Freedomain Radio Podcast 9
Hello, and welcome to podcast number three. This is an ongoing sequence of me chatting away in my car while I'm driving to work. This is actually take two of a podcast I did earlier this morning. I tried to get it to work, but traffic was too bad. I had a demo at 9:30, so I had to head back.
What I wanted to talk about today was the stock market. I know, it's a thrilling topic, but I think that hard-won experience of mine, I think, is useful to talk about to others because the stock market is one of the things that is criticized about the free market. You know, like “It's a roller coaster,” “It's up and down,” “It focuses business leadership on short-term numbers rather than long-term growth,” and so on. So I wanted to talk about the stock market and how government compulsion has destroyed the stability in the stock market, undermined the credibility of stock prices, and corrupted an entire generation of business leadership, and I think I can speak from somewhat personal experience in this. Although I managed to escape the worst of the corruption, I certainly do understand the temptations.
To start, let's look at the stock market and what it's really for. Its basic function, of course, is to provide capital for companies who can produce returns on that capital by investing in expansion, or plant equipment, or additional workers, or marketing campaigns, or research campaigns, or whatever. So the idea is that you need to raise money for your business, you've run out of friends and family to do it through, and so you go to the stock market. All well and good, we like the idea, and it all makes sense. So that is a perfectly valid approach to getting investment.
And I can speak from my experience here, that in 1995 I started a software company with my brother, and we first and foremost went round with another business partner to doctors and lawyers, and people that we knew, accountants and so on, who wanted to put in 5 or 10k. We raised about 80k, we started the business there, and over the next couple of years, through a ferocious amount of hard work, we grew the business to $4 million a year in revenue. And then we sold it in 2000, and it got sold again in 2001. Let me give you the brief story of what happened and why this idea occurred to me that it would be worthwhile talking about my exciting experiences in the stock market and abstracting those into some general principles that I think will be useful for others.
Well, so we started this company and it did well, we sold our software (it was environmental software) to a lot of big companies and everything was going along swimmingly. And then what happened was we sold the company because we wanted to get more capital expanded to the US, that's the holy grail or the Mecca of software companies, is success within the United States business market. And so we sold to a company which had a listing on the Alberta stock exchange, which is like not exactly the Penny Stock Corner of Canadian capitalism, but not far. It's not exactly the Toronto Stock Exchange, which has much more stringent entry and listing requirements. That company then ended up selling our software company to another company which had a listing on the Toronto Stock Exchange, which is much more prestigious and opens you up to a large number of institutional investors who are only permitted to buy companies on the Toronto Stock Exchange, because the other ones are simply considered too risky.
And so our stock price, or the stock price of the parent company, was originally a couple of cents, like 5, 6, 7 cents, and then as we began to move upward in the food chain of stock exchanges, the price of the stocks began to go up. And not like by a little bit here and there, but by multiples. So we went from 8 cents to 40 cents to 80 cents to $1, $1.50, $2, I think it peaked around $2.30 or $2.40. This is in a matter of a month, or two or three.
And then the stock crashed back down to a penny stock, and then basically vanished from view. And of course, this was quite a roller coaster for me, as a business owner and somebody who'd been given stock, the majority of which was in escrow. Now escrow stock, for those who don't know, is, if I sell a company, you buy my company, you don't want me to just sell you the company, cash in my stocks and hit the road, because a software company is really only as valuable as the talent that is in it. You want to make sure I'm going to stick around, and the best way to do that is if you give me a million shares in your company in exchange for my company, you want me to get the first third of the shares I can sell after one year, the second third after two years, and the third third after three years. And it's a way of making sure that the talent sticks around when a merger and acquisition takes place. So I was on a pretty wild roller coaster ride because some of the shares I could sell, some of them I couldn't, and it was a very wild time to be in business. Of course, late 90s early 2000s was a pretty exciting time in the software business.
So what happened though, I found, that once we got a listing on the stock exchange, all long term business management ceased. And i found this of course amazingly frustrating. I mean, I had like six CEOs in two years, people bungeed in and bungeed out, nobody made any strategic decisions, everybody was just watching the stock price. And the only news they wanted to hear about was the news related to what the stock was doing. We were happy to announce a sale only insofar as that sale would help us to boost the stock price (the sale of our software).
Nobody wanted to hear about any problems. Nobody wanted to reinvest back in our existing clients because that was not helpful in boosting the short term stock price. Basically the company had a huge jump in stock price and then had a huge collapse in stock price. It was gutted—emotionally, financially. It was eviscerated.
And so I guess I had a certain amount of curiosity about what had happened, or what was going on, and I'm sure those who have had some experience in this know the story. The sad tale of the demise of the emotional energy and intellectual energy of this company, which was that, because it was an environmental company, we were partly bought in order to appeal to green funds (the funds that only invest in green stuff, stuff that is environmentally friendly).
Because ours was environmental software, that fit the bill. That all of the senior managers gave up on managing the company and basically got involved in what's sometimes called a “pump-and-dump,” where you pump up the value of the stock, and then you dump it all, and it's a zero sum game. It's a cash transfer from those who don't know much about investing to those who know a lot about investing and thus can manipulate things to make them look good. Even after the stock price went up and down, the only interest that the CEOs of the parent company had was in returning the value to that stock price. In other words, there was a weird reversal of cause and effect. In my view, and what I argued for at the time, share price is a reflection of value. It is not a cause of value. (laughs)
If I finish l basement of my house, the price of the house goes up. I don't raise the price of my house, and then, with the money that I'm going to get, finish the next basement of the house. Share price should be a reflection of value, not a cause of value.
But in the topsy-turvy world of the modern stock market, it is in fact considered to be a cause of value. And so it really corrupts long-term business management.
Picture this. As a CEO you are entirely judged by most markets on short-term stock price. So you've spent like five or seven years in graduate school, you've spent 15-20 years rising to the position of CEO, and you then are put in a situation where you can either tell the truth to the markets, or you can basically not lie exactly, but tell them what they want to hear. The truth of the markets would be, “Here's my 5-year plan: No, there's going to be no immediate rise in stock price. It's going to be slow and steady wins the race. We're going to build this thing properly. We're not going to refuse to reinvest in R&D and client satisfaction and upgrades and so on. So we're actually going to build this thing for the long haul.” Well of course the first thing that the markets are going to do, generally, is cut your stock price down significantly.
Because you're telling the truth, which is that there's going to be a slow and steady gain that's going to take five years to double the share price, but they've also got CEOs saying “I can double your share price in 3-6 months by doing whatever. Cut R&D, get rid of my programming team, focus on sales and marketing, basically eviscerate the future to feed the present. Eat your seed crop, I guess you could call it. And if you are a CEO and you tell the truth to the market, which is that it's going to be a long-term, incremental growth, where the fundamentals are going to be satisfied, well, guess what? You're going to get punished, you are going to face a shareholder revolt, your board is going to rise up in arms and they're going to fire you. And then your career is over. What are you going to do? Are you going to say, “Yes, I got fired from my last job because I had a shareholder and board revolt, and they kicked me out with extreme prejudice”? Well, no one's going to hire you, especially if they dig in further and find out you were fired for causing the stock price to drop by a quarter, or a third, or a half. Or more!
Well, CEOs just aren't going to do that. They're just like you or me. They aren't going to shoot themselves in the foot for the sake of a fight that they cannot win. I mean, if the stock market were different, if the stock market looked at these pump-and-dump scenarios and went, “Well that's kind of wrong, I'm not going to do that,” then of course CEOs would start telling the truth, because they would be rewarded for it rather than punished for it. Nobody is going to end their career, get fired and disgraced, and never be able to get a decent job for the sake of telling the truth to a bunch of people who are not going to listen to you and are just going to punish you and hire someone else who's going to lie to them. That's simply the fact of the matter when it comes to business. So why is the stock market like this? Why is the stock market so messed up?
Well, I think it's important to understand what the stock market is for and then to recognize what it's not for. The stock market is for raising capital for business that want to grow. And so if you're going to invest in a business, you really should know something about that business and it's market. Like, I think I would be fairly competent after spending nearly ten or so years in the higher echelons of software management. I would be fairly confident to look a software company and say, “Okay, well, do they have good change control management? Do they have a way of controlling scope creep? Do they over-promise? Are they investing in their existing clients? Are they building architecture up, or are they still on VB6 and Axis or whatever.” I'm fairly good at being able to ask the kinds of questions that can help me determine whether it's a well-run software company or a poorly-run software company. But you ask me that for a manufacturing company, I'm really not going to have much of a clue. So investors are those who can have some sort of capacity to evaluate a company and its prospects and its marketing potential and its management and its processes and separate the wheat from the chaff and invest properly.
Now that's time-consuming. You've got to go interview these companies, you've got to figure out the market, it's time-consuming and the investment that you put in, though, tends to pay off in more stable returns, and blah blah blah. So that's one type of person who's in the stock market, and that person is called an investor. And whether you delegate that to a fund manager or not, the issue is, Are you looking at the fundamentals of the business and do you have an understanding of what you are investing in? So, all well and good. This kind of investor is in the tiny, tiny, tiny minority these days.
Let me tell you about the other type of investor. The other type of investor is called a speculator. Now, a speculator doesn't have much of a clue of the business that he is investing in. He's kind of playing the numbers. He's saying, “Well, the stock price usually does this after that,” or “I think that other people are going to want this stock based on X, Y or Z, so I'm going to buy it.” They don't really know what they're buying. Like if you asked most investors in Internet companies in the nineties what platform those Internet companies ran their software on, or what was the average age of experience of their programmers or project managers and so on, they wouldn't have a clue. What they'd say was, “Yeah, online airline bookings, that seems fantastic! I would use that! I think other people are going to want—” and they just threw their money over the wall and hoped that more money was going to be thrown back at them, but they sure as heck did not know what they were investing in.
These kind of investors are called speculators. And there's nothing intrinsically wrong with speculation, of course. Everybody's free to gamble as they see fit. Take your money, throw it into the roulette wheel, and see what comes out. More power to you!
However, in the real free market, in a truly free stock market, the speculators are pretty heavily punished. It's not called speculation to buy a set of Microsoft shares, because they're not going to be worthless next year. However it is speculation to buy a stock in a small mining company that may or may not be able to find some gold or diamonds or whatever.
So the reason that speculators are discouraged is that speculation is enormously risky, and you don't normally put more than a few percentage points of your portfolio into speculation, because it's like fun money. It's like roulette money, you know? Ten of the companies you invest in are going to go down, and maybe one of them will produce ten or fifteen times return on investment. But you really can't make a living off speculation, because it's far too random, and you can just get completely hosed very, very quickly, as the people who invested in the parent company that bought my company, I'm sure, became all too aware. Speculators also drive stock market prices up and down wildly, because they're on innuendo, on possibility, on rumor. They also may have inside political connections and so on to find out that FDA approval is going to a small company or some company is going to get a large tax break or an investment from the federal government or whatever.
So speculation is not what the stock market is designed for. Of course you can't eliminate it, and neither should you, but the problem is that if the incentives for speculation versus investment get screwed up, then so does the stock market. So once you have a prevalence of speculators in the stock market, you also corrupt business leadership where all they're looking at is short-term ticket prices rather than long-term growth. And as I mentioned before, long-term growth strategies get heavily punished. Short-term pillage strategies get enormously rewarded and, of course, a CEO who's looking at either losing his job and career versus making $50 million is going to have some sort of incentive to not be up front and long-term and strategic in his approach to communications with the market. He's going to say, “Oh yeah! Everything's going great! We're going to double our profits next quarter, blah blah blah,” the stock price goes up, he makes a fortune. He's going to cook the books to match his projections, he makes another fortune, and then he can bungee out later if he wants, and say, “Well, look, I doubled the stock price after I left. Look, the new management screwed up the company.”
The fact that he may have pulled out investment from things like R&D, client satisfaction, long-term growth strategies, it's pretty obscured to anyone that's going to be looking at his performance down the road. He's not going to know all of that, and he's certainly not going to be told by the CEO. So it looks pretty damn good if you're a CEO and you focus on pleasing the market: you make a fortune, your company makes a fortune, and then you get out before the consequences of your short-term investment strategy take root. If you don't do R&D, if you don't satisfy your existing customers, it's going to show up a couple of years from now, but it's not going to show up next quarter. And of course a couple of years from now, the CEO's gone, so he can blame the poor performance on the new CEO. Enough about that. Let's talk about why the stock market has become this bizarre, and this counterproductive, and this “non-optimal,” I guess you could say. Well, of course, a good mental trick (or approach) to looking at any of these kinds of situations is to look for the gun. Look for the gun. Anytime you see a counterintuitive, counterproductive, messy, oscillating, seemingly random, and corruption-inducing situation, you know for sure there's a gun at the bottom of it. And let me tell you what that gun is.
In the stock market, you should only be in there if you know what you're doing. You should only be investing if you know the company, or you trust whoever is investing to handle your money because he or she knows the company or the market.
Now I want you to just think about your own economic life for a moment. How much money do you have in the stock market that you didn't choose to put there? I'll give you some hints (And I'm going to make generic terms for Canadian and US financial instruments, but you can apply those as you see fit to your own particular locale). #1. Social Security, your old age pension. It's called the CPP or Canada Pension Plan in Canada, Social Security of course in the US. 15% of your income — 7.5% from your employer, 7.5% from you, is taken from you and “invested” on your behalf. Now, did you want 15% of your income to go into the stock market and be managed by people that you really don't know anything about? Well of course not! Of course you wouldn't, that would be a lunatic strategy, especially when the people who are managing it are political and don't even profit from a growth in your investments. So there's 15% of your income right there. Now what about your 401k plan? What about what in Canada is called the RRSP plan, which is the tax-sheltered income that you're supposed to put aside for your retirement? Well in Canada you can put up to $13,500 a year into this and it's all removed from your taxable income, so hunky dory, you've saved yourself whackloads of money, assuming you're in one of our gruesome tax brackets, which most Canadians are. So there's another, what, 8%, 10% of your income forcibly pushed into the stock market against your will. There's another example of money. We're already at 20%-25% or so of your income that is being forcibly at gunpoint herded into the stock market against your will! So we're all speculators. And hundreds and hundreds of billions of dollars are being forced into the stock market, where they just damn well should not be.
Let's look at another one! If you work in a public sector, then you have another retirement plan, and all of that money is being forced from your paycheck into the stock market against your will. Pension plans for teachers in Canada — huge, tens of billions of dollars — if you are part of a union, even in the private sector, you probably have another kind of plan for your retirement or whatever.
The politicians and the lawmakers love retirement plans because it's so far off the benefits that they can screw you for decades and you won't really pick up on it until you actually try to collect your check at the end of your life, or near the end of your life. So there's another 5%, 6%, 7% of your income that's being forcibly put into the stock market, because you don't have an option to not be part of these particular retirement plans or plans of that kind. I'll give you another example! Unemployment insurance, or, in Canada it's called “employment insurance” because if they change the name, they've changed the program. Here's another enormous amount—I think it's 4% or 5% of our income here that's taken for employment insurance, which is also invested in the stock market. And there is another example of money that's going to the stock market against your will, which if you don't give it to them, you're thrown into jail. Here's another example. In Canada (I don't know how it is in the U.S. ), there are income trusts which you can put in. They have to be invested in the stock market and you get a certain amount of tax deductions and so on. There's registered education savings plans which also force you to put money in the stock market or given up at the point of a gun through taxation. These are just the ones off the top of my head. I bet you there are hundreds more.
What they do is they march your money at gunpoint into the stock market against your will, and you don't have the time to manage all of these different investments, and you don't have the power to for the most part even if you could! You can't tell the government how to invest your old-age pensions, it's impossible! So, why? Why does the government want all this money in the stock market? Well, because it gives the government power. Of course that's why the government does anything. And I'm not saying they sit there with a white board saying, “Ah, here is how we're going to get power!” and they stroke their pencil-thin mustaches or anything. It's nothing like that. It's just natural, you know? Like children can be bullies because people have an instinct for how to expand their power and how to humiliate others, and if they grow up as bullies or thwarted bullies then they become politicians and they have an instinct about the best way to expand their power that they have.
And so the way that they do it is, both in the long term it corrupts capitalism and gives them the power or legitimacy to regulate industries. If you start to corrupt people's decision-making processes in business then you get horrible results like Enron and WorldCom and the whole bubble and the burst of the Internet stock booms and so on. And so the government says, “Well, we have to come in and regulate because it oscillates so wildly, and blah blah blah.”
But of course the reason that it's oscillating so wildly is quite simple. There are hundreds and hundreds of billions of dollars that are being forced into the stock market, they are overcharging it! So you have all this money sloshing back and forth in the stock market, looking for tiny variations in returns in share prices and promises and nobody's in it for the long term because in the long term it's absolutely impossible that the stock market can produce enough returns to satisfy the amount of money that's sloshing around looking for investment. So whenever you try to invest too much, you're not going to get a return, so you're going to look for pump-and-dumps, you're going to look to raise the price of a stock and dump it to someone else, because it's actually a negative net sum gain. The money is going to decline, so all of that is occurring, and that's going to corrupt the entire process of the stock market. Everybody's looking for short-term gains, there's hundreds of billions of dollars sloshing around, there's overcharged stock market looking for minor discrepancies, and so the whole process has been corrupted. Oh, and before I forget, there is one other way in which your income is also charged into the stock market. This is perhaps the biggest one, which is of course, the national debt. The government borrows money, spend it on this, that or the other, which completely distorts the economy, and in the future you're going to have to pay all of this money back to the institutional investors who lend to the government or the people who buy stocks and bonds. The bonds that the government sells are also instruments which are going to require investments. If you buy bonds in a school board, they actually have to invest that money and so everybody who's buying savings bonds or whatever, federally backed or state-backed instruments, they are also forcing money into the stock market. So this is another way in which the stock market is corrupted.
The other reason that politicians want money to go into the stock market is because they get a lot of pressure to get money into the stock market from people in the stock market. I mean, Goldman-Sachs, and all these other major trading companies, large industrial concerns, all in the upper echelons of the financial elite, all want money going into the stock market because, well, guess what? That's their job, to make money off the stock market. Most people, we are raising our kids, we're working our jobs, we are not tracking what's going on in the stock market from a macro level, so we are a complete disadvantage and ripe for fleecing. The moment that this stuff gets jammed in the stock market, the moment that all our money gets stuck there, it is now open to the manipulation from the financial elites whose full-time job it is to understand the stock market and to profit from it.
So what happens? Well, the politicians get an enormous amount of pressure to rope all this money and put it into the stock market. There is an enormous amount of money that can be made from having an overcharged stock market, of course. If you have an overcharged stock market, the billions of dollars that can change hands through this pump-and-dump scenario—it's absolutely staggering how much money gets transferred because of this corruption within this stock market, because of herding everybody's money into the stock market, far more than can be reasonably absorbed by the stock market. It all becomes a zero-sum or negative-sum financial transaction game where those who are in the know are basically taking money in small increments from a wide variety of people who aren't in the know and who have no choice about investing. So this is where political fortunes are made, of course. Of course it's completely immoral, absolutely wrong, to force people at gunpoint to put their money into the stock market, because it is not designed for this kind of speculation, and what happens is, the negative punishment that speculation normally draws (you speculate, you lose a lot of money) doesn't really occur as much, because you're constantly getting new money coming into the stock market that's being forced to go there, so losses which come from this kind of problematic investment are just not as big a deal. Plus you've got lots of incentives, wherein you can transfer stock losses through tax incentives into deducting taxes against future capital gains and all that kind of stuff. And I haven't even gone into that, how the system for the stock market transactions and taxes and profits and loss is entirely skewed to benefit those who play the stock market. If I found a business and pour a lot of money into it and lose that money, I don't get all of that money taken off my taxes the next time I get a job! But if you're in the stock market, you get all of these capital losses translated into tax deductions into capital gains down the road. And of course this is all, as you would expect it to be, given that financial instruments of this kind are very complicated and difficult to understand and highly profitable for those in the know, so naturally you would expect that those who are not in the know are going to get fleeced, and those who are in the know are going to make an absolute fortune. The way that they're going to do this is to use the violent power of the government to force people into doing what they wouldn't normally do, i.e., throwing a quarter, or 30% or 40% of their income into the stock market against their will, and then having all of the profits from that accrue to a small percentage of the population. This basically is mercantilism all over again with financial instruments taking the places of East Asian spices or the trade routes that were bought and sold in England in the 18th and 19th centuries, and of course all over the world.
This is a mercantilist system wherein the small number of financial elites are in bed with the government and the government is passing legislation that both enriches and enslaves that financial elite, because now they're enslaved to the whim of the government. The financial elite then of course will give an enormous amount of campaign contributions to those who promise to maintain and exacerbate this system.
The challenge of explaining the negative consequences of this system to the uninitiated is prodigious. It's very hard to sit down and explain to somebody who doesn't really understand anything about the stock market exactly how this is hurting him. And to what degree is it hurting him? Well, $10,000/year, $12,000/year, $8,000/year. To what degree can he change it? Well, nothing.
You can't change it. The mismatch of incentives, as we all know, is so extreme that there's simply no way to match the incentives to the rewards. If I go and fight this tooth and nail, I may stand to gain $8,000/year out of it. However the people who I am fighting are all gaining hundreds and hundreds of millions of dollars a year from having this coercive system stay the way that it is. And it's going to cost me hundreds of thousands of dollars to fight this, and there's going to be no incentive for any judge to rock the boat in this are. It's like farm subsidies or whatever. There's no incentive to fight it, because you have to pay in terms of time, money, and frustration. It's going to take you ten years or whatever. So there's a huge negative incentive to fight it, and there's a massive positive incentive to maintain it, which is that the financial elites are making hundreds of billions of dollars a year from forcing everyone at gunpoint to stick their money, or lobbying the government to do it. And the government of course gains an enormous amount of power, it gains enormous influence over the financial elites. So they can say, “You're going to do X, Y, or Z, or we're going to, by God, get rid of your capital gains entitlements, in which case they'll all stand in line.” And also the government gains power to regulate, it gains legitimacy for itself because it can say, “Look how crazy capitalism is! The stock market is insane! Of course we need to have Sarbanes-Oxley, and we need to have regulations to make sure that people aren't ‘cooking the books.' And we have to absolutely make sure that the market is not going to stay crazy, because, I mean, look at it. It just goes up and down, people's savings get wiped out, people's retirements get wiped out, so of course we need the government!” There's a large number of reasons why this kind of system tends to stay in place, but I guess the most important thing to get out of this is that there's nothing wrong with the stock market at all. The problem, as it always is with these kinds of situations, is the fact that an enormous amount of violence is being directed at people, which is forcing them to have their money taken from them and put in the stock market, which completely corrupts the essential nature of capitalism, which is that you really are going to get heavily rewarded for long-term strategic gains and heavily punished for only focusing on the short-term. The fact that all of this money is being forced into the stock market has completely reversed that trend and that fact, to the detriment of the market as a whole.
So when you're talking to someone about the stock market, and they say, “Oh, capitalism is so crazy,” just tell them about these simple salient facts and I think that they'll understand that the problem, as is always the case, is not the free market or human nature, but coercion and compulsion and the State. Thank you.
