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Investment and contribution

18 September 2020

Finance is important. It wins wars. Modern finance is one of the drivers for the quality of life we currently enjoy.

Money and our financial system enable us to enter into transactions, specialise, and allows us to take money into and out of the future.

Capital allocation

One of the most important roles of our financial system is to allocate capital. When resources are scarce, having a good system for using them will result in a more effective and efficient use of these resources.

The basic idea of capitalism, facilitated by modern finance, is to allocate resources to where they’re most valuable.

Yes, it’s awesome to own 2,500m2 of prime residential property with a single large house on it. But there’s a reason why, over time, these properties start to get subdivided and built up. Property is scarce. Two or four or more households living on the same piece of property creates more value for society than a single household, and the respective households, so these properties start to get carved up.

It’s the same with investing in a business. Businesses that have demonstrated revenue, a proven leadership team, and evidence that there is more demand than the business can keep up with, will more easily attract capital for expansion (whether by debt or equity), on better terms, than if my 20-year-old nephew and some of his drinking buddies with no IT experience wanted the same amount of capital to build the next TikTok.

Money is attracted to better opportunities.

No, I’m not attributing this to “money” itself. It’s an emergent factor. Capitalism, well-run, with thoughtful, properly-enforced rules which also acknowledge where private markets don’t lead to ideal outcomes and collective expenditure is necessary, allows this to happen effectively. Financial markets help modern capitalism work.

Two forms of investing

There are two main types of investing:

1. Investing to create capability.

2. Investing to buy an interest in existing capability.

(Yes, I’m simplifying. You can characterise investments across lots of different dimensions as well as these two. Most investments also fall across a spectrum rather than in just one of the two categories. You get the point.)

Investing to create capability

Peter Thiel (billionaire ~Kiwi; Paypal co-founder; early Facebook investor; etc) wrote a book several years ago titled Zero to One. It’s a well-written, interesting, and contrarian book.

Thiel’s book is about the types of businesses he likes: businesses that build capability.

Thiel likes businesses that innovate and create something that wasn’t already there. Ie: businesses that go from zero to one.

At the time Thiel co-founded Paypal (along with the “Paypal mafia”; early employees of Paypal have since gone on to build many billion-dollar-plus including Youtube, LinkedIn, Square, Palantir, and a couple of others I’ll mention soon), there weren’t any good options to facilitate online financial transactions. So Thiel helped create something that didn’t yet exist.

One of Thiel’s Paypal co-founders was Elon Musk. Since exiting Paypal, Musk has gone on to create multiple companies that are based on creating capability. He founded Tesla, which has popularised the electric car. He also founded SpaceX, which is in the process of revolutionising space travel – and building capability to send humans to Mars.

I have a special affinity for companies and founders who want to create capabilities that don’t currently exist.

Investing to buy an interest in existing capability

When I first sat down to write this article, the working title was “Are you adding value with your investments?”.

My starting point was: if you’re buying an interest in existing capability, what are you actually adding to society?

My starting point was going to be buying residential property to rent out. But I was also going to talk about investing in publicly listed companies (ie, shares).

If I like businesses that create capability then, as a financial adviser, doesn’t that make me a walking contradiction?

For most of my clients, I’m not recommending that they invest in creating capability. I am recommending that clients buy an interest in existing capability. Most commonly this is in financial assets such as shares and bonds (more specifically, managed funds that invest in shares and bonds). Another example is investing in direct property.

Am I encouraging people to invest in companies that aren’t creating capability? From a “capital allocation” perspective, am I encouraging clients to spend their money in ways that aren’t in line with where I think the real potential for economic development lies?

In new capability lies the potential for great riches

There are enormous potential benefits from investing in building new capability.

There’s enormous potential for people to create value at scale for a lot of people. Some of that value is likely to accrue to the people who make that happen, including people who provide the necessary capital (investors).

This might also be your way of making a dent in the universe.

The way to make enormous amounts of money is to get involved in high-growth ventures. You can start these ventures, or you can get involved in some other way – for example, by being an early investor or early employee (it’s easy to focus on the founders of companies, like Mark Zuckerberg, but let’s not forget that Facebook created over a thousand employee millionaires).

When this goes well, the debate amongst traditional investors – of saving 1% in fees, or generating a better return by 1% or 2% over time – seems like polishing brass on the Titanic. In the face of potential returns of 100% or more on your investment, 1% here or there seems like a waste of time.

The super-wealthy don’t become super wealthy by investing in widely diversified, low-fee, index-based managed funds.

Nor do they become super wealthy by picking stocks (unless they’re doing it on behalf of lots of other people and charging high fees for doing so – in which case, they’re making their money on fees, not returns!).

New Zealand’s tax system encourages building capability

Publicly listed shares in New Zealand tend to pay out a greater rate of dividends (which are taxable) than listed shares in other countries.

This is a little weird, because we don’t have a capital gains tax. If NZ listed companies had the opportunity to grow, it would probably be in their interest to reinvest and pursue capital growth.

At the individual level, it makes sense to go for capital growth. Ultimately, income and capital gain have the same impact on your net worth. But income is taxed and capital gain, for the most part, isn’t. All else being equal, it’s best to pursue the gain that doesn’t have the handbrake of tax.

(Before you pull me up on this, it’s worth noting that this is a policy decision. The tax system is designed this way, and one of the ostensible purposes is to encourage Kiwis to pursue capital gain. Again: building new capability that adds value to people tends to be good for people and the economy.)

… but in new capability lies the potential for great loss

There’s one little chestnut that stops me from encouraging people to spend all their money on starting businesses, or funding their neighbour’s son’s girlfriend’s new venture.

If preserving capital is a key goal, then it’s worth investing in existing capability.

Think of it this way. There’s a difference between getting rich and staying rich. Sometimes the super-wealthy lose their wealth by spending, but they most often lose it by investing. You don’t stop being super wealthy by investing a good portion of their wealth in widely diversified, low-fee index-based managed funds.

Also, it’s one thing to try to build new capability. But some people are better suited to this than others.

My 20-year-old nephew and his buddies? They should be focusing on other things, not trying to attract venture for their drunken idea mapped out on beer coasters.

Building capability is rewarding. But it’s hard. Not everyone can do it.

Not everyone is able to be a successful serial entrepreneur like Elon Musk or Peter Thiel.

Reinventing the wheel

Some people keep trying to reinvent the wheel. I know this, because I’m one of those people. I can’t help myself.

Sometimes this is great!!! I’m super proud of Fairhaven Wealth, for instance: as well as generating an income, I feel like I’ve created a template that other advice businesses can follow. When I started there was an element of going from zero to one.

You may have also gathered, I have different ways of doing things in all sorts of domains – for example, how I deal with social situations and consuming media. For me, these approaches are effective.

But most strengths are a double-edged sword. They’re strengths and weaknesses.

I take a long time to learn new things because I’m always second-guessing what I’m learning. I often try to do things by myself. Why pay for a piece of software when I can do it myself in Excel or Access? Why pay someone to build a website when I can spend hundreds of hours trying to do it myself?

Instead of spending hours doing something, it’s often better to pay someone who can do it better in a fraction of the time.

Instead of building your own car, buy a car.

Instead of building a house, buy a house.

In other words: it’s often best to buy capability, rather than try to create it.

When it comes to investing, if you invest in proven capability, it’s likely that you’ll get a return, as opposed to a loss, especially once you factor in the opportunity costs.

(All else being equal, my hope and expectation is that if you invest your capital in things like direct property or listed companies, you will receive a higher return on your investment than investing in a savings account. You’re taking on more risk, and you don’t have quite the same level of liquidity.)

At the end of the day, capital is necessary and important. By investing in pre-existing capability, whether in the form of, say, property or shares, you’re still contributing capital, and allowing for others who have other needs for their own capital to use it for other purposes, such as expenditure during their retirement.

Are you adding value?

One of the things that has historically nagged at me about investing in a share of existing capability was – you’re not really adding value.

One of my prejudices against investing in rental properties, for example, has been that I didn’t think it adds any value to society.

If your capital is invested a rental property, it generates an income from the occupants who pay rent to you. But what is the net difference in society? It could just as easily be someone else who owns the property. Maybe they would have paid slightly less for the investment at auction that you were prepared to pay. But arguably, you haven’t really added any unique value with that investment, which wouldn’t already have been created. The world goes on.

In fact, there’s an argument that you’re actually depriving society of value. It’s well-known that with property it is hard to match supply with demand: if there’s surplus demand, it takes time (and involves risk) to build more properties to respond to this demand, notwithstanding any regulatory hurdles that might be in place. If supply is relatively constant, and demand increases, what happens? Then all you’re really doing is driving up the price of property.

(If you develop a property, on the other hand, then yes, you might have added some value. If you own a home and spend your evenings and weekends renovating, then I hope you get something in return. You’re putting in time, effort, and money in. It’s not just a passive investment: it’s a venture. Think of this as fitting somewhere between the extremes of buying existing capability and creating capability.)

The same is true, however, of investing in publicly listed shares. In part, the purpose of writing this article was to interrogate a nagging belief that I was suggesting something to clients that seems a little wrong.

By buying shares in a particular company, or by owning an interest in a managed fund that owns an interest in lots of different companies, are you adding any unique value to the world?

Yes, you’re providing liquidity to existing shareholders who want to sell their shares. But it’s unlikely that you’re really providing capital to the business to help it grow and provide new goods and services to its clients or consumers. If you don’t buy those shares, someone else will, for roughly the same price.

The world will go on. Very little gained, very little lost.

Still, you’re taking on some risk compared to investing in more “safe” investments such as bonds. You’re also providing liquidity to existing investors who might now have a different risk profile due to their circumstances. The aggregate effect of our individual decisions is price discovery and efficient capital allocation, which drives the wheels of capitalism (in a good sense, not the “capitalism is evil” sense).

Investing in existing capability is part of the merry-go-round that’s necessary for our capitalist economy to function.

Picking stocks

Being a day trader, however, is a different story.

Professional investment managers serve an important role in our economy. They are “capital allocators”: their aim is to invest in businesses that are undervalued (on a risk-adjusted basis). The effect of many investment managers operating in this way is that the value of large, publicly listed companies are aligned with how valuable they are, relative to other companies.

Professional investment managers don’t just invest their own money: they invest the funds of the people who invest with them. Their decisions might be worth tens of millions of dollars, if not hundreds of millions or billions. All up, their transactions make a difference.

The reality is, however, that beyond a certain level, the marginal benefit of any additional investment manager falls pretty close to zero. (This is one of the reasons I never entertained investment management: it seems really attractive, but I just can’t square the circle with the fact that although the role of investment managers in the aggregate is important, my own role would not be especially valuable.)

If you try to pick stocks personally, with your own investment portfolio, are you going to have an impact on this pricing discovery? No.

If you’re the sort of person who thinks you can beat the market, you’re probably a clever person. You’ve accumulated some capital. The application of your talent, skill, and knowledge could benefit other people. But here you are, playing a zero-sum game that doesn’t really benefit anyone.

What value are you creating for others? What else could you be doing that is adding value to other people’s lives – whether family, friends, or your community? There is a genuine social cost to spending time trying to pick stocks.

If you’re trying to get an additional 1% or 2% on your returns than you might get from an index fund, then good on you. But that’s polishing brass on the Titanic compared to setting up a business that could generate 10% or 100% on your investment, that’s also adding value to others.

Maybe you find this to be an interesting hobby. But I put it to you: could you be using your time more profitably in other domains?

Conclusion

Investing in existing capability is a legitimate thing to do. It’s part of the merry-go-round that makes our economy function.

Instead of reinventing the wheel, it’s much safer to use the wheel that has already been invented, and invest in a much safer way compared to building capability.

But if you really want to make a dent in the universe, and you really want to generate better returns than you could by investing in shares or property, consider whether you can build capability and go from zero to one.

Be warned, however: building capability might have large potential rewards, but the potential cost can be enormous as well. Not everyone can be like Peter Thiel or Elon Musk.


Tags

building capability, capability, creating value, economic growth, innovation, investing in existing capability, reinventing the wheel, zero to one


About the author 

Sonnie Bailey

In his spare time, Sonnie likes telling people that he’s a former Olympic power walker, a lion tamer, or that he is an orthodontist. He is none of those things. In reality, Sonnie is a financial planner based in Christchurch. Through his business, Fairhaven Wealth (www.fairhavenwealth.co.nz), he provides independent, advice-only, fixed-fee financial planning services. Sonnie is a “recovering lawyer”: he has specialised in trusts and personal client work. He has also worked as a financial services lawyer for many years.

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