A very wise man, well-known to all of us, said the incentive that impels a man to act is always some uneasiness.
My act to prepare this presentation for you is no exception.
My uneasiness stems from an apparent contradiction between my theoretical convictions as an Austrian economist and my practical beliefs as an investment manager.
Specifically, in managing my clients' money, I act as if I believed in the implications of efficient market theory, that means the possibility of stock picking and market timing, although, as an Austrian economist, of course, I don't believe in efficient market theory.
So in order to avoid, to suffer from schizophrenia, I decided to reconsider and to explore as rigorously as I can, the implications of Austrian economics for investments in financial markets.
That's what I'm going to talk about. You can see there's a kind of group therapy.
So, if you look at the Austrian literature, the answer is quite clear, most Austrian economists support an active investment approach known as value investing.
So what's the claim that value investors or fundamental analysts do?
They claim that some investors, always including themselves of course, can systematically outperform the market by identifying temporarily undervalued securities.
I could provide you lots of quotations expressing this view. I provide only one, which has particular authority because it's from the Elgar Companion to Austrian Economics.
So the investor-co-entrepreneur has the ability to find temporarily undervalued stocks and to get out of overvalued investments.
Why do Austrian economists support this view? If you look at the literature, there are basically two reasons.
First of all, they reject the efficient markets theory, which is logical.
It is this theory which implies basically that value investing is impossible, that you can't pick stocks with superior performance.
And the second reason for this view is that they transfer the concept of entrepreneurship that is central to Austrian economics from product to financial markets.
in Financial Markets.
So, obviously, if entrepreneurs with their superior foresight can generate profits,
why shouldn't they be able to do this in financial markets as well?
Well, my view is that these arguments are not as strong as they appear to be.
That doesn't mean that they're wrong, but they raise some questions at least.
So, first of all, regarding the rejection of efficient markets,
we may agree that we don't believe in this theory,
but that doesn't mean necessarily that the empirical phenomenon
that this theory tries to explain is invalid as well, which is the random walk phenomenon,
the unpredictability of stock prices. If you look at the first Pharma paper in 1965, it
doesn't contain any neoclassic economics, it's pure statistics. So my view on this,
given this possible objection, is that perhaps just rejecting the neoclassical explanation
is a bit too easy. I think what we should really do is to ask what are the implications
of Austrian Theory for the Predictability of Security Prices.
Now regarding the second argument, the entrepreneurship,
there are two possible objects, I think.
First of all, financial markets clear much faster
than most product markets.
Ludwig von Mises himself pointed out
that the stock market clears every day.
At least it reads a temporary equilibrium, a plain state
of rest every day.
So if you want to benefit from this equilibrium,
So you have to be very quick.
Second of all, I would argue not all investors are entrepreneurs.
So what we should ask ourselves as Austrian economists,
what information are actually required for superior investment
performance, and who are actually the entrepreneurs
in financial markets?
And these questions I'm going to address now
in the time I have left.
So to start with, we want to value securities, which
There are titles to future earnings by business, either ownership titles or credit titles.
So the question we have to ask ourselves, what is actually the income accruing to a
business and to what extent is it predictable and by whom?
So according to Rothbard there are four elements of income, interest, wages, rents and profit,
but I will focus on profits here because I believe without having time to argue the point
If you can predict profits, you can also predict the other elements.
So in Austrian theory we don't talk much about investors. The investors are actually called capitalists.
And they are clearly distinguished from entrepreneurs.
Capitalists, they provide financial capital to entrepreneurs.
Entrepreneurs transform financial capital into real capital.
That means they combine capital goods with original factors of production in order to produce and sell lower-order goods.
So, what is inseparable from the function of entrepreneur is the direction of factors of production.
So, we actually have three cases. We have the pure capitalist on the one side, the pure entrepreneur,
and we have the combination that Austrians are very fond of, which is the owner-entrepreneur.
Now, the income, the capitalist earns interest, the entrepreneur earns a wage if managing the business involves some labour.
The Theory of Money and Credit
Entrepreneur, he can provide equity, or he is a lender, he provides debt.
So let's look at the first case.
Here we have the strange situation that one, the entrepreneur makes the decisions, but
the other one, the capitalist bears the consequences, which is profit and loss.
This is perhaps not a very pleasant situation, but logically it's possible.
That's the situation you find yourself in every time you pay a lawyer or your doctor.
For someone who makes a decision, you bear the consequences.
The other case, if the capitalist is a lender, is even weirder.
Because here, the entrepreneur makes decisions which generate profits or losses if everything
goes well.
If there are profits, the capitalist gets the interest, but the entrepreneur keeps the
profit.
If the prediction is not that good, and there's a loss, it's borne by the capitalist.
Because first he won't get the interest that he expected and if the loss is high he won't
even get the capital back. So this is a bad deal for the capitalist. He takes the risk
but the entrepreneur gets the profit. And this is actually the pure entrepreneur as
he was described by von Mises. He does not own capital, he just borrows it. If he makes
a profit it's his. If he loses it's bad luck for the capitalist. So just exploring the
The theoretical implications of these two functions, entrepreneur and capitalist, leads to some paradoxical situations.
I call them the equity paradox and the debt paradox.
The equity paradox says that the pure entrepreneur makes decisions that affect only the owner,
so he doesn't have an incentive actually to generate profits and avoid losses.
The debt paradox says the pure lender assumes the risk of losses but without the potential reward of profits,
Where as the entrepreneur has actually an incentive to take excessive risks, a phenomenon we are very familiar with recently.
So how can we solve this? One possible answer, and that's the answer given by most Austrian economists, actually they have to be the same.
They may be theoretically different, but in practice they have to be the same, otherwise things don't work.
That's the concept, for example, of the integral entrepreneur proposed by Professor Salerno,
It is one solution, but I want to argue it's not the only one. For two reasons. First of all, it's logically possible, as we've seen, that they are separate. And also in practice, if you look at the complex corporate governance structures in real market economies, they are not always the same. Sometimes the functions are different. So the question is, is there any other solution? I would argue, yes, there's another solution, which is not identity of the two, but a part of the whole.
and the partial sharing of the functions.
By sharing the function, the capitalist tries to mitigate
the serious incentive problems in the setup
and there are two ways to do this.
Either he insists that the entrepreneur
provides some of the capital himself,
so the entrepreneur has to become
a little bit like the capitalist,
or the capitalist controls the entrepreneurial decisions.
That means the capitalist gets involved somehow
into entrepreneurial decisions.
So, if you take this into account, every capitalist considering investment actually has to make two choices and has three options.
First of all, this is a bit slow, you have to deduct it from my time, do I want to assume the entrepreneurial function myself?
So if I do this, then there is no problem, no need for control. I'm the integral entrepreneur that Austrians write about so much and lots of them say it's the only one.
But unfortunately, it's not the only one. There are many other cases.
If I don't, as a capitalist, want to assume the entrepreneurial function,
the second question is, do I at least want to control the decisions?
Do I want to control what this guy is actually doing with my money?
If yes, then I become an inside investor.
As a capitalist, I provide capital and I control his decisions.
If not, I'm an outside investor. I just give the money and hope for the best.
and I only rely that the entrepreneur has enough incentives to do a good job for me either because he has an equity stake or he's motivated by his wage or his reputation and what I can do is just diversify, just pick ten entrepreneurs and hope that some of them will do well.
So what I'm proposing is that to see the full picture we should actually add one function to the capitalist and the entrepreneur which is something intermediate.
I call it director now, because that's what we see in large corporations.
The director controls entrepreneurial decisions on behalf of capitalists.
So why is that useful?
If we now explore the logical combinations of these three basic functions,
we get the full picture of the institutions of a modern market economy.
So in the center we still have the integral owner-entrepreneur that we are often also fond of,
but it's just one case.
We have now the pure director, which is a non-executive director.
Then we have the combination of director and entrepreneur, which is the executive director.
Then we have the pure entrepreneur, which is basically a corporate manager without equity stake.
That's hard to swallow for Austin because the one guy we like, the other one we don't like so much, but logically they're actually the same.
Capitalists and entrepreneurs would be a corporate manager with an equity stake.
Now, capitalists who control entrepreneurial decisions would be inside investors.
So it's either active owners, large shareholders, venture capitalists, private equity investors, or active lenders.
That could be a bank giving a large corporate loan and appointing a representative to a corporate board.
That was very common in Germany, for example.
Or a hedge fund. They recently got into the lending business.
Small. And then in the end we have the pure capitalist, which is the outside investor.
The passive owner, a preference shareholder, another small shareholder, a passive lender, a bondholder, or even a bank giving a small business loan just based on a credit scoring.
They don't deal at all with the management, they don't care what they decide, they just look at the data and give the credit.
So why is this important?
You see that almost all of these functions we have identified are to some extent involved in entrepreneurial decisions.
Either they make them or they control them.
So I would define all these functions together which are involved in decisions, the entrepreneurial group, and the only function here that's not part of the entrepreneurial group are the outside investors.
So you see that I think the Austrian literature says, well, of course, the entrepreneurs, so they create profits, is correct as far as it goes, but it doesn't go very far because it's almost true to say yes, if the capitalist is also an entrepreneur,
If you are an entrepreneur, then you can make entrepreneurial profits, what is really interesting, that's the question for me, the real question about value investing, what about the other guys, the outside investors, how can they generate superior profits?
So this, I think we have to look at the entrepreneurial decision process to see actually what kind of information the outside investors have access to on which they can base their profit predictions.
Just pick one decision in the middle.
All decisions concern either reactions to exogenous changes or creation of endogenous changes.
So there's one decision, whatever its source, it's always based on anticipation of future uncertain market conditions
and it applies a price and a profit prediction. Of course that's private knowledge.
So, if this is confusing, everything that's blue is private knowledge and only the red is public knowledge and the key message here is that it's actually very little what is public knowledge or becomes public knowledge in the process because once the entrepreneurial decision is made by the entrepreneurial group, there's constantly new information arrive and they can react, they can update their predictions, they can make new decisions and at the end, they have some result. They've seen whether, for example, the decision to enter a new market or to differentiate product, whether this has worked out or not.
This is still not observable by outside investors because there are many decisions parallel and one after the other.
The only thing that an outside investor can actually observe is then the overall result of all these decisions in a certain period as reflected in the financial statements.
That's why you see the red on the right side.
And the other information an outside investor has access to is basically either exogenous changes that affect the company.
Yes, that's obvious to anyone or announced decisions by the entrepreneurial group, but it's always only a part of the information that will be announced with delay.
So, to conclude, the current valuation of securities is always based on profit predictions.
It reflects the current expectations of all market participants, including the entrepreneurial group, that means inside investors, and outside investors who have only access to public information.
So, as you've seen, there's a lot of information that's only accessible to private, to inside investors, because one of the main reasons is that they actually generate this information themselves.
themselves. So they know what were the realized results of previous decisions they made. They
have updated profit predictions for more recent decisions. They know what are the most recent
decisions they've taken that may not even be, they have no results yet, but they know
what they decided. They know what planned adjustments they have in mind to direct to
to some recent exogenous changes.
And they even know what are the next planned
endogenous changes they want to do.
So nobody else knows that.
So compared to that, the public information
that's available to outside investors
is actually very, very little.
So as we said, it's basically cumulative results
of decisions made in the past, so it's historical data,
the public announcements of the entrepreneurial group,
And finally, exogenous changes affecting the company.
And I would argue that's actually the only source
of potential profits for outside investors are these,
exogenous changes.
So if there's a war somewhere, the oil price goes up
and you're the first trader to buy energy stocks
and then 10,000 others, because that's the job
they do the same, and you sell the share at the end
of the day, then you have a profit.
But the problem is that the other 10,000
want to be the first as well.
Of course, this kind of short-term trading profit
is also possible for insiders.
It's even, they have the additional chance
to also trade before some of the changes
that generate themselves are announced.
That's classic insider trade, that's illegal,
but that doesn't mean it doesn't happen.
So, but more importantly, only the members
of the entrepreneurial group have actually
all information required to at least try
to predict long-term profits.
That's why they actually are in a position to do that.
Compared to that, the information available
to an outside investor is so limited
that I would argue it's basically impossible.
It's like tossing a coin.
So my conclusion on this issue is actually that
the argument of Austrian theory for the impossibility
for outside investors to earn systematically superior returns
is actually more convincing than the neoclassical.
The empirical hypothesis resulting from the theorem is actually quite similar, I argue that if you look carefully at the implications of Austrian economics, outside investors cannot earn systematically superior returns based on an analysis of publicly available information.
This is actually the same as the neoclassical, the semi-strong form of the random work theory, but the explanation is very different.
In neoclassical theory, it's this thing that we, of course, we don't believe, that market price is efficient and all information is included. No.
The osteo-explanation is that information, most of the relevant information is actually private to the entrepreneurial group. It's dispersed.
And if there's really company with low valuation, the only thing that valuation will go up are future entrepreneurial decisions, which as actions are inherently unpredictable.
The hypothesis on outside investors is again similar, based on Austrian theory I would say of course insiders, they can generate superior profits trading in their own securities, that's also admitted by the leading exponents of efficient market theory.
Of course there's the possibility of gaining from inside information, but again the explanation is different, all that new classical economy can say well there must be some monopolistic access to information.
But Austrians, they can say much more, actually it's not only access to some given information,
the entrepreneurs are generating the information themselves.
So to conclude, I think the Austrian argument against the possibility for outside investors to generate systematically superior returns is actually stronger
than the new classical because it's based on realistic assumptions about dispersed information
and not on unrealistic assumptions about market efficiency.
Thank you very much.