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How Value Is Created: Or Why Fundamental Research Is Important

|Includes: Amazon.com, Inc. (AMZN)

How value is created.

A Parable

Imagine a world where the entire population survives off of meat and foraged fruits. Think of this world as a sort of simplified pre-stone age. The only tool in existence is "The Sharp Stick" TM Between each person, and their sharp stick, society is able to produce enough food, after 16 hours of work, to feed everyone. To be more accurate, each person gathers or hunts enough to feed themselves. Those with children too young to help, go through some lean times, but scrape by and feed their children with some sacrifice and extra time spent foraging.

There is no surplus and no storage for a rainy day. In this world, it takes every bit of brainpower to come up with enough food to feed oneself. Because of this, no additional value is created, and life is simple but short, and prone to unfortunate incidents.

Now imagine, one day, a hunter discovers an unguarded fresh kill in his first hour out. His mate is gone looking for food, so he suddenly finds himself with no need to hunt, and no opportunity to engage in his other favorite pastime. He decides to solve his most burning problem: how can he kill more efficiently? He spends all day testing different materials… bones, rocks, etc. Bones break too easily. Rock is hard, and hurts, but one in the hand doesn't have the reach of the sharp stick. Then he tries to put a rock in an animal pelt to give it greater reach. Swinging this around is fun, and somewhat effective, but thanks to the pelt cushion, doesn't seem quite as effective as a sharp stick.

Then it happens. His grip loosens, and he lets go of one part of the pelt mid swing. The rock flies out of the pelt and strikes a nearby tree. An idea forms. Killing something at a distance is much better than sneaking up and stabbing it.

Our hero spends the next few days working out the mechanics of his new weapon, The Sling, on his hunts. He's getting hungrier and hungrier and the family considers him a fool, but he intuitively senses that this new device will net him more food if he can just get down the mechanics.

After the third day, he has the technique down. Suddenly, he is able to kill enough food to feed himself in only 8 hours of work. He is, in a sense, the wealthiest person in the tribe.

Being an entrepreneurial sort, he immediately begins to use his free time to develop, market, and sell his new product. Prices vary per individual, but suffice it to say, it isn't long before all of the hunters in the tribe own their own Sling (the name of the product was changed to make it "cleaner").

Our inventor's hours of developing the sling, and the hours spent marketing and selling it, halved the workload for roughly half the tribe. His investing created tremendous value for himself (multiple payouts from his students, 8 hours of free time a day… at least) and ultimately for his tribe. Each tribe member's time invested in learning how to use the new tool increased their utility as well. Ultimately, this tribe now has the "leisure" time either to watch water drip from stalactites (low value added), or to go on to invent wheels, utilized fire, shaped stone tools, and agriculture (high value added).

The state of today

The world is much more complex. Since the first few tools were discovered, invented, and exploited the costs and benefits for investments, inventions, and political decisions have become harder and harder to conceptualize. Movement to currency from a barter system has further divorced us from the connection between the value creators (time, effort, risk) and the green pieces of paper or electronic bits and bytes we exchange for goods and services.

As I write this, I think how obvious this definition of value will probably strike anyone reading this. However, it is equally obvious, from actions we can witness all around us, that the idea of value does not enter into the equation of most citizens as they make decisions on what to spend their money on, what policies to support etc.

Such a concept of value has enormous implications in both economics and the somewhat related field of finance.

Implications on Economic Policy

With the concept of value being central to my economic and financial thinking, I struggle with the fact that Keynesian economics dominates our political landscape. Keynesians argue that economic busts occur when demand for goods drops, instigating an inescapable spiral downward in the value of goods. The only way to halt the death spiral is to pump money into the system, boosting demand, and ultimately restoring equilibrium. The Keynesian flaw, as I see it, is that it ignores the principles of value creation. Every dollar spent by the Government on "green" lightbulbs, salary increases for mid level bureaucrats, and "shovel-ready" projects must be collected from taxpayers at some point. That means, at best, the government collects crystallized time/effort/risk from those who know exactly how they want to use it, distributes a small portion of that as a handling fee, and then regurgitates the crystallized time/effort/risk into new projects that may or may not be beneficial to the taxpayers. In other words, at best, value created from the money spent should be equal to what would have been generated prior to collection minus the value spent to pay middlemen in an unproductive transaction. At worst, the money will be frittered away on low to no value projects, producing much less then would have otherwise been produced. A third option, of course, is to assume a few policy makers know the needs of each of their constituents far better than the constituents know, and that those same policy makers are always free from vice and corruption.

In my example world, an economic downturn would be a lack of available edible plants or animals for a length of time. Everyone recognizes that the real problem is a lack of food, and if the tribe could just raise animals, or grow crops, their particular problem would be solved. But they can't do so. Their current means of creating value relies completely on producing sharp sticks, and wandering the jungle looking or hunting for food. If you are screaming out, "But it's completely different now… we can print more money!", then you've fallen for the fallacy presented by Keynesianism. Producing more food by raising animals or growing it requires more time, effort and risk… in other words, the value is created. Printing money is not equivalent to printing food. It creates no additional value. With more dollars chasing the same amount of "value", all you've done is dilute the worth of each $.

Impact on investing

With all the talk of death crosses, momentum and cups and saucers, it's easy to lose focus on value in the investment world. If you don't believe me that the average investor has a disconnected view between value and his/her investments, please read the comments following any article discussing Amazon.com (NASDAQ:AMZN), LinkedIn (LNKD) or Facebook(NASDAQ:FB). "Investors" defend high P/FCF (or P/E if you insist) ratios based on a myriad of reasons such as this one from:

"fine. Every single product that we ever want in my family from Kid to adult family member even from oversea family member ask to buy for them. Every time we want to buy anything."

Or these from:

"The numbers that matter -
1997 $5
now $368"

"Doesn't matter. Fact of the matter is that AMZN is all time high today and my account is that much bigger today."

The truth is, as weakly correlated as fundamental analysis is when compared to day to day stock price movement, it's the only concrete guidepost in the face of changing investor emotions. Many investors, who are not willing to pay Rolex prices for a Timex watch, are willing to do so when it comes to equities. They are convinced that if there is rabid excitement over a company, or its proposal to deliver dozens of packages to a few customers at an unknown cost sometime in the future, then any share price currently being offered on the market is a fair one. Unfortunately, the triggers of market disillusionment are both subtle and sudden. It's very unlikely that you will predict the minute market sentiment shifts.

The Emperor's clothes is a tired cliché in the media and on Wallstreet. But it became cliché because the behavior that story highlighted is so prevalent in human nature. Efficient market theory bolsters this behavioral failure. EMH teaches us that if everyone else sees value in a $500 a share company that loses money, and we don't, we are wrong. If we don't see it, we must be ignorant, so why fight the crowd? History is stuffed full of examples where ordinary people were, as a large group, insanely irrational and insanely wrong (Salem Witch trials, Nazi Germany, Penn State Riots, etc). Sometimes the crowd is just stupid.

Disclosure: I am short FB, LNKD.

Additional disclosure: I have a somewhat short position on FB and LNKD, through option spreads. I intend to close both positions before the year's end.