Could you answer the question: “What value do investors add to society”?
Not venture capitalists, not activist investors, not owner-operators, not macroeconomic investors either. This question pertains specifically to money guys who pick stocks. Hedge funds have become synonymous with high pay and – with the rise of passive investing – many are questioning what value fund managers actually add.
As a thought experiment, imagine you were in charge of all the resources in a country. You had to decide who got what, which projects got funded and which sectors are most important to the public. If you were the government, this would be communism.
Capitalism is the opposite: no one person decided who gets what or what is more important to society. Instead, people (with capital) bid on prices of things they want – a roll of toilet paper, company stock, or a legal contract. These bids create demand for the thing, and the thing becomes more valuable. This way, the collective bidding by people with capital – capitalists – tells society what it values. Society then creates more of the valuable things and less of the not-valuable things.
What has this got to do with investors? Understanding how capitalism works lays the foundation for understanding the value that investors, as a collective, add to society: They tell society what is valuable. The public markets, where investors act as a collective, are the medium through which investors can tell the world what to value.
This is very important. If investors value innovation more than they do the fundamental provision of basic necessities – as is often the case in stock market bubbles – then for a little while the world becomes innovation-central. Bubbles come from narratives about future growth. They can offer innovative and enterprising companies (like Tesla) the cash and freedom to tinker and experiment. Tesla promises future yield, and through funding capital raises, investors give Tesla money.
Sometimes this innovation pays off handsomely. The market loves the product and it creates real value for people. Other times, investors overestimate the real value the innovation creates. Overall, the public markets allow for investors to dialogue with each other about what really creates value, and what doesn’t.
The 18th century French economist Jean-Baptiste Say first coined the word entrepreneur in reference to someone “who shifts economic resources out of an area of lower and into an area of higher productivity and greater yield”. Defined like this, investors of all kinds can be seen as entrepreneurs – everyone is looking for higher yield.
But why is yield so important? This is the question-in-response-to-the-question asked at the beginning. Figuring out where money can be used to create real value is the main job of an investor. If we are wrong in our bets, we lose money. Investors take this risk because when money is used well, it funds activities that produce more than they cost, creating yield for the investor.
Broadly, there are three “buckets” of financial instruments: insurance, debt, and savings & investment. Each of the three buckets play a different role in helping money flow from where there is too much (usually where it is created) to where there is not enough (usually where it is needed). Yield is what we get when we move lazy money to a place where it can be used. Yield is also what investors call risk premium.
Insurance is a method of transferring risk. Big companies can afford to pay your hospital fees, whereas you would get “blown up” if you had to foot the bill. You pay risk premium to your health insurer for the favour of them bearing this risk.
Debt is like ownership, but with less risk. It also helps grease the economic wheels. Some debt is low risk (like home mortgages) and therefore gives low yield and charges lower interest rates. Other debt is high risk (like unsecured lending) because the borrower could bail, and the lender would have nothing. This is why junk bonds have high yields.
Savings & investment is the realm of the stock-picking money guys. These guys are the investors who are trying to find out whether businesses create real value or not. All profitable businesses create some kind of value.
Business is easy: you need to create value for others, you need to capture value for yourself, and the value that you capture needs to be more than the cost of creating that value. Excellent businesses can reinvest the captured value into new projects which serve more customers with better value. The more of these businesses that there are in the world, the better off the world is, because more value is created for more people. Taking lazy money and putting it into businesses which can do this should be the goal of investing.
But some investors bid up prices of excellent businesses too high. When this happens the added value of another investor putting her money to use in an excellent business falls away. Her opportunity cost is too high. There is too much money chasing too few opportunities.
Because all profitable businesses create some kind of value, investors have to manage the trade-off: do they invest in great businesses, or do they buy ones which create value, but are unloved? Is the yield higher with this great business, or are people missing the value that the unloved business creates?
Since the public markets allow for investors to dialogue, it is the collective answering of these questions over time that determines the value of a company to the world. This value is a factor of how much value the business adds, how much risk there is in buying it, and how much yield it can make for the investor.
Nassim Taleb noted once that “we should study risk-taking, not risk-management”. Because the future is uncertain, and the world is a complex place, there will always be risk in business. So, the goal for all investors is to take this risk well.
The three financial “buckets” act as tools to help us seek out the risks that enable us to progress as society. When investors of all stripes dialogue together unknowingly, the public markets set our societal values and tell us what is worth chasing. As the venture capitalist takes the riskiest bets, he looks to the private market to reward him. The private market in turn looks to the first public investors, and those investors finally to the secondary market – our stock-picking money guys.
So what value is a value investor? She is the counterweight to society’s hype. It is her role to inject sanity into the market, bidding up the price of a business that creates more value for more people than the world is currently giving it credit for.