Chapter Three: Efficient Investing in Inefficient Markets
Where is the leakage?
Despite a litany of Nobel Prize winning work by a number of top-drawer economists, none have explained or even commented on the gap between the returns earned by the companies whose shares comprise the S&P 500 Industrial Index and the returns earned by the shareholders of those companies, who have realized returns 300 to 400 basis points lower than the return on equity of the companies themselves. If the owners of the companies are getting less than the companies earn, someone else is getting a piece of the action. Who?
That question is complicated and nuanced.
A macroeconomic perspective is a good place to start. It has been said that all wealth is created by altering the shape of matter at or near the Earth’s surface. In the digital age, we can modify that definition to include wealth created by altering the order in which vectors of sets in fields of characteristic two appear in lines of code - simply stated, software. That software exists only if there also exists hardware on which it can operate. Intellectual property is “wealth”. So is fine art.
We can tell what is “wealth” by whether it is something we can leave to our children when we pass. Wealth is not the same as “well being”. Many services create “well being” but do not create wealth. If they do not create wealth, they are either irrelevant to wealth or engaged in a process of redistributing wealth already created. Hair salons, massage therapy clinics, fitness clubs, nutritional advisors, etc. are in the “well being” industry. They do not create wealth but consume wealth created by others.
Stated simply, if it cannot appear as a line item on the list of assets you set out in or attached to you will to leave to your heirs, it is not “wealth”. If may be important, useful, valuable in the sense of the degree to which it makes us feel good about ourselves or others, but it is not wealth.
Economic returns are related exclusively to wealth. The “securities” that populate secondary markets are not the direct products of wealth creating activites, but are claims on the fruits of those activities. They comprise “wealth” as first derivatives of the wealth creating activity in which they comprise a “share”. They can be left to heirs in a will and be valuable to the extent that the company in which they comprise a share creates wealth. Perhaps that is why financial intermediaries describe a large of part of their activities as “wealth management”.
But let me start by asserting that there is a whole industry dedicated to the task of reducing the returns enjoyed by investors by pretending to be able to generate returns for them better than the market averages - the investment banking, fund management and brokerage industry. Every dime they earn comes from the investors in whose interests they claim to act. Every dime.
There are other “leakages” that explain why returns on capital employed (and returns on equity) are lower than the value created by operating the companies that create the wealth we share as a society. The underwriting fees are paid by the issuer and already come from the operating companies so that part of investment banking is not a leakage. Indeed, the existence of secondary markets which harness the savings of citizens everywhere to fund corporate growth depends on underwriters. That part of investment banking is part of the “wealth creation” enterprise and often the lifeblood of the wealth creating sector of the economy.
As secondary markets developed, securities regulation to protect investors grew as well, and the costs of that regulation are paid by the regulated entities by and large, but there is also a “leakage” when the costs of regulation burden investors by an amount greater than the value of the protection they provide. Excess regulation is parasitical to returns on investment not only for the regulated corporations (and already counted in their return on equity) but also for the investors themselves since the costs paid by regulated intermediaries to comply with regulations comes out of the fees they charge investors. That regulation is intended to protect investors and it does. It also punishes investors when it becomes over-regulation. I will discuss the regulatory costs in a separate chapter.
Transaction fees, commissions, advisory fees and fees charged as percentage of “assets under management (AUM’s)” are primary leakages that explain much of the gap between the returns earned by the issuing corporations and the returns actually earned by the investors (the owners) of those corporations. In the next chapter, I will discuss the parasitical nature of the investment banking, advisory, fund management and brokerage industry and demonstrate why it is a cost, not a benefit to investors. I will provide some data to show just how much of the income earned by public corporations is distributed to financial intermediaries at the expense of the owners of those corporations, and in another chapter how much of the economic rents garnered by wealth creating activities in those corporations is lost to “securities regulation” - a necessity to keep markets safe but often an excessive cost when regulators over reach their role and impose regulations that are not enacted to make markets save but to achieve some other “social good” like ESG or concern about the specious but popular notion that CO2 emissions cause climate change.
Curiously, it is not only securities regulators that over reach, but also the financial intermediaries embracing the ESG or climate change narrative and directing money entrusted to them by owners of corporations to corporations which embrace ESG and climate change “goals” and necessarily earn lower returns for owners of their securities burdened with the costs of disclosure of progress towards those goals and lower returns on capital from funds misdirected to projects they believe will advance those goals rather than achieve the corporate purpose of returns to owners. If intermediaries know (and they do know) that ESG and climate change goals damage returns, why do they promote it?
One argument for ESG and Climate Change as goals is promoted as creating a lower cost of capital. It is unclear whether that is an outcome, but irrelevant. A lower cost of capital is identical to a lower return to investors, since what corporations pay to raise money is precisely what investors get for providing it. A lower cost of capital manifests itself in higher share prices which benefit those charging fees based on AUM but punishes investors who suffer the lower returns.
Another argument for burdening corporations with costs to provide a “social good” is the benefit to society from corporations having as primary objectives not only returns to investors but also social justice objectives. No one can argue imposing those costs on corporations does not lower returns unless there are no costs. Corporations are generally managed by people who want better communities and if there is not cost they will naturally take steps to improve their communities and avoid those that create harm - not always but in general. Society develops civil and criminal laws to curb corporations whose actions create harm.
The problem with imposing social goals on corporations is that “social goals” are the domain of legislators who we elect, change with those in power, and often reflect ideology rather than some objective measure of goodness. The term “public good” appears over 6,000 times in Canadian statutes but is defined in none of them, leaving it to judges to determine whether a particular act or omission is in the “public good”. Circumstances alter cases and what is in the interest of society is neither absolute nor broadly accepted. That is why we have elections - to change government and laws if the electorate is not satisfied with policies in force.
Famed market theorist Aswath Damodaran has written about ESG and not favorably. His most recent article calls ESG a feel good scam (which it is). Man caused climate change is utter nonsense, promoted by left wing ideologues to rally support for socialism. Many physicists have pointed out the holes in Anthropogenic Climate Change (AGW) theory only to be vilified by the alarmist community. A recent peer-reviewed (and quite readable) article by German physicist Dieter Shildknecht masterfully exposes the nonsensical underbelly of AGW in an article “Saturation of the Infrared Absorption of Carbon Dioxide in the Atmosphere”. Shildknecht’s analysis has the benefit of conforming to the laws of physics if not to the rationale for the “climate change” laws enacted by left wing governments and destructive actions promoted by the United Nations, the World Economic Forum, and socialist leaders everywhere.
Chapter Four expand on the reasons for the lower returns for investors (which I described as “leakage”) and Chapter Five will put dimensions on the size and scale of the “leakage” of returns between the corporations that create them and the investors who own those corporations.