Tuesday, May 15, 2018

Das Capitalist

I'm in kind of a weird position these days. I'm fortunate enough to have accumulated a bit of a nest egg and have enjoyed learning how to nurture it: practicing frugality, sound investment strategies, simple financial planning. Over the years I have started to dip into some slightly more esoteric topics like tax efficient fund placement and portfolio management. At the same time, I'm increasingly skeptical of our financial system, investment, and, honestly, American capitalism in general.

With this odd confluence of interests, I've found John Bogle a refreshing voice. He has an impeccable background to speak on financial issues: he founded Vanguard, created the world's first index mutual fund, and today is a sort of emeritus godfather to the company overseeing more than five trillion dollars of investors' money. But, as I learned while reading Enough., he is deeply distressed at the state of the financial world, and has been more forceful than almost anyone in calling for its reform. And not just forceful: articulate and detailed, using his insider's knowledge to point out where the bodies are buried.

I'd been meaning to follow up on Enough., and was drawn to the fiery title of one of his earlier books, The Battle for the Soul of Capitalism. I'd picked it up imagining that it might question the roots of capitalism. It doesn't. Bogle is a true believer in free markets and takes the rightness of capitalism for granted. He is a prophet in his own country, speaking to those who share the same fundamental beliefs.

In retrospect this totally makes sense: of course the founder of an investment company would be fervently devoted to capitalism. The title is really about freeing a virtuous soul from the carapace encrusting it, not about redeeming a damned soul.

The book also ended up being more technical than I expected. That was a good thing in some ways: it includes some really clear explanations of concepts that I hadn't fully grasped before, like how to calculate a stock's fundamental expected return (combine its current dividend yield with earnings growth). But, since the book was written more than a decade ago, much of the technical detail is now irrelevant.

The Battle for the Soul of Capitalism was published after the dot-com bust but before the global financial crisis, and for better and worse he proved to be very prescient in many of the alarms he sounded. Several of his specific policy suggestions were eventually addressed by the Obama administration or by shifts in the market. Earnings guidance from management is not as big a factor in 2018 as it was in 2005. Accounting standards seem to have improved, with stronger divisions between traditional accounting and consulting. More corporate boards are independent and it has become rarer for CEOs to also serve as chairmen. But many of the issues Bogle flags have gotten even worse in the past decade. High on this list is short-term trading: we now have high-frequency trading, which is causing unprecedented levels of churn and bizarre volatility.

He ranges over three related topics in the course of the book: corporate America, investment America, and mutual fund America. Each of these has lost its way, each has behaved inappropriately, each is bilking investors out of their money, and each needs to be corrected. (Perhaps surprisingly, he endorses government intervention to put things back on track: he would prefer self-regulation, but reluctantly observes that the industry has demonstrated it cannot police itself.)

The details of each domain are different. Corporate America has been taken captive by managers who behave like owners: instead of acting as stewards for their public investors, they run the companies for their own private benefit, granting themselves obscene compensation and resisting efforts at oversight, using accounting chicanery to defraud pension funds and claim unrealistic but lucrative profits. Investment America charges outrageous fees for abysmal performance, skimming enormous sums from their clients, promoting schemes that maximize their company's take rather than their customers' returns. And mutual fund America is a passive giant, holding a dominant portion of the country's companies but unwilling to use its power to advocate for its investors' interests.

Stepping back from the details, though, I think the core problem Bogle is pointing out is people caring about the company they work for, as opposed to just their own self-interest. Companies that are still run by their original founders or family members tend to behave rather well: they care about what they've created and have an emotional incentive to see it remain strong. In the vast majority of cases, though, a CEO is paid with other peoples' money and is continuing someone else's legacy. In those circumstances, it's understandable that managers will mostly want to enrich themselves, and that's the seed of the problem Bogle identifies in all three of these sections.

But! It isn't at all unique for managers to look after their own interests. Stockholders, after all, are also motivated to enrich themselves. I mean, if I own stock in Caterpillar, I don't really care all that much about what Caterpillar does, I mostly care whether Caterpillar makes me money. Bogle thinks that its acceptable for stockholders to demand profit through the shares they hold, but it isn't acceptable for managers to demand profit through the position they hold. Again, this is something he takes for granted and that's axiomatic for a capitalist, but it struck me many times while reading this.

If greed is the root problem, then apathy is what's preventing a solution. There are too many stockholders, too much intermediation, too little connection between the decisions made in the boardroom and the attention of the real owners. I thought this was very ironic, since Bogle almost single-handledly transitioned the American stock market into the super-diversified form it's in today. When he first started, an individual investor might have bought a number of shares in Coca-Cola, and actually cared about the firm: followed its movements, voted for directors, written letters to shareholder meetings. Now, an investor will own an infinitesimal slice in every company in America. That's largely a good thing for the investor, as it means perfect diversification and broad exposure to the whole market, but it destroys the opportunity for engaged ownership and corporate citizenship that Bogle seems to crave.

I thought Bogle's attack on the mutual fund industry was particularly interesting. He's admittedly biased, but he makes an incontrovertible case that publicly-held mutual funds perform far worse than privately-held ones. But... doesn't that seem like it would apply to other companies as well? Why are we buying stocks at all? Why are we investing in public companies if they do so poorly? He doesn't examine this question - again, it's a core principle that he takes for granted - but two possibilities occur to me.

The first relates to Bogle's belief in professions versus business, an idea he touches on here and deals with at greater length in Enough. In Bogle's view, a profession isn't primarily about making money, it's a prestigious and important element in civil society. He considers professions like law, architecture, and medicine to fit this category. (Think, also, of the old cachet of owning a newspaper: until a few decades ago, it was seen as a mark of prestige and civic engagement, not as an opportunity for creating wealth.) Business is great for making widgets: if you're creating products to sell, or providing a luxury service, then it's right and natural for you to seek high returns and charge what the market will bear. But a profession should remain primarily focused on their calling: they need to make enough money to support themselves and keep their office strong, but profit should not be the primary goal. With this way of thinking, then, publicly traded companies can be a good investment, but not every type of company should be publicly traded. Companies that primarily provide professional services should remain closely held, so they can keep their mission central and not be swayed by the market's demands for higher returns.

The other possibility is that public corporations are just bad investments. The best businesses will be closely held, run by the original founders for their own benefit, or as part of a tight legacy like a family, mutual enthusiasts (e.g. REI), etc. As soon as a business opens up to all investors, the original passion and mission will inevitably fade, second-generation managers will focus on their own interests, and profitability will slide. To adapt a phrase, publicly traded corporations are the worst form of investment, other than all of the other forms we've tried: it's the one form that allows us to easily buy a slice of a company, even if the fact we're allowed to buy into it means it won't be compelling.

Another way to look at it: you would have the most opportunity for upside by personally starting a business, or by directly investing into a private business. But those actions are extremely risky and require a great deal of time and attention from you. We're sacrificing some profit from those and accepting a lower return in exchange for lower risk and more stability. A Fortune 500 company is less likely to fail than your new cafe.

Again, though, all of the above assumes that the primary goal of a business is to maximize profit for the owner. Bogle's main thesis is that "owners capitalism" has been supplanted by "managers capitalism". In the former, a business is run for the benefit of its owners. This doesn't mean accounting shenanigans or short-sighted cost-cutting: it means building a strong, trusted, stable, enduring business that will continue for a century or more, steadily growing and generating profits for its stockholders. In "Managers capitalism", the business is run for the benefit of the CEO and other top officers: they are theoretically stewards who are employees of the stockholders, but instead view the company as their own property to milk, engaging in short-term maneuvers that will boost their personal compensation during their years at the company instead of making decisions that will strengthen it for years to come.

What's missing in the above tension between the owners and the managers? The workers! There are zero words in the book about the value generated by workers and whether they deserve a share, let alone how large that share should be. Bogle is concerned about how profit is distributed, but (in my opinion) it's ultimately the workers who create that value. The owners front the capital that provides opportunity, the managers organize the resources and ensure quality, but it's the workers who actually, uh, work and create economic value.

(The only time Bogle references workers is when discussing pension funds, which, to be fair, he's very passionate about. He seems to care deeply about the social compact pensions represent and is distressed by the likelihood that they will fail to provide their promised benefits. But he's primarily focused on pensions as funds and not as compensation: he mostly treats them as an investment made for a particular purpose instead of as a rightful share of profits earned by workers.)

At the end of the day, Bogle is a true believer in capitalism, but does not believe that capitalism is the answer to every problem. Oddly enough, the more important an enterprise is, the less likely that it should be run as a business. Crucial professions should be run for the sake of their mission and not to maximize profit. Capitalism by itself is not virtuous, just (in his view) a proven effective means of generating wealth and distributing that wealth to a group of people. Managers capitalism is still capitalism: managers are acting rationally to maximize their income. In Bogle's view, though, managers capitalism is a bad, dangerous, and inferior form of capitalism that does not produce broad societal benefits.

Finally! I wanted to jot down a few passages that I thought were especially interesting or well-said. (Transcribed by hand, please excuse typos.)

Page 43:
The truth is that most business measurements are inherently short-term in nature. Far more durable qualities drive a corporation's success over the long term. While they cannot be measured, such traits as character, integrity, enthusiasm, conviction, and passion are every bit as important to a firm's success as precise measurements. Human beings are the prime instruments for implementing a corporation's strategy. Other things being equal (of course, they never are), if those who serve the corporation are inspired, motivated, cooperative, diligent, ethical, and creative, the stockholders will be well served.
I thought this was very well-said. He develops this point further in Enough.: pay attention to the things that count, not the things that can be counted. Also, note that he accurately identifies employees as the primary source of business success. It seems like they should have a seat at the table.

 Page 44:
The companies that will lead the way in their industries over the long term will be those that have made their earnings growth not the objective of their corporate strategy, but the consequence of their corporate performance.
Another keen observation that I first encountered in Enough. Do not focus on improving a business' metrics: focus on improving the business, and the metrics will follow. Metrics should measure success, not drive it.

Page 163:
Looked at from yet another perspective, the investor put up 100 percent of the capital and assumed 100 percent of the risk, but collected only 57 percent of the profit. The mutual fund management and distribution system put up zero percent of the capital and assumed zero percent of the risk, but collected 43 percent of the return. If this example does not represent the paradigm of the triumph of managers' capitalism over owners' capitalism in mutual fund America, it is hard to imagine what would. Almost half of the fund owners' money was siphoned away by those who quite literally had everything to gain and nothing to lose.
Definitely good for investors to consider. I have to say, though, that I've never been too happy with the (nearly universal) statement that owners assume all the risk. It's only their capital that's at risk. When a company goes under, the owners will lose their capital, but the people who work for that company will be far more devastated: losing their jobs, healthcare, social bonds, professional edge. That isn't especially relevant to the specific case of mutual fund advisors he's discussing here, but it's a formulation that I think bears closer consideration than it receives.

Page 176:
  This devolution is hardly limited to the mutual fund field. It is reflected all across our society, as one profession after another has taken on the defining attributes of a business... I've seen this field move from being primarily a profession of investment management to becoming largely a business of product marketing. The same transition - albeit in a very different way - has taken place in the medical profession, where the human concerns of the caregivers and the human needs of the patient have been overwhelmed by the financial interests of commerce, our giant medical care complex of hospitals, insurance companies, drug manufacturers and marketers, and health maintenance organizations...
  Consider too how the profession of public accounting became dominated by the business of consulting. Think about the increasing dominance of "state" (publishing) over "church" (editorial) in journalism, as well as about the rise of commercialism in law and architecture that has eroded traditional standards of conduct. In all, professional relationships with clients have been increasingly recast as business relationships with customers. In a world where every use of services is seen as a customer, every provider of services becomes a seller. When a provider becomes a hammer, the customer becomes a nail.
  Please don't think me naive. I'm fully aware that every profession has elements of a business. Indeed, if revenues fail to exceed expenses, no organization - even the most noble of faith-based institutions - will long exist. But as so many of our nation's proudest professions - including trusteeship, medicine, accounting, journalism, law, and architecture - gradually shift their traditional balance away from that of trusted profession and toward that of commercial enterprise, the human beings who rely on those services are the losers.
  ... Roger Lowenstein... bemoaning the loss of "Calvinist rectitude" that had its roots in "the very Old World notions of integrity, ethics, and unyielding loyalty to the customer." "America's professions," he wrote," have become crassly commercial... with accounting firms sponsoring golf tournaments." ... And so it is as well in the trusteeship of other people's money.
Terrific explanation of the role of professional services in the landscape of America. I tend to be skeptical when people write about how bad things are today, that stuff was so much better in the good old days. But I do think there has been a sea change in America starting with the greed-driven 1980s, and that force is behind the shifts that distress Bogle here. It feels like we might be on the cusp of a reexamination of the social compact, which might seem like it flies in the face of Bogle's Republican instincts but could restore the more mission-oriented society he longs for.

Page 220:
When ethical values go out the window and service to those whom we are duty-bound to serve is superseded by service to self, the whole idea of the capitalism that has been a moving force in the creation of our society's abundance is soured... Rather than prizing financial profit above all else, we must work to become a society... once again celebrating achievement over money, character over charisma, substance over form, virtue over prestige.
A nice summation of Bogle's worldview. Capitalism has helped generate our abundance, but isn't inherently virtuous, and must be closely monitored and guided to achieve good ends.

Page 221:
  Numbers are only numbers, quantities on a scoreboard that are only one measure - and, truth be told, hardly the best measure - of an enterprise.
  Put the greater interest of of others and the dignity of our own characters first, and our own self-interest second; put enterprise and animal spirits first, and managing for the bottom line second; put the joy of creating and the will to conquer first, and the mindless conformity of greed last. 

Another good recap of the proper role of measurements. Focus on what counts, not on what can be counted.

Page 232:
Today's reliance on tax-advantaged savings, however valuable to our well-to-do citizens who can afford it, does little but further raise the ever-widening gap between our wealthiest families and our families most in need. This growing division of wealth is not only a destructive force leading toward the creation of a "two nation" society - rich versus poor - but represents an unwelcome departure from the basic principles of our Declaration of Independence and our Constitution.

This was a bit of a tangent from the main thrust of the book, but I found it very interesting. It's super-weird that someone as wealthy and connected as Bogle would sound like Bernie Sanders (way back in 2005!). The point he's getting at here is that our tax code is stacked to favor the already-wealthy. He doesn't proscribe any specific policy recommendations on this particular topic, but judging from his comments elsewhere in the book, it sounds like he favors a strong Social Security system that would provide a secure retirement to all of our citizens.

Anyways! I feel like this write-up has been more scattered than usual, which doesn't reflect the book itself. It's very well-organized and cogent, steadfastly building the thesis and showing how it applies to all of these aspects of our business and financial systems. I don't think I'd necessarily recommend this book; the most interesting aspects of it are more fully developed and better presented in Enough. But I don't regret reading it: despite some of the specific topical references now being outdated, the core problems Bogle identifies sadly still remain, and it's refreshing to see such a detailed condemnation paired with practical suggestions for fixes. To be fair, it sometimes feels like Bogle is writing to an audience of about a dozen people: unless you're the SEC chairman, a senator on the Finance Committee, or the President, you probably won't be in a position to implement the policy changes he wants. But I think all of us who participate in this economy can benefit from a clearer understanding of the systemic problems it faces and the forces that will need to be reconciled, hopefully sooner rather than later.

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