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Investing In Business, Not On Business

November 26, 2009

Where are the good investment opportunities today? Interest rates are coming down but long term fixed income investments are made less attractive because the expanding money supply is perhaps setting the stage for a return of higher inflation. The stock market’s recent volatility has dispensed a large dosage of caution to those interested in trading equities.

The best investment opportunities are right where they have always been. Investing private capital in private industry. Fundamentally there are two ways to create wealth. You can build something of value or you can supply the capital that is needed to build value.

When you supply capital to a company, you are investing “in” a business. However, most stock market investors are investing “on” a company, that is they are giving their money to another investor who wants to sell. It should come as no surprise that it is difficult to beat the averages while investing “on” a business.

Isn’t it interesting that two parties with presumably the same objective, wealth creation, take opposite actions, one selling and one buying, with each transaction. Giving your money to someone else who wants to sell you their stock so they can go and buy something different would appear to be a difficult way to create wealth. You might well be better off finding out what they plan to buy with your money.

Because the pool is big enough, there will be some winners and some losers, but in the long run this is a zero sum game. This is wealth maintenance. While some individuals will beat the system, in the aggregate, all the buyers and sellers will average out with the economy as a whole. You can’t beat the system.

The basic fallacy is that people feel that they have an investment “in” a company when in reality they have placed a bet “on” a company. Don’t people say, “I have an investment in General Motors”. In reality they haven’t provided G.M. with any capital at all. They have given their money to another investor in the hope that yet another investor will come along and pay a higher price again. Their investment has had little impact on helping GM create wealth.

Providing capital for business growth and expansion is generally an illiquid investment. That is, the cash invested is spent on fixed assets and other items that are necessary for the growth of a business but are not easily converted back into cash. “Stock exchanges” were originally designed to be institutions where people could trade their stock for cash if the need arose to liquefy their investment.

The price of the exchange should be related to the success of the initial investment. That would be a factor of how much was initially invested, how much the company had earned on that investment and the prospects for future earnings.

It appears that the markets have become the central focus of value rather than the companies whose stock they trade. There exists a breakdown in common sense when stocks selling for $20 are recommended as a good investment merely because they sold for $30 a month ago.

The best opportunity to create wealth as an investor is to invest “in” a company not “on” a company. You want your money to be going into a business that will spend that money to create wealth not to another investor who wants to sell you a piece of paper at a price higher than they paid for it.

Investing “in” a company is not without risk. A growing business will continually require sources of private capital. Finding and assessing the opportunities is not always easy but it can be done. Opportunities can be found with friends or acquaintances that need seed capital to start a business, small private venture funds and in the initial public offering market.

The market for initial public offerings is most frequently looked at as one homogeneous market and is often judged to be risky. Of the approximately one thousand companies that had their initial public offerings in 1987, sales ranged from zero to over a billion dollars, from companies that had never earned a profit to those with a long history of profitability, from companies with no assets to companies with billions in assets. Any analyst that views this as one group is certain to miss numerous opportunities.

The new issues market is a market that must be segmented to determine value. Because this is an investment in which the money is going “in” the company, the most important issue is how is that money going to be spent. Will the application of the proceeds of that offering create value at a greater rate than the economy as a whole? When, after careful consideration, you identify enough situations where the answer appears to be yes, you are on the road to creating wealth as an investor.

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