Dao of Capital

3 8 T H E D A O O F C A P I T A L

with slow early stages that create the structure for subsequent fast and efficient development. The conifers progress exhibits the teleology of purposeful behavior that shows a goal-oriented mechanism in action from their adaptation, as they retreat to the rocks as the means toward an end. In other words, conifers pay now for productivity gains later. In building efficiencies, they aim first toward means (step one), whereas the angiosperms, in their immediate fast growth, aim straight toward ends (the final step).

Such purposeful indirectness, focused on means to the attainment of a desired end, does not occur just within the growth of a single conifer. It also governs the growth patterns of conifer stands within the forest. (Of course, my intention is not to infer that conifers are capable of cognition; their strategy is but an optimized product of evolutionary adaptations.) In order to better their overall chances of survival, conifers

Figure 2.1 Growth Rate of Evergreen Conifers Eventually Catches Up with and Surpasses That of the Deciduous Angiosperms

Reprinted with permission from Biological Journal of the Linnean Society , 1989, 36:227249: W. J. Bond, The Tortoise and the Hare: Ecology of Angiosperm Dominance and Gymnosperm Persistence.

Conifer

Gro

wth

Rat

e

Angiosperm

Time

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Shi 6 1

with great effectiveness in weiqi . Learning the game of weiqi instructs and practices the specific strategic and operational ideas of the Sunzi , and provides insight into its philosophy, stratagems, and tactics.

How the game of weiqi unfolds is illustrative of shi versus li thinking, which can even unintentionally set up an east versus west contrast in philosophy and in war and diplomacy. Author and weiqi expert Peter Shotwell notes that li , as a general term, can mean a direct profit-oriented yang strategy, one that gets things done, while shi is a yin strategy that prefers to go for influence at the expense of immediate profit or advantage. 31 Shi is intertemporal; li is myopic.

Weiqi is played on a board marked with a 19 19 grid (smaller boards for beginners may be 9 9 or 13 13). Representative of the earth, then thought to be flat, the board has a square shape that symbol-izes stability and four corners that stand for the seasons. Stones are used as game pieces, one set black and the other white; their round shape connotes mobility, while their uniform size shows them to be equal in power with no differentiation among them. 32 (The contrast with chess is obvious, from its complicated hierarchy of pieces to its relatively direct pursuit of total annihilation.)

In essence, weiqi is a simplistic game, yet out of that simplicity comes great complexity and sophistication. Weiqi is, in fact, the most calculated of games. The exponential explosion of possible permutations of future

Shi versus Li

Shi Li

Roundabout, intertemporal Direct, atemporal Emphasis on means Emphasis on ends Patient, nonaggressive Impatient, aggressive Seeks to secure future advantage through immediate objectives

Focuses on immediate results rather than accumulating means

Counterforce Force Subtle, intangible Dramatic, tangible Outcome of most battles immaterial Outcome or every battle decisive Progress is continuous Progress is sequential Focused more on cause Focused more on effect Ziel, Mittel Zweck Wuwei wei

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Shi 6 3

black will appear to have captured no territory at all and, indeed, at the end of this sequence has scored no sure points; white, though, has 30 unassailable points, which seems to validate its li approachbut the allure is only in the immediate, the tangible. Black s current position will likely eventually amount to 50 points, which would be an extraordi-nary lead. (Competitive weiqi matches typically come down to very low single-point spreads.) White s territory is far more assured, but black s is greater. This was the cost for black s lead: an immediate payment in exchange for the edge further down the road. Black has essentially husbanded his resources, withdrawn them in order to assert them more decisively laterwhen black s subsequent moves in the center will have much support. It is an intertemporal tradeoff of aiming at a means to a greater end, rather than directly at the endit is the roundabout way.

We can see, too, in the weiqi match that the means of positional advantage provide for the opportunism of decisive blows that occur toward the end (in what might even appear as a surprising tail event to someone watching the scoreboard onlysee Chapter 9 ). Indeed, it is the whole point of the shi approach, the whole point of the difficult sacrifice of the immediate. Within shi is li (just as within shi s logogram is li ). After being loaded and drawn, the crossbow must be fired (because if it were never fired, it would not be shi ).

Figure 3.1 Shi (Black) versus Li (White) on the Weiqi Board

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9 2 T H E D A O O F C A P I T A L

Yet goods that could meet our needs directlywhat Menger called goods of the first orderwere not the only things that possess goods-character. Using the example of bread, a first-order good, there are also other goods that meet consumer needs, specifically the flour and salt to go into the bread, and fuel to heat the oven. We find that implements and tools for the production of bread, and the skilled labor services necessary for their use, are regularly traded. All these things, or at any rate by far the greater number of them, are incapable of satisfying human needs in any direct wayfor what human need could be satisfied by a specific labor service of a journeyman baker, by a bak-ing utensil, or even by a quantity of ordinary flour? That these things are nevertheless treated as goods in human economy, just like goods of the first order, is due to the fact that they serve to produce bread and other goods of first order, and hence are indirectly, even if not directly, capable of satisfying human needs. 46

Furthermore, as Menger demonstrated, the value of these ingredi-ents, the factors of production (used to make a final good), is always derived from the value of the consumer good, and not the inverse. (One exam-ple given is a bottle of wine that is not valuable because of the land and labor invested in it. Rather, it is because consumers value the wine that the land and the labor invested in winemaking are valuable. 47 )

Menger also augmented Smith s declared central driver of uni-versal opulence, the economic progress of civilization and the exten-sion of prosperity throughout. Smith saw this progressing division of labor as the driver. However, it was clear to Menger that this was but a single cause of progress in human welfarethat is, a proximate

ZWECK MITTEL VERWIRKLICHUNG

(ends or goals) (means) (achievement)

MENSCH AUBENWELT LEBENSERHALTUNG

(human being) (environment) (subsistence)

BEDRFNIS GUT BEFRIEDIGUNG

(desire or need) (good) (satisfaction)

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Umweg 1 2 3

Bhm-Bawerk had his favorite metaphors for capital heterogeneity. His stream, which is not of equal breadth at all stages, with dams at certain points, and leakages at others, 17 evokes the favorite image of Sun Wu. Best of all, though, and conveniently following our conifer leitmotif , Bhm-Bawerk offered the depiction of a tree s growth, spe-cifically a crosscut, essentially a large trunk, revealing its annual growth rings in a pattern of concentric circles ( konzentrische Jahresringe ). (See Figure 5.1 .)

What better image is there of the intertemporal, cumulative means-ends process that, as I argue throughout this book, is the very pro-cess of productive capital investment? Lose sight of this intertemporal structurelose one s depth of field and the productivity is lost. (Figure 5.1 should perhaps be affixed to everyone s Bloomberg screen.) If this book accomplishes nothing else but makes this point clearly, it will have reached its intended Zweck .

As the concentric rings illustrate, the production process and value emanate cumulatively from the core. The process flows outward over time, through successive rings as more factors of production are added

Figure 5.1 Bhm-Bawerk s Jahresringe .Shown are depictions of the capital structure of two different economies, where the life cycle of a production process starts on the inner rings and moves outward over time. The economy on the right is less roundabout (and very likely poorer and less productive), as most value is added in lower-order goods (the outer rings), where the goods are closest to the final consumption point.

Source: Eugen von Bhm-Bawerk, The Positive Theory of Capital, 1930, G.E. Stechert & Co., NY.

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2 3 2 T H E D A O O F C A P I T A L

through history, the story it fails to tell, I might add, is the human mis-ery and tumult and otherwise brake on civilization s march suffered over the deep credit cycles displayed.

This history depicts the clear footprints of historical monetary distortion. I regard it as pseudoevidence of Austrian Business Cycle Theory (ABCT); as academics struggle with empirically proving (a misnomer, to be sure) ABCT, I argue they have simply been looking in the wrong places.

The first obvious question to ask is: What is the subsequent effect of this distortion on the replacement value of all the capital valued in the numerator? That is, to what extent have higher expected profits in the price of title to existing capital been subsequently imputed into the source of those higher profits? Shouldn t high MS index levels above 1, for instance, logically lure profit-seeking entrepreneurs into greater capital investment, such that their successive efforts raise the replace-ment value and accumulated magnitude in the denominator (and thus offset the rise in the numerator of the MS index)? In fact, there is absolutely no statistically significant or consistent relationship between MS index levels and subsequent aggregate capital investmentvisible

19201900

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1940 1960 1980 2000

Figure 9.1 Footprints of Distortion: The Misesian Stationarity Index

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excess returnsincluding dividends; the error ranges around each bar, depicted by the vertical lines with hash marks at each end, are 95 percent confidence intervals of the sample statisticsfound through a nonpara-metric bootstrap. This same methodology is used throughout this and the next chapter.) Based on what we now know, we would expect to see an inverse relationship: When the MS index is low, the subsequent average stock return should be high; when the MS index is high, the subsequent average return should be low. (If we didnt observe this outcome, it would mean that somehow investors responded to lower rates with more new capital investment, and this new investment as well as the old remained, on average, profitable after rates normalized. An impossibility!) The data cooperate; with greater than 95 percent statistical significance, my conjecturederived from Austrian theoryis right.

What s driving these return differentials? Do stocks merely drift up at steeper rates under low MS index levels than under high ones, or is there something else going on? Of course we would expect to see the indications of severe malinvestment liquidation driving these results,

15

Perc

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1st 2nd 3rd 4th

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5

0

5

Figure 9.2 Lower Expected Returns with Higher MS Indices S&P Composite Excess Total 1-Year Returns (Arithmetic Mean)

Bucketed by Starting MS Index Quartiles, 19012013

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Austrian Investing I: The Eagle and the Swan 2 3 5

meaning severe subsequent stock market losses (and we ll look at the concentration or speed of such losses a bit later).

In the following test I use S&P Composite Index drawdownsor the amount by which our S&P returns cumulatively turn negative during any three-year window before rising againas a measurement of stock market losses. In bucketing these drawdowns based on the MS index at the start of each period, just as I did in Figure 9.2 , we start to uncover the market s dynamics.

In Figure 9.3 , the lowest dark bar indicates the 20th percentile draw-down, or the realized drawdown at which 20 percent of all the data in the bucket are lower, and the light bar above the dark bar is the 50th percentilealso called the mediandrawdown, or the realized draw-down at which half of all the data in the bucket are lower. (Error bars indicate 95 percent confidence intervals around each percentile estimate.) Going back over a century, this looks pretty bad for capital investment following high MS index levels. And for low MS index levels, there really wasn t much to worry about. Imagine that.

What a financially distorted world tells us is that the market, just like the overgrown forest, carries within it the seeds of its destructive

0

Perc

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1st 2nd 3rd 4th

Figure 9.3 Higher Expected Drawdowns with Higher MS Indices S&P Composite 20th and 50th Percentile 3-Year Drawdowns


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bills and roll them each month until we buy back into the stock market. How would that have done? (There is a good deal of ex post informa-tion in this strategy, because we didn t know what constituted a good MS index level at which to sell or buy until it was all over, of course. However, it turns outnot surprisinglythat s not a concern: If I instead start my test after, say, 1925the first complete cyclerather than 1901, and use only the information known at the time from then on, I get equivalent results. No cheating.)

As my old mentor Everett Klipp would have advised, our method-ology here is exceedingly simpleagain, dubiously so. But there is great beauty and effectiveness in our simplicity (see Figure 9.4 ).

The Misesian strategy outperforms the stock market by more than two percentage points per year. Think about what this shows. A basic toy strategy (with an alpha t-score of well over 4) based solely on an easily calculatable and logical measure of market distortion beats not only the average professional stock picker (who consistently underper-forms the S&P), but also the (highly survivorship-biased) average hedge fund manager (such as from the HFRI Fund Weighted Composite

0

5Per

cent

T-bill S&P Misesian

10

Figure 9.4 Misesian Outperformance 1-Month Treasury Bills, S&P Composite, and Misesian Investment Strategy,

Compound Annual Total Returns, 19012013

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they have occurred with exceedingly low frequency. By definition, therefore, it would seem we should be able to call such crashes in the stock market tail events. But on closer inspection, a different story emerges in Figure 9.5 .

Upon bucketing two-month returns by their starting MS index quartiles (over a 3-year window of overlapping two-month returns fol-lowing bucketing) and calculating the 2nd and 5th percentiles in each bucket, we see, again, that crashes follow distortion. (This is just as was done in Figure 9.3 with 20th and 50th percentiles of all the cumula-tive drawdowns, only here I m looking at 2nd and 5th percentiles of all the two-month returnsmeaning, in the case of the 2nd percentile, the realized two-month return at which 2 percent of all the two-month return data in the bucket are lower. Error bars once again indicate 95 percent confidence intervals around each percentile estimate.) To put Figure 9.5 into perspective, with 2 percent of two-month returns having been even worse than a 20 percent crash during the high MS index quartile (the lowest dark bar in the fourth bucket on the far right), one could expect to wait around 50 months (as the expected

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Figure 9.5 Higher Expected Two-Month Losses with Higher MS Indices S&P Composite 2nd and 5th Percentile 1-Month Returns


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surprisingly, since both use essentially the same monthly return data), the benefits of tail hedging are highly conditional on levels of distortion as evidenced by the MS index.

When the MS index is in the upper quartile (as it is as I write), there has been an approximate 4 percentage-point outperformance of the Austrian Investing I strategy (or a tail hedged index portfolio) over only owning the index (an outperformance that fades as the start-ing MS index level falls). Thus, there is a third choice between owning stocks or cash (as in the basic Misesian strategy) in a high distortion environment. (Indeed, when combined with the expected excess returns of equities alone shown in Figure 9.2 , it is clear that a tail-hedged equity portfolio is superior to any of the investment industrys misplaced fine-tuning between equities and cash only.)

This is the roundabout Austrian capitalizing on the fact that invest-ing in far out-of-the-money puts requires intertemporal vision, an indi-rect route (the likely loss in the immediate, as that one half of one percent spent on puts is lost each month without a crash) to achieving a later potential gain (the eventual profits from the puts, which are

Figure 9.6 Austrian Investing I: Tail Hedging an Equity Portfolio Annualized Outperformance of Tail-Hedged S&P Composite Portfolio (Arithmetic Mean)

Bucketed by Starting MS Index Quartiles, 1901-2013

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Austrian Investing II: Sieg fried 2 6 3

a net. The Austrian investor sees the fish jumping offshore, and realizes that Crusoe s inability to catch them is merely a temporary condition, as Crusoe is preparing himself for the big catch further downstream.

CASE STUDY: BUYING THE SIEGFRIEDS

We are now ready to observe our scorned Siegfrieds in action in the real world. (Our laboratory is the Compustat database of reported financial data, as well as historical stock price and dividend data, going back to the 1970s.)

Let s start by looking at the Siegfrieds and confirming that they do, in fact, tend to remain Siegfrieds. (After all, if Siegfrieds were to quickly deteriorate into Johanns, then certainly our presumption of their ever-advantageous roundaboutness would be mistaken.) On theoretical grounds, we expect a firm with high ROIC to remain in such standing, as its managers will continue to reinvest in the firm (why wouldnt they?), and this will only further solidify their positions of competitive advantage.

The data match up with our theoretical deduction. It turns out that high ROICs have been sustainable. 2 In Figure 10.1 we see that

Figure 10.1 Siegfrieds Stay SiegfriedsRolling 10-Year ROIC (Median), All Stocks

Bucketed by Starting ROIC Quartiles, 19702013

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IC

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70

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1 2 3 4 5 6Years

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Figure 10.2 Siegfrieds versus the Average Johanns of the S&P

The Siegfried Strategy s Cumulative Performance Alongside the S&P Composite Index

1,000

500

100

Cum

ilativ

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quity

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1980 1985 1990 1995 2000 2005 2010 2015

1

Siegfrieds

24.9%

11.3%

S&P

Figure 10.2 shows this simple portfolio s results (specifically the cumulative equity in the strategy, starting at $1 in 1978) through time, compared to the S&P Composite Index.

Needless to say, these are tremendous results (like Austrian Investing I, beating mostif not in this case allpeers), in the simplest of non-optimized screens (another basic toy strategy) built only on economic logic and focusing on just ROIC and the Faustmann ratio. However, again, these data say nothing of the validity of the Bhm-Bawerk argu-ments on roundaboutness; the data show us only the displayed magnitude of importance.

Now, let s investigate what s going on under the hood here. Put simply, why are there highly productive firms (ROIC over 100 percent is an outrageously big number) so scorned that they have such low Faustmann ratios to meet our thresholds? It turns out, as Figure 10.3 shows and as we anticipated, among the Siegfrieds (operationally defined in Figure 10.3 as companies with ROICs above 50 percentin order to provide enough data for comparative significance), those with the lowest (1st quartile) Faustmann ratios (the dark line at the bottom)

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have seen their subsequent EBITs take a temporary turn for the worse (and the shaded 95 percent confidence region around the mean EBIT changes for the lowest Faustmann ratio bucket indicates the rigor in this statement). In fact, the statistically significant differences between each progressive Faustmann bucket would suggest that the market is actu-ally pricing these differences in. As the EBIT paths diverge at one year, and as guidance and analyst forecasts seem to predict this far out in the future fairly well, this should not be surprising at all; what should be sur-prising, at first, is how fooled the market tends to be over the subsequent one-to-two-year bend in the road. When you consider that these diver-gences are essentiallyeven entirely, with high statistical significanceaccounted for by spurts of fixed and intangible capital spending, this is all the more surprising. These first-quartile Siegfrieds are merely becoming more roundaboutsacrificing today for growth tomorrowand paying the price today.

As we know, roundabout productionbearing the costs of capital investmenttypically results in an immediate hit on profits (particu-larly from noncapitalized investment such as research and development).

Figure 10.3 Roundabout EBIT Growth

Rolling EBIT Growth (Arithmetic Mean),All Stocks with ROIC >50% Bucketed by Starting Faustmann Ratio Quartiles, 19782013

60

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Years4 5 6

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latter is the superior deployment of capital to which the former serves. In Austrian Investing is a cohesive whole of intertemporal opportunism and the roundabout acquisition and construction of the factors of pro-duction; indeed, from the strategic framework and logic accumulated through the entirety of this book comes an effective framework for investors of all stripes and means.

VALUE INVESTING: AUSTRIAN INVESTING S ESTRANGED HEIR

Austrian Investing I and II should both sound somewhat reminiscent of what has come to be known as value investing. Indeed, Austrian Investing can be seen as value investing s intellectual forerunner, not only drawing on insights older than value investing but, more significantly, providing clarity and focus to its underpinnings and ultimate systematic source of return. Although their paths cross at times, value investing does not strictly follow The Dao of Capital . There are significant differ-ences, largely in the thinking behind the strategiesmost specifically Austrian Investing s deliberately roundabout approach rooted in a firm

Figure 10.4 Siegfrieds and the Effects of Distortion

Siegfried Strategy Mean Annual Returns and 20 th Percentile Drawdowns Bucketed by S&P Composite Annual Returns (over the Same Period)

20%

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the wheat from the chaff, focusing on what matters and ignoring what doesn t. In this, and to its credit, the value approach has come very close. But focusing the mind does so much more than just adding an additional 5 to 10 percentage points to what some smart investors are already doing pretty well. Most importantly, it provides a logical and sound basis for understanding the why .The rigor and appeal of Austrian Investing is in the intuitive logic of its principles; even before we test, we know why our edge exists. For most value investors, even when they see the edge that their approach provides, they do not compre-hend ittypically relying on mere nebulous long-term price mean reversions, and Graham famously called it one of the mysteries of our business, and it is a mystery to me as well as everybody else; they thus remain susceptible to being swept away by the next seemingly attractive investment scheme and distorted environment to come along (as even Graham himself was in the late 1920s).

Truly, the why is all that matters when we are faced with our profound intertemporal constraints amid investment results that appear, to the Phineas Gages among us, unacceptably inconsistent, even reck-lessly irresponsible. Understanding that we are investing in a means to

Figure 10.5 Stair-Stepped Refinement

Various Annualized Portfolio Returns (Mean and Range), 1978-2013

0

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S&P FamaFrenchMagic

Formula GrahamQuality:

Novy Marx Siegfrieds

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ffirsftocflastc01c02c03c04c05c06c07c08c09c10bepilbnotesbackbaboutbindex

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