Addicted to Liquidity
Over the last year I have been contemplating allowing certain aligned parties to buy into our family holding company. These folks would become co-owners in a permanent investing partnership containing the businesses we have acquired over the past six years.
The question inevitably always arises “How are you going to return my capital? What’s the liquidity plan?”
As a permanent investing company with no intention to ever sell any business we own, I never have a good answer. Liquidity is not our goal, permanent stewardship is.
Exploring allowing outside ownership has led me to believe that investors’ obsession with liquidity has disorganized our financial priorities. We’re more concerned about how we’re getting out before we even get in. Therefore we put less emphasis on truly understanding the merits of the investment and what the underlying enterprise proposes to do, which are key to good investment decision making.
Liquidity can enable impulsive action and can create an excuse for not doing the investigative work necessary to decide if an investment commitment is worth it. I also think it has removed some natural safeguards to the long term investor’s success, which we will explore later.
Let’s see if this idea holds water. Wind back to England, circa 1720. The South Sea Bubble, regarded as one of the first large-scale speculative bubbles in recorded history, had just burst. This resulted in a society - wide attitude of fear and pessimism towards the many companies with tradable common stock circulating through England. Which were scams and which were legitimate enterprises?
In response, Parliament passed The Bubble Act of 1720 banning all joint-stock companies with more than six shareholders unless directly approved by the monarchy. This effectively eliminated the ability for new companies to issue common stock to the public. It made it illegal for your company to be so widely owned that there was a liquid market for it. For the next 105 years (until The Bubble Act was repealed in 1825) there were effectively no new tradable common stocks and thus no liquidity for owners of new companies.
Despite an illiquid capital market lasting over 100 years, the following innovations were developed and commercialized JUST in the field of textile manufacturing:
The Flying Shuttle (1733 -John Kay) invented a way to speed up the weaving process, which was a precursor to the automatic machine loom.
The Spinning Jenny (1764 - James Hargraves) - This machine allowed one laborer to spin multiple spools of thread simultaneously, dramatically improving productivity.
The Power Loom (1785 - Edmund Cartwright) - The first mechanized weaving machine, which speaks for itself.
Not to mention the Bridgewater Canal (1761) was opened, the Watt Steam Engine (1776) was commercialized and a little economic boom called The Industrial Revolution (~1760 - ~1840) kicked off its party.
Productivity, and thus England’s Gross National Product, improved steadily over that period despite companies not being able to raise money through selling ownership to the public. They could only finance their innovations through borrowing money or selling ownership to a small group of investors.
So imagine with me for a moment that it is 1730. You and I, along with four of our friends, pool our capital and file a new joint-stock company called “The Innovators Investment Company”. We then, for the remainder of our lifetimes, simply went about making investments into inventions that we thought were beneficial to society. We knew that we could own a piece of each of the works of genius listed above and benefit from the value they would create.
Could I convince you, my partner, that these are fantastic investment opportunities regardless of the fact that there isn’t a ready market to sell off our ownership? In making such a decision I imagine we might discuss the merits of the invention, the inventor and the potential futures of this enterprise. Owning something valuable, productive, and durable would be the goal, regardless of how liquid that ownership is.
Granted, at some point we may begin receiving royalties from these investments or interest payments (some would argue that is a form of liquidity), but a few key points matter more here:
We would have to fully understand what we were buying into and its proposition to society because we could not sell it to the next “greater fool”. There would be almost no market for our stock so we would make our investment decision based on the business fundamentals, not our ability to resell our ownership.
This level of critical thought would limit speculative bubbles and “chain letter” type effects that have wracked the world of finance since Tulipmania of 1634.
We would have to wait to see how these investments turn out before seeing any returns. There is no telling how long that may take, thus forcing patience.
That just sounds like investing to me.
It seems to me that liquidity is not necessary for society to march forward and for investors to benefit from funding those advancements. John Maynard Keynes speaks a bit to this in his “The General Theory of Employment, Interest and Money.” He says, in effect, that a high preference for liquidity can lead to insufficient investment for long-term projects, negatively impacting society’s advancement.
So why do we love liquidity, even just perceived liquidity, so much? Better said, why does it scare us when we don’t have it? Why is it so scary when it is hard to sell off something?
I think there are two main reasons:
First, we don’t have a true, comfortable understanding of what we invested in. If we knew it well and the value it is meant to create in the world, then the opportunity to sell shouldn’t really be on our minds.
Second, this fear is based on the root, human idea that accessible money is personal security. We highly value cash and instinctively grasp its value. It’s not rocket science. It pays our bills and buys our groceries. We can spend it now to meet our needs.
However we do not naturally relate to the “value” of a productive asset. What is a manufacturing facility and a bunch of machines worth in cash? Depends on your viewpoint and external forces we cannot control (CRE market, used equipment market, customers buying our manufactured goods, etc). This is scary to us because (using a word from Keynes) we cannot immediately “command” its economic value to another end. That is why logging into your brokerage account is so stimulating. You get an immediate translation of your ownership in a far away, nebulous business (a stock) to the cash someone is willing to give you right now (the stock price). You can command that, but you cannot command what Caterpillar does year and year.
I’ll put a Warren Buffett question to you: “If they closed the stock exchange for ten years, would you still buy that business?”
Said another way: “If you couldn’t exit this investment for a decade, would you do it?” That is one of my best acid tests for our company’s investing decisions.
[You will find a lot of Buffett and Munger quotes in my writings. I can’t help quoting the best!]
Funnily enough, this safety effect is all over the human experience played out in our obsession with gold as a universal safe haven and proxy for cash. There is implied liquidity in the way we behave around gold (as if it would substitute for currency in an emergency). I find Warren Buffett’s essay on gold vs farmland in the 2011 Shareholder letter hilarious. I have copied it here for you:
“Today [2011] the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.
“Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
“Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.
“A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.
“Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.”
Quite a strong argument for the ownership of productive assets even though they may be more “illiquid”.
In investing, having the option to act every day can really hurt you. Physiologically, dopamine is released when we act. It feels good to act! It removes ambiguity, uncertainty, and is satisfying. When a choice is made, our bodies chemically reward us for having acted. Decisiveness and quick action are features we value in leaders and it is fun. Ambiguity, uncertainty, and patience are not.
(Schultz, W. ([1998]). Predictive reward signal of dopamine neurons. Journal of Neurophysiology, 80([1]), 1-27)
If I woke up every day and had a price quote on my manufacturing companies and rental properties, I would face a daily temptation to sell (especially if a buyer gave me an fantastic price). If the transaction was very easy to execute, then (to compound my error) I would be tempted to put very little thought into it. “Push this button, sell a company a thousand miles away, get money now? Sounds great!” Having to go through the arduous process of selling something more illiquid (fraught with frictional costs and emotional damage) makes it easier to say no, reinvest earnings and be rewarded with the benefit of continued compounding. High switching costs make it easier to choose patience.
That daily decision to wait and reinvest compounds into incredible things. Charlie Munger said: “The big money is not in the buying and selling, but in the waiting.” Illiquidity makes it easier to wait.
I’ll end with this short story.
We recently allocated some of our capital to an active manager with an incredible track record. He started a long-only, value investing partnership modeled off of the original Buffett Partnerships. He has all of his capital in the partnership and only gets paid when he beats the S&P.
His “lock-up” period is five years because he wants partners who will commit for the long term, regardless of short- term macro issues, fear of the economy, politics, etc. I told him “I wish you would make it ten years!” It is easier for me to be satisfied with my decision to commit if I know that I won’t be able to make another choice for 10 years.
I think this spirit of a “long-term investing partnership” is a foreign concept to most of us today. If we bought a building or a farm together we are buying it first for the cash it generates, not our ability to sell it later. We may like to have the option, but it is not the reason to invest.
I’ll leave the final word with Mr. Buffett and Mr. Munger from the 2004 Berkshire Shareholders’ Meeting beginning at timestamp 3:02:23: “The notion […] that liquidity [...] is a great contributor to capitalism, I think that is mostly twaddle.” https://youtu.be/aCke4ICvGiQ?si=INeRBBCyZ53QUWl7&t=10943
