— Karl Marx
Investing your capital, besides its financial incentives, allows for the efficient distribution of access to money to where it is needed most. Hence, investing is important for world organizations, single states, communities, and individuals. You, as an individual, play a major role in this economic structure. Your investments are an economic resource that can create jobs, develop new technologies and help accelerate the development of human life and society as a whole. Your investments, if made properly, will enable you to see your wealth increase through either annual returns or modest capital increases. It provides each individual with more capital that can be reinvested in new investment projects, which repeats the cycle of growth and prosperity.
Investors needed some objective references and structure for deciding to where to put their precious capital, leading to the development valuing property on the basis of understanding risk and return. In this chapter, we will have a look at capital protection through the rights of property ownership and the mechanism of assessing the fair value of any investment to further reduce risk.
Personal property
In early civilization and throughout history, merchants and farmers made independent investment decisions based on the data they had available, without being able to predict the future or even the understanding of the basics of economic activity. Additionally, they constantly had to deal with the uncertainty of having their capital returned. The fiction of universal trust in credit and a better financial future still did not exist at that time. So even before people could engage in any sort of investing at all, there needed to be a consensus on what, exactly, was being invested in. In other words, people needed a generalized concept of private property, before they could even begin to consider taking their property and increasing its value.
Without the notion of property—more specifically, the right to own property—we’d still be fighting like barbarians, killing and ravaging villages, states, and other countries, just to get other people's possessions and wealth. Hence, private property is one of the first things covered in early law codes. Eventually, and as early as the reign of Hammurabi in Babylonia (c. 1810-1750 BC), there were clear concepts of a debtor and debt – that is, the idea that someone owns something exclusively, but can temporarily give possession (but not ultimate ownership) to someone else. Crucially, this was all done with the understanding that they would have to give it back at an agreed time.
Over time, these contracts have become more elaborate and complicated, with each one having their set of unique stipulations and terms. Today, if you hear people talk about investing in real estate, stocks or bonds, they are basically referring to different types of sophisticated contracts that protect their property. The bottom line is this: the laws and conventions which handle the movement of wealth are the most important part of any financial system. As we shall see, it is through manipulating and controlling these codes that the world’s elites maintain and justify maintaining their wealth.
Having your property protected by law does not mean that you are protected from entering financially unfavorable contracts that would result in a loss of money. What is paid for an asset and what is gotten in return, is entirely the investor’s responsibility. Therefore, one of an investor’s primary responsibilities is ascertaining what kind of contract is being entered into, and having, at the very minimum, an understanding of the underlying asset. As a good friend and professional investor once told me about adding something to my investment portfolio, “You should date a bit before you make a final decision.”
Another essential framework is valuation and valuation theory. Valuation, determining the value of an investment, has become the single most important factor in making more informed investment decisions.
Unfortunately, valuing an economic asset has also been the starting point for some amount of skullduggery and corruption. How do we value something today on the basis of uncertain returns in the future? What are the odds of money flowing back into our pockets, and more importantly, how much? And how much money would be in it for you? Take Google Inc. for example (now Alphabet Inc.). We all know the company, we all use it, and we all know they made $16.3 billion in 2015 and most likely have a bright future ahead. But how do you value the company, exactly, without accessing all sorts of data you don’t have? More specifically, what price should be paid today to receive the value we hope to receive? Whereas this relationship is apparent when purchasing consumer goods, it is much more complicated for investments, and learning to handle the difference is crucial to success.
Baseline Valuation
If you buy something for your home (i.e., a piece of furniture), this new item is your property; and in accounting terms, it will be booked in your asset column of your personal balance sheet. The left-hand column lists all your possessions, usually in order of liquidity, i.e. how quickly we could turn it into cash. You start with cash, gold, and all your jewelry first and end with your house, your cars, everything you’ve ever bought.
Now, this left-hand column has a tendency to decline over time, if you don't add anything new. One reason is that most consumer items decay over time. But if you had just to sell everything you own, you could do so at an estate auction, when entire households are auctioned off. The money you would get through liquidating your entire asset column at short notice is an investor’s base valuation model. Professionals call it the liquidation value.
Imagine, though, if we sold all of Google's physical assets today—all the crazy and colorful furniture, massive servers and candy bars from their offices around the world, we wouldn't get much. At least, nothing close to Google’s listed market capitalization of more than $500 billion in the middle of 2016. So where does that figure come from? What constitutes and explains this massive discrepancy between liquidation valuation?
Cash Flows
The difference can be easily explained by the money that flows into Google’s pockets on a daily basis. This is known as cash inflow or free cash flow. Free cash flow just means the money in your pockets, the net of all monthly financial obligations and money spent to maintain existing operations. It is these cash flows today, and into the future, that makes Google so valuable.
If you ever wanted to put a price tag on yourself, you would use the same rationale. If you add all cash you would ever earn over a lifetime, and add all our possessions at liquidation prices at the end of your life, discounted by the risk-free rate that represents our opportunity cost (more on this topic later), you could, roughly estimate your personal value today.
In reality, this is certainly much more complex. As an individual, the capacity to earn money in the future grows over the lifetime of a career, and the risk-free rate might change dramatically, as it has so many times before. Your personal value increases with your earnings potential, i.e. the potential to increase your salary over time. Unfortunately, we all have only a vague idea of our future earnings potential, so your personal price tag varies, depending on the investments in yourself or your personal achievement at your current job. The more relevant data we have available, the easier it is to assess one’s monetary value. The price tag of a commercial banker with ten years of experience is much easier to calculate than a teenager’s value. The teen may grow up to be the lead singer of the world’s most successful rock band – but then again, may not. The commercial banker, on the other hand, is probably going to make $200k next year plus a considerable bonus. Given a choice, who would you invest in?
The Chicken Conundrum
To demonstrate the power of cash flows, and the effects it has on the price of investment opportunities, I would like to introduce my friend, the Cash Flow Valuation Chicken.
Let’s assume you have a chicken that lays an egg every day, an egg which you sell to your neighbor for $1. After a month, you have sold 30 eggs, so you have $30 in your pocket (minus all the chicken feed for a month).
Now imagine your neighbor wants to borrow that chicken for a month. How much would y
ou charge your neighbor for that rental period? It makes sense to charge him $30, right? That’s what your chicken would be worth if you kept it for yourself.
But let’s imagine that, the day before your mother’s birthday, you neighbor comes to you and says he’ll pay you $27 for your $30 chicken. You don’t want to say yes, of course, because it’s $3 less than you would have made. But, you know, and your neighbor knows, that there is no other way you have of securing money before your mother bursts into tears because, yet again, you forgot she was turning 43. So you take the $27 and call it a day—because 90% of the price is surely better than 0%, right?
Now, it turns out your neighbor is the crafty sort. He’s sold all those eggs to his wealthy friend, who has plenty of money, for $1.50 each, and made $45 already! So, from your neighbor’s perspective, he has $42 minimum (subtracting about $3 for feed, etc.), minus $27 rental, earning him a nice profit of $15.
Your neighbor was able to do so because he had a pure information advantage – namely, that his wealthy friend would be happy to buy an egg for 50% more than he would. Among investors, we call this a mispriced investment—one that was undervalued due to the missing information.
But then, disaster! The rich customer finds out about the price markup and now will only pay $1 per egg like everyone else. So the next year, your neighbor won’t rent the chicken for $27. He does remember, though, that your mother’s birthday is soon. He’s a good man and wants to help you out, so he offers to rent it for $15. Less than last year; but since you need the money now, you take the deal. This time, he sold 28 eggs and made the expected $28 in revenues minus the $15 rental price—a nice net profit of $13. Again, not a bad return on investment. And again, he had a simple information advantage: he knew that your mother’s birthday was coming, she always wants expensive presents, and you’re always broke this time of year. Again, the bet or investment was mispriced from his point of view, with almost no risk for him.
Returning to investing, any investment needs to be valued on the basis of its future cash flows to determine a price you would be willing to pay today. This is where even the most intelligent, experienced, and most informed market participants make mistakes. They overpay, make ridiculous assumptions, and later sell in panic when cold reality sets in. Why do investors make errors in such predictable fashion? Why do they continually overpay for something even though they are aware their assumptions might be a bit on the optimistic side? There are three logical explanations for this:
They have no intention of investing in the proper sense of the word. They just want to speculate on rising prices. For example, speculating that egg prices will increase dramatically, or the demand for chickens suddenly increase. The chicken itself is not important.
They overpay for investment by miscalculating future cash flows. Humans tend to be overly optimistic, especially in a conducive environment. Hoping that a chicken would lay two eggs a day instead of one, because that is what everybody else believes and is promoted by chicken salespeople.
They just didn’t know what they were buying in the first place. They thought they bought a wool-giving sheep, but received an egg-laying chicken.
What we can take away from this: know your chicken, and don't overpay for it.
Financial Markets
In the above chicken example, both parties negotiated a private contract and all its terms between the lender and borrower. This is often time-consuming and inefficient. This is why financial markets are so important for our economic system today. They don’t only raise capital for people with ideas and expansion plans, but they also put a price on vast amounts of financial assets around the world, ranging from equities to bonds and complex financial products. By so doing, they provide all players with a daily reminder of their wealth.
Delving deeper, the functions of financial markets can be divided into raising capital for businesses on one hand, and providing a place where buyers and sellers of issued securities agree on prices on the other. This latter function is much more potent in creating and destroying fortunes. Among professionals, these two functions are known as primary and secondary markets, and we will learn more about them below.
Primary markets are where actual money is raised for the party that needs capital. The most common image a bystander might have of primary markets is that of stock exchanges, such as in New York, London or Tokyo, and their regular IPOs (Initial Public Offering). When a private company goes public and sells its shares to the public, it can either raise capital by issuing new shares or simply sell its existing shares from early investors. An IPO also gives permanent access to public markets, in order to raise more capital, if the need arises.
Today, as in the past, shares can only be sold and transformed back into cash by selling to other investors, usually through an agent or a broker—“game facilitators.”
The secondary market’s purpose has nothing to do with raising money, as no money flows to the corporation which issued these securities in the first place. For instance, when you buy shares of Google through an online broker, no money flows to Google. Someone who previously owned the same shares of Google decided to sell. In this world, Google might not even exist. It could be an imaginary entity. The question would then be at what price should one investor sell to the next investor. That is where secondary markets reveal their real power and influence over investors.
The Pricing of Everything
A theory states that asset prices fully reflect all available information, and hence financial products such as stocks always trade at their fair value; over- or undervaluation can therefore never exist. This is somehow contradictory to another common law of economics—the law of supply and demand. Basic economic theory of supply and demand teaches us that price quotations are a function of the immediate demand and supply for the item in question. When there is high demand for goods or services, but the supply is limited, the price automatically goes up, regardless of the long-term outlook. We can observe this phenomenon when we go on vacation and have to deal with in-season prices. The same idea applies when we buy luxury brand items. A handbag that has a highly sought after brand name can be ten times more valuable in the eye of the beholder than the same bag produced in the same factory without this particular brand logo. So how can we always have fair prices, when there is an unreasonable or even irrational demand for goods or services? It gets fascinating when we add the element of deception and supply and demand manipulation to the price equation.
The real issue is that future cash flows for most private business investments and even real estate investments vary and fluctuate. It can drop or rise depending on the economic environment, or even seasons. For new business ventures operating in the field of High-Tech, pharmacy, and biotechnology, we don't have a conclusive set of data that would allow us to make any constructive estimates about cash flows far into the unknown future. We are like the early explorers searching for new riches in far distant regions, but risking our wealth (but not our lives). It is this hope and imagination of future wealth that keeps any financial expedition alive.
For investors, today’s known cash flows are stories of the past, and what really counts are future imagined cash flows. Here is where the fiction starts. In our Google example, if the majority of Google’s shareholders believe that the company can grow its future cash flows substantially, higher market prices are justifiable today. Unfortunately, nobody knows if any particular scenario comes to fruition. There is the factor of uncertainty; the unknown that makes things so interesting for investors and punters alike.
However, uncertainty is only a function of how much you don’t know. In other words, the more you know, the less uncertain you are about your investment. It is only natural to assume that business insiders might be better equipped to anticipate future growth and revenue streams of their operations in question. Outsiders, by definition, have less insight, unless they have access to management or do detailed research and investigative work. The broad masses (i.e., you and me) w
ill be at the very bottom of the information food chain, as we have no clue about what actually goes on internally. More investors than you think just formulate views based on other people’s opinion and captivating promotional campaigns, in the hope the bet will pay out in the future. They take risks; they take chances.
CHAPTER 3
RETURNS AND CHANCE
“Take calculated risks. That is quite different from being rash.”
—George S. Patton Jr.
What are adequate returns and why are they so important?
Adequate returns compensate investors for handing over their scarce resource—money. Investors want money, and they want more money, in real terms, after inflation and any tax obligations. But what is adequate? 1%, with a capital guarantee (Even though 100% guarantees have never existed in the world of investing)? Or should we consider 15%? Why not 25, or even 50% per annum? Before the idea of stock markets and capital markets, money lenders were only willing to give up their money in small amounts, short-term, and at high-interest rates. Today, if you borrow money from more dubious sources connected to the underworld, the same principles apply. Anybody making a decision to pass money, from their pocket’s to someone else’s, have to understand two things – money, and risk.
Money and Investing
One of the catalysts for humans founding cities and empires “was probably the appearance of fiction,” notes Yuval Harari, author of Sapiens. “Large numbers of strangers can cooperate successfully by believing in common myths. Any large-scale human cooperation – whether a modern state, a medieval church, an ancient city or an archaic tribe – is rooted in common myths that exist only in people’s collective imagination.”6
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