"What capitalism just cannot get right"

[a_unique_person]

I have wondered the same thing. I would have thought that a company is logically priced at a mulitple of earnings with the dividend factored in. If you are a gambler, add in something for growth. Companies at present are worth more than these, unless you are just a gambler. Yet private equity is out and about snapping up companies at the moment for more than the share market believes they are worth. Is it just that the wealthy have so much money, they have nothing better to do with their wealth?

http://www.theage.com.au/news/opini...1163871400762.html?page=fullpage#contentSwap1

Capitalism is brilliant at setting the price of potatoes. But how good is it at setting the price of a large company? To all appearances, the stockmarket is capitalism operating under near-laboratory conditions.
Yet the prices set are patently wrong. That is not my opinion. Well, yes, it is my opinion. But it is not only my opinion. It is held by America's financial leaders, though they don't put it quite that way. Actually, it is close to a provable fact.
The free market cannot be setting the right price for financial assets like shares of stock, because often there are different prices with equal claims to be the product of free-market capitalism. They can't all be right.
..All of this depends, though, on the assumption that the stockmarket sets the right price for shares of big companies. But a whole separate part of corporate finance is based on the assumption that the prices are wrong. These special deals used to be called leveraged buy-outs. Now the term is "private equity".
The details are different, but the principle is the same. Private investors buy a company from its public stockholders. They have a letter from an investment bank saying the price is fair. They usually have the support of management, or actually are the management. The public stockholders have little choice. But time and again - surprise, surprise - the bank turns out to be wrong. The company is actually far more valuable. Soon the company is sold at a large profit, to another company or back to the public.
So free-market capitalism has decreed three different values for this company. One is set by the stockmarket; one is what the private investors are offering - usually a bit more than the market capitalisation. And one is what the private investors sell the company for a blink of an eye later - usually a lot more than the other two. Which is the true capitalist price? Which one represents the most sublime interaction of supply and demand? Anyone? Anyone?
Defenders of this procedure say it's not that the stockholders have been swindled. It's that the company is actually far more valuable in private hands because managers - even the same managers - can manage far better without the constraints of public ownership.
Maybe. But if these deals aren't a swindle, then the stockmarket is a swindle. It does not maximise value for its working- and middle-class investors. It leaves money on the table waiting for "private equity" to swoop and pick it up. Furthermore, Friedman was wrong and the other famous economist who died this year, John Kenneth Galbraith, was right: the free market in corporate shares doesn't produce well-run companies.

 

[Francesca R]

I would have thought that a company is logically priced at a mulitple of earnings with the dividend factored in.

Locigally a company is priced at the net present value of all the future cash flows it is expected to generate.

If you are a gambler, add in something for growth.

What do you mean by "gambler"? It can be perfectly rational to expect growth in a company's EPS based on classical economics (the presence of barriers to entry, imperfect competition and competitive advantage, incomplete information, etc . . .)

Companies at present are worth more than these, unless you are just a gambler.

There is a numerator and a denominator in the formula for NPV: the numerator is [expected cash flows] and the denominator is [discount rate]. Now you can't declare the share price to be wrong just with reference to one of these. You are claiming that the expected cash flows embedded in stock prices "must be too high"—but you need to address the discount rate too. The discount rate is not merely a long term interest rate (such as the one embedded in the government bond yield curve)—but includes an equity risk premium for the company (or for the market if you are talking about a market index). The ERP is the compensation (return) demanded by investors for the expected uncertainty of that same return. It can be low if the dominant view among investors is something like "solid economic growth, low inflation, productivity gains likely, business-friendly government, . . ." and so on.

If the ERP is low (investors perceive little risk/uncertainty about future cash flows), then the expected cash flows of the company are worth more today, because they are believed to be more certain. In that case the share price (= the net present value of a claim on those cash flows) should be high.

Markets frequently revise their expectations, and individuals at any time disagree with the market consensus. But this is not "capitalism failing"—it's capitalism working.

Yet private equity is out and about snapping up companies at the moment for more than the share market believes they are worth. Is it just that the wealthy have so much money, they have nothing better to do with their wealth?

That would certainly help to redistribute their wealth (to the people they bought their equities from)

 

[Geckko]

I remember enough of my economics to know that this part of the comment:

To all appearances, the stockmarket is capitalism operating under near-laboratory conditions

is just plain wrong. Maybe that is why the writer then fails to understand or rationalise the outcomes.

Seems like this is another case of a journalist (they who know nothing but write on everything) venturing into opinion when they really needed to search out, and report on, more knowledgable comment.

 

[Rob Lister]

Locigally a company is priced at the net present value of all the future cash flows it is expected to generate. ...
...
...

A brilliant rebuttal but, I fear, wasted on the audience.

I summarize the opening post as:

"Bubbles happen, therefore capitalism is flawed"

To which I would agree. But until something better comes along, in a provable fashion, I'll opt to endure the occasional bubbles.

 

[Darth Rotor]

http://www.theage.com.au/news/opini...1163871400762.html?page=fullpage#contentSwap1

"The right price," suggests the author, as though such a thing can be fixed in time given that expectations, estimates on future conditions, and misinformation (or simply bad or no information on an important variable) can influence stock share offering and selling prices.

Forecasting is less than 100% accurate, given the immense number of variables that differentiate between projected and actual performance. A given bid or valuation will tend to be weighted by what a given party sees as the most important variables, and the estimates that those lead to.

Note of interest: ON Oovember 20, 1995, the Dow hit 5000, the highest it had ever been. It was recently in the vicinity of 11,000.

Facts, so my above comments deserve a grain of salt:

I am not an economist
I am not particularly good a guessing future stock prices. (If I were, I'd have retired for good quite a while back, and be golfing in North Carolina now)
I did not breeze through my courses on Finance, nor on the projects we undertook to determine Book value assessments. I had to work my butt off.

DR

 

[Beerina]

It's just something to consider before diving in. I'd vastly rather have that than...what? Government officials with armed police behind them dictating according to whatever public platitudes got them elected most recently?

Freedom made this country great -- not democracy.

 

[Ryokan]

Everyone talks about capitalism, but few people know what it is or bother to find out.

Injustice in the world? Blame capitalism, which takes money from the poor and goves it to the rich! Booo!

 

[Ziggurat]

The free market cannot be setting the right price for financial assets like shares of stock, because often there are different prices with equal claims to be the product of free-market capitalism. They can't all be right.

Why can't they all be right? The different prices are from different buyers, and they aren't even actually for the same thing. By taking a company private, the buyers will have something DIFFERENT from, and in some ways more valuable than, the public company that the original stockholders were swapping around. Because it is now private, they are free to do things with the company (especially with regards to management) which may increase the value of the company even further. The company may have considerable dead weight stripped, for example, and when it's resold to the public, it's worth more because it's not the same thing anymore.

But I'm not surprised AUP likes this article. It's got the same political inclination AND unwillingness to even think through the foundations of its own arguments.

 

[Francesca R]

I summarize the opening post as:

"Bubbles happen, therefore capitalism is flawed"

"Bubbles" happen because of the incidence of correlated mistakes ("everyone runs to one side of the boat, then back to the other"). Behavioural finance tries to explain this away as irrationality in human behaviour in the domain of fear and greed as it relates to financial gain and loss. But IMO bubbles can result from market participants behaving fully rationally. I wonder how many self-professed sceptics were buying dot.com shares in 1999.

You can theoretically regulate to prevent correlated mistakes (such as have central banks adjust interest rates to try to stop asset prices veering massively away from equilibrium). The problem is whether the central bank will actually get it right, and whether their actions introduce moral hazard.

Injustice in the world? Blame capitalism, which takes money from the poor and goves it to the rich! Booo!

Unfettered capitalism would allocate resources in such a way as to maximise the total value of output, which might be logically achieved by some people starving to death whilst others become trillionaires. That would violate most ideas of (social) justice (including mine), hence capitalism is better when constrained by governments acting for social welfare.

 

[casebro]

"To all appearances, the stockmarket is capitalism operating under near-laboratory conditions"

Well, yes but...

My feeling is that tooo many corporations are run on the basis of stock value, rather than the value of it's product. They will lie cheat and steal to inflate their stock value at all costs, when selling a good product ought to do enough to raise market value.

So far as the investment value of the market, it can only go up. Where else can all those billions of retirement funds be invested? I don't so much think it is price/earnings, as the market is a giant pnzi scheme- as long as everybody keeps buyin, the price keeps going up. Nothing to do with product or profit, just the fact that the next retirement plan will pay more, 'cause where else can they dump funds?

 

[Ziggurat]

Unfettered capitalism would allocate resources in such a way as to maximise the total value of output, which might be logically achieved by some people starving to death whilst others become trillionaires. That would violate most ideas of (social) justice (including mine), hence capitalism is better when constrained by governments acting for social welfare.

Governments aren't the only way around that problem, though. People can and do act charitably on their own (in fact, private charity seems inversely correlated with the desire for government-enforced wealth redistribution).

 

[Gurdur]

.. (in fact, private charity seems inversely correlated with the desire for government-enforced wealth redistribution).

Really? How do you figure that?

You have any statisics on comparing private charity, GNP and tax-driven wealth redistribution?

Because I am pretty sure you're very wrong on this point; what are the private charity rates per capita recently, for example, for the USA, Sweden, Norway, Denmark, the UK, France, Germany and Japan?

 

[Francesca R]

Governments aren't the only way around that problem, though. People can and do act charitably on their own (in fact, private charity seems inversely correlated with the desire for government-enforced wealth redistribution).

But charity is not implemented in the public interest—rather; in the interests of the benefactor (charitable and altruistic though they may be). Also a societal need does not conjure a willing charity out of thin air to address it. One may happen to be along, but it may never arrive. Charity as a concept is no substitute for elected government welfare provision—more a complement to it.

 

[Ziggurat]

Really? How do you figure that?

Because there MUST be a tradeoff between taxation rates and charitable giving, because there's a finite amount of wealth to be either taxed or donated to begin with.

You have any statisics on comparing private charity, GNP and tax-driven wealth redistribution?

Because I am pretty sure you're very wrong on this point; what are the private charity rates per capita recently, for example, for the USA, Sweden, Norway, Denmark, the UK, France, Germany and Japan?

I don't have those numbers handy (though I'd be quite surprised if private charity rates were higher in those countries). But within the US itself, that divide is definitely supported by the evidence.
http://philanthropy.com/free/articles/v19/i04/04001101.htm

And it makes sense, too: if you think private charities are more effective than government, then you'll want less taxes so people can donate more to charity. If you think government works better than charities, you'll want higher taxes so that this money gets allocated by the government instead.

 

[Ziggurat]

But charity is not implemented in the public interest—rather; in the interests of the benefactor (charitable and altruistic though they may be).

I'm afraid that's just semantic games. How, exactly, do you define "public interest"? Any sensible definition you could arrive at will reveal, in short order, that there are indeed charities which act in the public interest and government programs which do not. And you'll also probably find that you cannot reach universal agreement about what constitutes "public good" anyways. It may (or may not) be true that the government is better at allocating resources than private charities, but that's a different argument.

Also a societal need does not conjure a willing charity out of thin air to address it. One may happen to be along, but it may never arrive.

And there's nothing magic about government which is fundamentally different in that respect, either.

Charity as a concept is no substitute for elected government welfare provision—more a complement to it.

This is an opinion you hold. And it may even be correct. But do not confuse it for being more than your opinion.

 

[Francesca R]

I'm afraid that's just semantic games. How, exactly, do you define "public interest"? Any sensible definition you could arrive at will reveal, in short order, that there are indeed charities which act in the public interest and government programs which do not. And you'll also probably find that you cannot reach universal agreement about what constitutes "public good" anyways. It may (or may not) be true that the government is better at allocating resources than private charities, but that's a different argument.

You are missing my argument. Government (the democratic sort) and its policies are implemented by majority rule on the basis of "one person = one vote". Charity is set up on the basis of "one dollar = one vote". That is why Bill and Melinda Gates—and not you—get to decide what their foundation does, and why the trustees and the committee of Care International—and not I—decide where their money goes. I also have no say in how large the charitable funds available are beyond my own ability to contribute. If I am poor, that might be very little.

Regardless of whether charity and philanthropy identify good causes in the public interest, it is/was fundadmentally their interest, and not the public's, which caused the charity/foundation's giving to be there. The difference is not semantic.

And there's nothing magic about government which is fundamentally different in that respect, either.

Please put aside for a minute your (correct) and often-repeated statement that "governments in real life are not fully effective". The concept of government is qualitatively different from voluntary private giving.

This is an opinion you hold. And it may even be correct. But do not confuse it for being more than your opinion.

Disagreed. It's not my opinion. I would even agree with you (I think) that much government aid in real life is squandered, badly implemented, misdirected and ultimately wasteful, whereas much charitable aid (particularly the Gates' philanthrophy in fact) is likely to do much more. But they are different concepts. One is mandated democratically (effective or not). The other isn't

 

[Ziggurat]

You are missing my argument. Government (the democratic sort) and its policies are implemented by majority rule on the basis of "one person = one vote". Charity is set up on the basis of "one dollar = one vote". That is why Bill and Melinda Gates—and not you—get to decide what their foundation does, and why the trustees and the committee of Care International—and not I—decide where their money goes. I also have no say in how large the charitable funds available are beyond my own ability to contribute. If I am poor, that might be very little.

Regardless of whether charity and philanthropy identify good causes in the public interest, it is/was fundadmentally their interest, and not the public's, which caused the charity/foundation's giving to be there. The difference is not semantic.

As far as I can tell, you've essentially defined the public interest as whatever 51% of the population wants. Yeah, umm... I'm not going to agree on that part. Yes, everyone has a vote, and if you happen to be in the 49% faction instead of the 51% faction, then you have essentially NO say in how your forcibly taken dollar gets spent.

And if you don't think someone like Gates has more influence on government, even in a democracy, than you and I do, then you're also kidding yourself.

Please put aside for a minute your (correct) and often-repeated statement that "governments in real life are not fully effective". The concept of government is qualitatively different from voluntary private giving.

I KNOW that, and I'm not claiming otherwise. In particular, I don't think law enforcement can work on a private basis. But there's nothing about helping people who cannot or do not succeed in a capitalist system which government is uniquely qualified to perform. Maybe they can do it better than private charities, but again, that's a different argument than the one that they MUST be the agent that steps in to help such people. There really are other possibilities.

 

[Elizabeth I]

To all appearances, the stockmarket is capitalism operating under near-laboratory conditions.

Actually, the best I can tell the stock market is run by superstitious...is idiots too strong a word?...who can be stampeded by rumors of rumors, never mind actual catastrophe.

 

[Art Vandelay]

These special deals used to be called leveraged buy-outs. Now the term is "private equity".

Actually, there's a big difference between a leveraged buy-out and private equity. "Equity" means that it's financed by selling shares. "Leveraged" means that it's financed by selling bonds.

They usually have the support of management, or actually are the management. The public stockholders have little choice.

Cite for that claim?

But time and again - surprise, surprise - the bank turns out to be wrong. The company is actually far more valuable.[/quote}And how often do we hear about it when the company is less valuable?

So free-market capitalism has decreed three different values for this company. One is set by the stockmarket; one is what the private investors are offering - usually a bit more than the market capitalisation. And one is what the private investors sell the company for a blink of an eye later - usually a lot more than the other two.

Can't the same logic be applied to retail stores, which buy in bulk, then sell the same thing "a blink of an eye later" for a lot more? It's not really "a blink of an eye later". It's after the company has been reorganized. The same question can question can also be asked about changes in price in general.

Maybe. But if these deals aren't a swindle, then the stockmarket is a swindle. It does not maximise value for its working- and middle-class investors.

How does that make it a swindle?

Furthermore, Friedman was wrong and the other famous economist who died this year, John Kenneth Galbraith, was right: the free market in corporate shares doesn't produce well-run companies.

There's a difference between non-optimal and not well-run.

 

[Francesca R]

As far as I can tell, you've essentially defined the public interest as whatever 51% of the population wants. Yeah, umm... I'm not going to agree on that part. Yes, everyone has a vote, and if you happen to be in the 49% faction instead of the 51% faction, then you have essentially NO say in how your forcibly taken dollar gets spent.

The public interest is identified and best served via a bargaining process with equal representation, that reaches equilibrium with the fewest number of people pissed off. Now if do you have a 51%:49% split on some binary policy issue, then yes—appeasing the 51% is the best solution IMO. Since you disagree, how do you suppose public interest be best served? The greatest force prevails? The greatest wealth prevails? Anarchy? What would you prefer?

Of course a government which regularly alienates 49% and offers them nothing in compensation will struggle to form enduring legitimacy. Typically it would look to widen the constituency of "winners" from its policies as far as possible.

And if you don't think someone like Gates has more influence on government, even in a democracy, than you and I do, then you're also kidding yourself.

I never said this.

I KNOW that, and I'm not claiming otherwise. In particular, I don't think law enforcement can work on a private basis. But there's nothing about helping people who cannot or do not succeed in a capitalist system which government is uniquely qualified to perform. Maybe they can do it better than private charities, but again, that's a different argument than the one that they MUST be the agent that steps in to help such people. There really are other possibilities.

And I never made the argument that there are no other possibilities, but that government-provided social welfare—if you believe it is justified—cannot be substituted by voluntary donations but can be complemented by them.