Financial Thinking

The title of this post is somewhat inaccurate. What I believe, in fact, is that ideas need to be free. This thought, however, is not widely accepted in our Western capitalist culture. Our society has constructed systems and laws around the protection of “intellectual property” in order to induce profits for thinkers and inventors and to encourage continued innovation.

This mental model shows a lack of understanding of how ideas are formed and why thinkers innovate. Corporations are motivated by profit and exist to protect their process and expand their profitability. When corporations get hold of an idea, they push for greater protection and a reduced ability by others to compete. It turns out that the whole idea of “intellectual property” comes, not from the need to protect ideas, but from the desire to translate those ideas into profitability. This is where our capitalist system demands that we strictly enforce copyrights and patent protections.

Ideas, however, do not originate with faceless, soulless corporations. Ideas originate with people. Sometimes they come unbidden, sometimes they arrive in response to creatively toying with thoughts and other ideas. Let’s look at each possibility in relation to the need for protecting ideas through restricting their adoption by others. Ideas that come unbidden are the ones that arrive in the middle of the night. Do you know anyone who sleeps with a notepad at the side of their bed? There are people who can’t sleep because their mind is spinning, running, moving around ideas, thoughts, possibilities. Only by writing down these ideas for processing during the daytime can the subject obtain a peaceful sleep. Some people wake from their sleep with ideas half or wholly formed and need to write about before the ideas are lost. Would these ideas stop coming if the subjects were not paid to produce them? Of course not. Is the case of thinkers who purposely create new ideas very different? I submit that it is not. In the same way that athletes train and politicians campaign and artists design, thinkers think. Whether their thoughts are useful or not, interesting or not, novel or not, thinking is what defines these people. That won’t change by paying them more or less.

Even though it’s not always clear where ideas come from, it usually involves other ideas. Ideas seem more organic than synthetic, that is to say they grow more than they are created. By being aware of more ideas, a thinker can more easily combine existing ideas in new and interesting ways. Or a prior idea may spark the recognition of a new idea. Existing ideas are the fertile soil from which young and tender ideas sprout and, if nurtured, grow into fully-formed ideas. If past ideas are protected or access to them is restricted, the “soil” is impoverished and not available for future growth.

Unlike the scarce resources of micro-economics, ideas can be shared, used and spread without diminishing their usefulness (quite the opposite). This is where our capitalist system can impoverish us with respect to the potential in our society. When ideas are artificially made scarce, it becomes costly to use those ideas to benefit others. One example seems to be AIDS medication in Africa, where companies who own patents want to protect their ability to profit rather than making drugs available to people who need them. This is their right, and the issue then becomes a competition between a person’s health and another person’s financial gain.

But the sharing of knowledge does not necessarily put an end to financial gain. Besides having an understanding of how to create the drugs, a group would require the ability to produce them. While we are developing new knowledge, we are also developing the ability to apply that knowledge in a useful way. Being able to apply knowledge is what sets us apart, and allows companies to profit, even when their intellectual property is no longer protected. Think, for example, of Apple, whose electronics are often imitated. Their brand is strong and respected, however, and they are extremely profitable even though their ideas (which they originate) are very difficult to protect from use by others.

The reason I write articles that are free for all to view and share is so that my ideas may respond to the ideas of others and so that my ideas may spark new ideas in others. In this way, I expect that we will all benefit as our collective thinking, about finance in this case, grows and strengthens.

Last week, I wrote about market commentary. I find it distracting to read anything that tries to predict where the markets are going or even that tries to explain why the markets are moving as they are. There is not always an explanation for the repeated quick interactions between thousands of emotional human beings. The answer to “why did a stock go down just now?” could be as simple as “it’s not very liquid and an individual somewhere needed cash.” Market commentary should be viewed with a large grain of salt, if at all.

What analysts are good at, however, is understanding the quality of businesses. Even if they can’t predict market prices (think of fluctuating P/Es, as an example), analysts can tell whether or not a company is financially strong and well managed. Reading an analyst report can be helpful in understanding a business, how it generates revenue, its level of profitability and the professionalism of management. Often, it will also include risks that an investor should beware. However, analyst reports seem to always include target prices and expected returns. It can be funny to look back over the past and review analyst reports from a couple years ago because target prices and returns are probably wrong more often than right.

The reason that analysts can’t predict future stock prices is that there are too many variables that interact in unpredictable ways. The analyst begins by predicting future earnings. I have not been trained as a stock analyst, but there are only two ways I can think of to do this. First, by extrapolating current and past earnings along a straight line. That is to say, use the current earnings growth to predict future earnings growth. This might work, except when a recession, or other negative event, arrives unexpectedly. The second method involves trying to adjust the earnings for future events, like an economic recovery, a takeover offer or a labour dispute. The problem with this method is that, even if the predicted events take place, the magnitude and timing of their affect is unlikely to be as expected.

Where fundamental company analysis can be helpful is in comparing two companies for relative strength. As an example, an analyst may look at two banks. Ignoring future earnings and future market movements, the analyst can compare current profitability, indebtedness and the quality of management to form a judgment of which company is relatively stronger. Investing in relatively stronger companies won’t avoid market turmoil, but it should provide a relatively good return over long periods of time. As an aside, this is how the first hedge fund arose; the “hedging” was pairs trading, buying strong companies while selling short weak ones. The difference in growth became the return, while hedging away market fluctuations.

When I write about stocks as an “investment idea”, my purpose is to look at the quality of the company. I try to find whether or not the stock is priced attractively in the market compared to the past. I try to see whether the earnings have been consistent and whether or not management is capable. I find the debt level to try and determine the risks. I don’t claim to know whether or not the price of a stock will rise or fall in the future, since I view that as unknowable. This explains why I prefer stocks that pay a dividend: it makes one aspect of the total return more predictable.

Casual investors seem to believe that it is helpful to stay abreast of market news. Even market commentary seems important to them. They start to check stock prices daily and even watch BNN. How helpful is this?

How would you feel if you walked into your stockbroker’s office and she had BNN on. You ask her: “What are you watching?” “BNN,” she replies. “I’m just getting ideas for your portfolio.” If this seems perfectly logical to you, stop reading. The rest of us realize that the media simply filter and promote a single, narrow view of the world. I’ve had a number of examples of clients phoning to invest in a stock that they “found” on BNN, where the price had run up (causing the interest by BNN hosts, but then caused by the interest among BNN viewers), they purchased it and it continued to run for a day or two before falling back to pre-media coverage levels, well below what the client paid for it.

Market commentary is the worst form of this distraction, though. It consists of creating a backstory for whatever is happening or has happened in the market. Here is an example of something I received in my morning email, from my employer. This is verbatim, unedited, with nothing added or removed:

European stocks are higher in spite of political turmoil in the Middle East as investors have faith that the global economic recovery will not be swayed by current geopolitical challenges. Stocks in Asia however are sliding lower as fighting in Libya persists as higher oil prices weigh heavily on airline stocks.

Look at that. Fighting in Libya is NOT the reason that European stocks are higher, but fighting is Libya IS the reason Asian stocks are lower. The rest of the email read very similarly. I guess fighting in Libya is the only thing going on in the world that could explain the movement of stock markets. And as we’ve seen above, the effects are unpredictable.

In my mind, this type of intellectual dishonesty (unintentional, I’m sure) is why market commentary is useless and stock analysts can’t predict future prices. We don’t know what the outcome will be of the fighting in Libya, we don’t know what other global events might transpire and, even if we did, we can’t predict how they might affect the future prices of stocks.

Freedom does not seem to be a universal value. I say that because not everyone values freedom and is willing to work for it. It appears to no longer be uncommon for young people to live at home or in their parents’ basement into their 30s. This is not a criticism of those people, who probably face difficult choices. But not everyone is trying to find freedom. Those who are will probably move through the following stages. These don’t necessarily happen in order or over a set timeline. However, freedom is a mindset more than anything, and I believe that it is at odds with the default outlook of much of our society.

An early stage is becoming independent from parents and caregivers. For me, this included living abroad and attending university away from home. I learned many skills and improved my ability to manage my life. It was a first step toward self-determination. The education I got wasn’t particularly practical, and it didn’t lead to a specific career path. I get the impression that there are people who go to university so they won’t have to determine their life work. They choose a course of study that leads to a predictable career path. The transition from education to working, often in a large corporation, takes little real though. Some of these people never had dreams of anything larger, while others give up their dreams in order to be practical. I don’t mean to say that these people aren’t free, but in my mind freedom equates with choosing what to make of my life.

I have noticed that employment can cause dependence in two ways. First, it provides a regular income. Many people translate this into regular spending patterns and much of the money becomes committed before it is earned, either to debt payments or consumption patterns. We might allow our neighbours to dictate our lifestyle, by trying to “keep up with the Joneses.” And while earning a generous income can move a person toward eliminating debt and building financial independence, when combined with expectations for consumption it can be addictive. Second, work provides meaning and opportunities for socialization for many people. How many people define themselves by the work they do? When I meet new people, and they ask what I do, I sometimes wonder if they see me as “a stockbroker”, or if they are simply curious about how I spend a large part of my time. Being free means having meaning in my life outside of my employment and having a lifestyle that could survive a disrupted income.

A major hindrance to freedom is debt. Debt has rightly been referred to as economic servitude. When people buy anything, including a television, a vacation or a car, on a payment plan, they are giving up some of their freedom. They put at risk their assets and their credit score in order to have instant gratification. There are debts that make sense, when it’s a house or an education, but even then caution is warranted. I was talking with a retiree the other day who bought his first house for less than his annual income. It was a 500 square foot bungalow. Another retiree told me that they bought an 1100 square foot bungalow and their parents asked how they would be able to manage so much house. Is it necessary to go into 30 years worth of debt for a house? Is 10 years of debt reasonable for an education?

Suppose, then, that an individual is free of debt and gains financial independence. This is economic freedom, but there’s more to life than just money. To truly feel free, people need to feel that their life is meaningful and that they’re making a difference. As far as I can tell, people have a desire to use their abilities to create something worthwhile. This may be dependent on economic freedom, but it may be a completely separate aspect. There may be no need to be financially independent before figuring out what you should do with your life. It seems like the passion that results allows people to support themselves and their families with income, if necessary.

Freedom doesn’t necessarily take money. Economic freedom depends on being free of debt and being able to produce enough income to support oneself, whether it’s through work or investments. Freedom in the rest of life is the ability to work for something that is meaningful to oneself. Whether it’s a job, a cause or just a hobby, freedom comes from knowing that you are spending your time and energy in the way that’s right for you.