Posted 2/24/2009

Last night I was visiting with a couple of my very good friends who are soon to move from sunny Scottsdale back to New England. Why they would move from somewhere having 80 degree weather today, to a place where the high today was 35 degrees, I can’t say. Perhaps it has something to do with the clam chowder?

While we were talking about things, the topic of making money came up. One comment was that all the money made by paper shuffling is really not useful; buying and selling stocks, bonds, and the like, while quite lucrative at times (and for certain people) appears to not really “do” anything. Money, she said, should be earned by providing a definite good or service – like selling cars, or cookies, or paying someone to clean your home. [I’m paraphrasing here …]
And it got me to thinking. Is there anything to this idea? I know the US has become more of a “consumer” nation rather than a “producer” nation, and I know this has hurt us economically. Of course, one of the things our government has been “producing” like crazy is credit, and this, too, has led to problems.

To think about whether equity transactions (buying and selling stocks and such) is just paper shuffling, I had to think about where it starts; usually, a small business is put together by some partners, and to raise capital for operations, the partners put in some of their own money, and often raise capital from family, or angel investors, or other sources. In return for this, the investors get equity in the form of stock certificates.

If a company is started with, say, $100,000 initial capital, and there are initially 100,000 shares of stock, then each share is worth $1. It doesn’t usually work this way, though, because the founder’s ideas and the fact that they are doing all the work (often without a salary) lets them value the company for more than the initial capital contribution. So maybe the founders value the company at $1,000,000 and sell the 100,000 shares for $10 each, but only sell 10,000 shares; then they have the other 90,000 shares left to reward themselves later, or to sell for additional capital if they need it.

I don’t see anything wrong with this sort of transaction; it is in furtherance of creating a business which will provide a good or service. The question really comes when one of the initial investors needs money and sells his shares (we won’t quibble over private offerings, restricted shares, and SEC rules here) to a friend for $15. Now the investor has made a 50% return on his money, but there wasn’t really any value added in terms of a product or service, unless you count the due diligence and relationships required from the initial investor; he deserves a return for making those efforts. So while this is starting down the slippery slope, I’ll still give it a pass.

Now let’s expand this view to the New York Stock Exchange. This is the place where millions of shares change hands, and mostly the companies whose shares are traded do not get any benefit from the purchase and sale, unless the company is buying or selling its own shares. As shares rise and fall, so go the fortunes of the employees of the company with investments in stock options or 401k plans, so I suppose you could say that it is in employee’s interest to keep the stock price high; but really it is in the interest of the investors to keep the price as high as possible, so that they can get a return on their investment.

When I buy stock in a company like GE or Johnson & Johnson, there are so many large stockholders that my investment is like a gnat on the butt of a rhinoceros. So I really have no control over what happens with the stock price, and I am generally just along for the ride. When I buy the shares at the exchange, rather than directly from the company, I am buying them because someone else wants to sell at the price I am willing to pay – the company itself is really not involved in the transaction. So this purchase has, apparently, nothing to do with goods or services – I’m buying a rock in hopes that later someone will pay me more for the same rock. Of course I am hoping that I picked a really pretty rock, and that it will stay pretty, because if it gets ugly no one else will want it. It isn’t like buying a service or a product, because all I bought was paper. And, I don’t have the rock. Someone else is taking care of it for me and I trust that they will keep it pretty.

What if I actually buy a rock? As in a gold nugget? I think this is different, because gold has industial and other uses which drives demand. It isn’t just that gold is rare, there are many rare metals (and other pretty rocks); it is that it has use. And if something has a useful purpose, then it is more of a product than a rock. So while you can make money buying gold and holding it (at least over time that seems to work well), in terms of my discussion last night I’m not sure if it qualifies as a product. I personally think it does, because at the least it is a raw material for which there is demand, and it shows up as jewelry and contacts on circuit boards and many other uses.

I haven’t seen a time when a product was sold which was made of stock certificates (especially when the actual certificate may be electronic in form), except for the ones I use for wallpaper in my Hall of Investment Shame.

However I am called back to the fine words of Francisco d’Anconia, as written by Ayn Rand:

“So you think that money is the root of all evil?” said Francisco d’Anconia. “Have you ever asked what is the root of money? Money is a tool of exchange, which can’t exist unless there are goods produced and men able to produce them. Money is the material shape of the principle that men who wish to deal with one another must deal by trade and give value for value. Money is not the tool of the moochers, who claim your product by tears, or of the looters, who take it from you by force. Money is made possible only by the men who produce. Is this what you consider evil?

“When you accept money in payment for your effort, you do so only on the conviction that you will exchange it for the product of the effort of others. It is not the moochers or the looters who give value to money. Not an ocean of tears not all the guns in the world can transform those pieces of paper in your wallet into the bread you will need to survive tomorrow. Those pieces of paper, which should have been gold, are a token of honor–your claim upon the energy of the men who produce. Your wallet is your statement of hope that somewhere in the world around you there are men who will not default on that moral principle which is the root of money, Is this what you consider evil?

“Have you ever looked for the root of production? Take a look at an electric generator and dare tell yourself that it was created by the muscular effort of unthinking brutes. Try to grow a seed of wheat without the knowledge left to you by men who had to discover it for the first time. Try to obtain your food by means of nothing but physical motions–and you’ll learn that man’s mind is the root of all the goods produced and of all the wealth that has ever existed on earth.

“But you say that money is made by the strong at the expense of the weak? What strength do you mean? It is not the strength of guns or muscles. Wealth is the product of man’s capacity to think. Then is money made by the man who invents a motor at the expense of those who did not invent it? Is money made by the intelligent at the expense of the fools? By the able at the expense of the incompetent? By the ambitious at the expense of the lazy? Money is made–before it can be looted or mooched–made by the effort of every honest man, each to the extent of his ability. An honest man is one who knows that he can’t consume more than he has produced.’”

This is not his complete speech, which you can easily find on the web if you google a few of the keywords. However it illustrates what I was thinking: that shares of stock, like money, are backed by faith. Money is backed by the faith people have in the issuing government; stock is backed by the faith people have in the issuing company. Both are traded between people and sometimes by the backer.

So if money represents goods and services of the nation, then equities represent the goods and services offered by the issuing company. That is what gives them value; and that is what gives money its value. And, as faith in the USA to meet its obligations and endure waxes and wans, so does the value of the dollar. If a massive crisis arises in Europe, we will see strength in the dollar. If our government is no longer able to meet some of its obligations, or if it prints money like crazy (just as if a company diluted its stock), then we could see the value of the dollar fall.

Just a quick aside: what is meant by “the value of the dollar”? How do you measure your wealth? Locally, we can measure it by looking at how many dollars it takes to buy certain things: a week in a hotel, a plane ticket, a loaf of bread, a six pack of beer. Globally, we should really look at the dollar’s purchasing power on the world market. One way to do this is with the Stable Currency Index, a measure of some stability in terms of various global currencies. By measuring our dollar’s “value” in this way we can get a better picture of what it is worth. Of course, you can also measure it against gold or silver.

I haven’t really addressed the ideas of options (stock options) here, but I think the same thing applies: If equities are the representation of the products and services of a company, then an option on an equity is not that different from an option to buy a home, or extend a lease. In purchasing an option, you are asking the seller of the option to take a risk with his equity, and so they should be paid for it.

I’m still a little conflicted about this, and would love to hear some comments!

-PLH