR Treasury notes, but then you’re exposing yourself to substantial interest rate risk with yields flirting with historic lows.

Meanwhile, most asset owners are earning strong internal returns on their invested capital right now. Say you’re earning 20% a year on your investments, why would you sell them to collect 1.5% over the next 10 years while taking enormous interest rate risk? Or to collect zero for some unknown amount of time sitting in T-bills or cash in a savings account? Every year you stay invested, you get ahead by almost 20% more. Could the value of your investment really drop by that much?

The business cycle is an inevitable fact of owning and operating a business in a modern economy. The question is not could it, but when will it drop by that much, or more? For many business owners and investors, the waiting is the hardest part. Giving up 20% a year for some period of time and avoiding the risk of a 50-60% or greater decline in asset values just isn’t attractive. It isn’t even attractive when thinking about the fact that buying back those same assets at half price could potentially double your return on invested capital during the next boom, an interesting strategy for shortening the compounding time necessary to achieve legendary riches.

For many, this inevitable decline in asset prices is inconceivable. It’s embedded deeply in the fear of selling and going to cash. The implication of this premise is that the economy is officially closed to additional investment. Those who invested earlier in the cycle can stay inside and watch a magnificent show as they earn outstanding returns on their capital while the boom goes on. But for everyone who sold too early, or never bought in, they have to wait outside, indefinitely, and wonder what it’s like– the cost of admission is just too high.

What makes this a stable equilibrium? By what logic has a competitive market economy become permanently closed to new investment, or a change in asset values, or a change in ownership of assets? Under what set of premises could this condition last for a meaningful amount of time and leave people who sell now out in the cold, starving and bitter for returns on capital, forever, or for so long that they would be losing in real terms over time in making such a decision?

To me, this “new normal” is absurd. It is juvenile to believe that the economy is closed and no one else is getting in. It’s silly to think that the people willing to pay those astronomical prices for admission are making a good decision, that they’re going to have a comfy seat and years of entertainment, rather than paying more than full price for a show that’s about to come to an abrupt end. It’s a topsy-turvy world in which the reckless and courageous high-bidders are the ones who get rich. If paying too much for things was the path to riches, we’d all be there by now. I think when everyone’s perception of reality and value skews toward a logical extreme like this, we’re closer to the show being over than the show must go on.

In the meantime, sorry, the economy is officially closed.