Sunday, October 7, 2012

Who Creates Wealth? (III)

In the previous post in this series we saw that shareholders or capitalists do not need to contribute anything to a firm's productive process in order to gain from it.

Their gains, we also saw, come from their ownership of the shares.

In other words, their part ownership of the firm, represented by the stock, allows them to accumulate financial claims on wealth they did not generate.

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Some would object that successful investors deserve those gains, even if they don't contribute to the productive process. It's a matter of morality: they are like the virtuous ant in the ant and the grasshopper tale.

Let's add another, related, objection: it takes an analytical mind to pick a winner in the stock market; there are risks involved, too; successful investors must be real smart.

This last objection is arbitrary and as likely to be true as it is to be false. Maybe these successful investors were just lucky, buying into AAPL (as exemplified in the previous post) because the name was pretty. Sometimes people, even exceedingly moral ones, like investors, get insider information. Then they put their holding inside a safe and forgot about it; or maybe just fell into a coma.

Research has found no evidence that investors systematically outperform the market. At most something like:
"(...) Results suggest that the pros selection statistically outperforms the random selection only in the one-week period. Over a six-month holding period, the random stocks perform better than the pros recommendations". [1]
And that possibly because of a kind of "self-fulfilling prophecy": a respected advisor recommends a stock, investors buy into it, making the price go up.

Regardless, for the sake of the argument, let's assume our friend Fred is a true "market visionary", who heroically saved money, penny by penny, and invested it in AAPL at great personal risk. Doesn't he deserve his gains, even if he did not generate the wealth he claims?

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Foxconn assembly line workers are paid to assemble machines; not for their personal virtues: no bonuses for playing the clarinet, being nice or smarter than Odysseus. Apple Inc. designers are paid for their designs; computer programmers, for the software they write. No morality considerations are sufficient to change this [2]

They all contribute to their employer's bottom line and that's why they get paid. No morality considerations are necessary: if they are not paid, workers stop producing, the firm stops selling and there is no money to pay suppliers, taxes and dividends. Workers generate their own pay, plus a lot more.

"Ah!" - the free-market believer says - "Governments, too, extract money from the firm, as taxes. But they don't contribute to the productive process. Why don't lefties denounce this?" It's questionable that governments aren't functional for capitalists; but to argue why would take us far from the subject. [3] So, it's easier to assume it: "You are right. Governments are parasites and do not contribute in any way to the productive process".

As we saw last time, shareholders (Fred among them) contributed nothing at all to Apple's performance, and legally extracted money from it. If I were a free-market faithful I'd find it difficult to differentiate a shareholder from the Government in this sense.

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Let's look at this from another perspective. If the reader is a shareholder (say, an Apple Inc. shareholder), try the same thought experiment: write Tim Cook a forceful letter demanding higher dividends for you, because you are really nice, a good clarinet player or smarter than Odysseus. At best Apple's CEO's reaction would be something like: "Good for you! So what?"

That answer would sum up the notion that for Apple Inc. Fred's morality-based claims are as irrelevant as his age, religion, height, wisdom, beauty, or musical tastes. After all, firms, too, own shares and firms have no virtues.

Careful readers may have noticed the adjectives "sufficient" and "necessary" used above: morality and pay "smarts" are neither necessary nor sufficient to justify workers' pay. This means that for workers, in a logical sense, pay and morality are not logically equivalent. Why should dividends/capital gains and morality be equivalent for shareholders?

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I'll try next the last common objection I've heard: Small shareholders (like Fred) don't control the firm. Big shareholders do; their momentous decisions on crucial matters, that's what creates wealth!

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Readers are invited at all times to submit their questions, to offer their own original objections and comments. Please, however, check the Comments page before posting.

Notes:
[1] Liang, Youguo; Sanjay Ramchander and Jandhyala L. Sharma (1995). The Performance of Stocks: Professional versus Dartboard Picks. Journal of Financial and Strategic Decisions. Volume 8 Number 1 Spring 1995

[2] Skeptical readers may try the following thought experiment: demand a pay raise forcefully from your boss because you are really nice or a good clarinet player. DISCLAIMER: if you do this in real life (which I don't recommend), you assume all responsibility for your losses.
[3] "Adam Smith: the Retcon?" hints towards the real contribution of the State to capitalism.

5 comments:

  1. @Magpie,

    A couple of things.

    First, I would not embrace a substantial degradation of the English language by accepting speculators on the secondary equity markets as "investors." Participants in any public offering or private placement of stock may be properly called "investors" because they are actually giving the company money in exchange for stock, but everybody else is just a gambler, as the stock price is not determined by anything other than a calculation of the net present value of the company that makes numerous assumptions about future growth and certain conditions that simply are not true in the real world.

    Second, the individual investor has no say on how a publicly traded company is run. Most individuals trade with brokers who themselves trade the stock, and it is usually the broker who votes the shares. This means that, in reality, it is only the institutional shareholders that matter. Everybody else is meaningless. Why? Because large holders of a stock can substantially suppress a stock price by quickly selling out of their position. What matters is the stock price, and the individual investor has no say on that. Large holders of a company's stock effectively hold company management hostage except to the extent management is willing to do what is necessary to succeed in the long run.

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    1. Thanks.

      That's precisely the topic of my next installment (in one or two weeks, if time permits).

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    2. I speak from firsthand experience as a public company exec who had the pleasure of engaging in investor relations from time to time. Feel free to contact me directly if you want to test out any theories. While I can only speak from my own viewpoint, you might find it helpful.

      taojonesing "at" gmail dot com

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    3. Thanks Tao.

      Your input will be appreciated and certainly, given your experience, most valuable.

      Let's wait until I have my own reasoning here and then we can discuss it.

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    4. Apologies for the delay.

      Here I reply to one of your two objections:

      Who Creates Wealth? (IV)
      http://aussiemagpie.blogspot.com.au/2012/10/who-creates-wealth-iv.html

      I am considering the reply to the other objection.

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