Ted Malloch: Defending Capitalism
Capitalism is as American as apple pie.
President Trump knows that and he embodies its very spirit.
His top economic czar, Larry Kudlow, defends the market better than almost anyone.
Capitalism is, however, under attack everywhere — from the House of Representatives to the socialists penetrating our culture, media, universities, big tech, and the economic system itself.
You could make the claim that common sense is patient and capitalism needs to be so too, if it is to succeed over the long term.
Good capitalism must succeed or we are all doomed.
In fact, if you charted all of modern history, worldwide, from 200 years ago you would graphically see that we have gone from sick & poor to healthy and rich.
There are differences of course even within societies.
But what exactly made this dramatic and remarkable result possible?
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In a word: capitalism (free markets) and the technological progress they have fostered.
But patience might sound at first to be antithetical to success in business.
Believe it or not, when we talk about patience in business we shoot for the same “bigger, stronger, faster” that the impatient, flash-in-the-pan businesses are shooting for.
And we’re after the same worldwide impact and influence.
We just want it for the long haul—not only this fiscal quarter.
Day trading does not an economy make.
And we want our impact to contribute to the betterment not only of the company but of every group the company touches, that includes workers.
“Patient capital” investing has an eye on long-term stability and strength.
It also bridges the gap between the efficiency and scale of market-based approaches and the social impact of pure philanthropy, which is another great American tradition rooted in generosity.
Patient capital has a high tolerance for risk, masters the long-time horizon, flexes to meet the needs of entrepreneurs, and refuses to sacrifice the needs of end customers for the sake of shareholders.
At the same time, patient capital ultimately demands accountability in the form of a healthy return—proof that the underlying enterprise can grow sustainably in the long run.
There are boom and bust cycles in any economy, and the U shape demands that companies invest in order to survive.
Common sense tells us that such investment requires patient capital, which has a longer-term horizon.
Patient capital isn’t just good for people; it’s good for profits.
There is a palpable impatience infecting much of our investment decision making today, and a corresponding decapitalization of business accompanies it.
It’s happening in every sector and across industries.
As a result, our standard of living as a nation has stagnated, despite an increase of more than 50 percent in economic output since 1970.
Real average wages have dropped until last year.
There has been an increase in productivity (in the 2 percent range), but it is not keeping pace and shows signs of leveling off.
Declining prices and swelling competition have left nothing over for wage increases in American business.
So most people who feel that their wages in real terms are not going up are right.
In recent years, equity has actually flowed out of our corporate world.
Dividend payments have moved to half of current income, up from less than a quarter only two decades ago.
U.S. firms constantly announce stock repurchases (that they probably did not buy at all).
The figures are quite astounding.
And American companies continue to relocate overseas because of taxes, transfer pricing, or holidays offered by distant regimes.
Asian and European companies, which follow systems defined by dedicated and patient capital, are outperforming U.S. businesses in general. And they invest in both tangible and intangible assets at a noticeably higher rate.
Business owners in these locales consider themselves principals rather than agents, so they seek long-term appreciation for shares, which are generally held by buyers for long periods of time.
U.S. publicly traded companies, by contrast, increasingly chase the approval of the transitory owner.
The stockholders themselves are indoctrinated to buy low and sell high—and quickly.
It’s part of the rush of “playing” the market.
In order to feed the need of the impatient stockholder, firms favor consumption and debt over earnings and capital formation—whatever will post the right numbers.
Spending a fiscal quarter investing in assets would result in a knee-jerk reaction by stockholders to the resulting short-term decline in profits.
So despite growth in many sectors, shareholders are not benefitting.
If you compare U.S. shareholder earnings over the last thirty years with those for Asian and European counterparts (and adjust for currency fluctuations and purchasing power), the U.S. shareholder has not done so well.
Europe may have a serious stagnation problem in terms of jobs and employment rigidities, but they are still building plants, training their work force, and developing new products.
As for Asian companies, they are expanding in every possible way.
Why are firms in the United States behaving differently?
There are four things to consider:
Over the last fifty years, U.S. companies have concentrated on the need to improve their return on investment and earnings per share (EPS).
This was easy to do by decreasing the size of the denominator—cut the asset size down and keep the earnings the same.
This results in an increased ROI.
Then if you buy your stock back, you further increase your earnings per share.
Like most of America, management are influenced by their own compensation, which is based on current accounting profits, or by unrestricted stock options that heighten stock price sensitivity.
Business schools have done a very good job of turning out bright people who have figured out how to do this ‘denominator magic’ and do it efficiently.
Underinvest in intangible assets, and improve return on investment.
That’s why net investment in fixed assets has fallen from twenty-five years ago.
Important intangible assets such as research, work force development, and establishing brand names, new products, new markets, and first-rate distribution systems are all underfunded.
Meanwhile, U.S. industry continues to spend on acquisitions.
Much of the “investment” in acquisitions is only a change in ownership.
It does not create anything new. Most fail.
If you build a steel mill in Arizona, for instance, you take a big hit.
The start-up costs can kill you.
Acquiring a mill, on the other hand, means smoother sailing for now—though it also means less innovation, job creation, and improvement from the ground up.
U.S. companies also demand higher hurdle rates than do their foreign competitors; we won’t invest unless we can expect a return of over 12 percent.
That’s the “cost of money” in our minds.
If you look at the ROIs of Asian, European, and U.S. companies, you will find U.S. companies outperforming the other two by about five percentage points.
But the higher hurdle rate in the United States only gives Asian and European companies a performance umbrella to work under while dissuading U.S. firms from making a whole range of important investments.
The third reason is that the real owners of U.S. business today are retirement funds.
Fifty years ago, 70 percent of stock ownership was in private hands.
Today more than 70 percent is in the hands of pension and mutual funds.
We have passed the responsibility for managing onto an agent, and this is essentially incompatible with capitalism.
Capitalism in the long run relies on people and their interaction with businesses.
When we lose that because our economy is based mostly on institutional and not individual investors, we lose core strength.
Individuals think about long-term gain.
Most of our agents trade not only quarterly but nowadays by the nanosecond.
In an ideal world, the process of capital investment in a nation would align itself with returns of private investors and those of society overall.
But our brokers are making all the decisions for us, and their goals are chiefly to keep their clients happy by fattening their portfolios.
While the U.S. capital system is still the most effective, it is not because it creates a divergence of interests between shareholders and corporations; it is in spite of that.
The U.S. capitalist system in fact impedes the flow of capital to those corporate investments with the greatest social and private payoffs over the long-term.
Finally, the current governance system of U.S. companies does not serve the companies very well.
Bankers, customers, or suppliers can’t serve as members of a company’s board of directors. But the Asians and Europeans don’t face the same laws and take full advantage of their insight.
Further, we have laws that keep shareholding in the United States fragmented rather than concentrated. The power of group influence to inform companies for the better is therefore diluted.
Management has to interpret signals from somewhere, and their views are frequently colored by the latest televised sound bite.
Corporate boards have become dominated by outside directors with no other links to the company, and they exert only a limited influence on corporate decision making anyway.
What’s more, the agent who now does the investing for us does not have a tax consequence when he makes a trade.
So pension funds will sell a company out on a whim or a rumor and will manipulate the last decimal point, any time day or night.
The rest of us have a 40 percent cost on selling stock.
In light of these challenges, how can we in the United States still practice patient capital and invest with common sense?
First, we must not fear failure in the short-term, even though stockholders may balk. This is easier said than done; we are a society that punishes failure.
But making some investments that fail is essential to a dynamic plan of learning and growth. An institutional structure that over penalizes failed investments may in fact, over time, undermine the competitive capacity of a firm.
Some investments generate no profit but rather create capabilities that benefit future development.
Certainly, a company can increase profits by cutting out certain things—such as R&D, employee training, and customer relations.
However, you would also “save” yourself the trouble of invaluable social returns such as watching candidates compete to work for you, seeing worker skills grow, and improved quality of your product and service.
You also wouldn’t have to worry about happy customers and cutting-edge breakthroughs that raise your firm’s leadership in the field.
Governance in most U.S. publicly traded companies is not for perpetuation or long-term investment and strategy.
To curtail this trend and stop decapitalization, we should tax pension funds so they have a transaction cost.
If they hold a stock for less than one year, they should be taxed at forty percent and let the rate decrease annually so that in year five, there would be no tax on trades.
Only then would pension funds look at companies that had some kind of long-term future.
This kind of proposal would have lots of advantages: it would increase government revenues, correct the tax inequity between individuals and institutions, punish short-term stock speculation strategies, and focus ownership on long-term performance.
It would also give management courage to stop playing the game of “denominator management.”
It is likely that transaction costs would also drop, because there would be less churning, thereby increasing investment in the U.S. economy.
This could improve the savings rate, increase jobs, and help to get the capital gains tax down for transactions within a family or closely held unit.
We should also relax some restrictions and allow banks to hold stock in companies and bank directors to sit on boards. They are allowed to do so in Germany and Japan.
These changes would start to align the firm with the purpose of society—and that is a profound task in front of business everywhere.
We need to invest in those intangible items— training the labor force, new distribution systems, and research and development—for the very future of business and capitalism, as well as the American worker.
If we fail to do so, we are going to end up in the near future seeing the last public company in the United States disappear.
We can’t let that happen, so shouldn’t we start defending capitalism, again!
Featured post via Ray Marr