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Ed Sonderling’s profound investment wisdom. Be a Capitalist. Here’s how.

Two days ago, I mentioned that my favorite (and most brilliant) investor, Ed Sonderling, hadn’t bought any stocks since the end of May. That day Ed emailed me what essentially was his logic and mechanics of his investing. If you missed it, you can read it here. 

My readers loved Ed’s investment logic. Today Ed returns with his investment philosophy in much greater depth.

Read and study. You’ll learn a lot. I did.

Harry,

My advice: Be a Capitalist!

To be a capitalist you must invest, and to be a successful capitalist the first thing to understand is the importance of Long Term Thinking.  Investing long term will permit you take advantage of many key elements of success that become wholly evident only in the fullness of time, like:  the persistence of commerce, the magic of compounding, reversion to the mean, the indefinite deferral of capital gains taxes, multiple points of observation, and the way leverage can amplify all of these things.

When you start to think long term you will see that Diversification is critical to investment success.  Diversification is a way of expressing humility.  It recognizes the imperfection of knowledge – accepting that the future remains unknown.  Mistakes will be made.  What matters most when investing is survival.  Without survival there is no long term.  And without the long term, there is no success.  Diversification insures survival, and it insures participation.

Diversification is inherently optimistic, because it says “I want to participate!”  Diversification generally refers to spreading out your investments by asset class and especially by sensitivity to a range of economic conditions.  But it also means diversification by vintage.  Diversifying by vintage means spreading out your entry points over time.  Don’t ever bunch up your investment decisions.  This is one important reason to always have fresh cash available – to be able to take advantage of opportunities when they arise.  This is what the cognoscenti refer to as “optionality”.  Diversification is about more than spreading out your investments by asset class and vintage.  It also means diversifying your sources of income.  Consider all the many and various types of unearned income in the world: interest, dividends, rents, royalties, user fees, and profit-sharing arrangements of every type.  Exploit all of these.

Being a capitalist is completely different from being a speculator or a trader or a gambler.  It starts with understanding what capital is.  Capital is durable productive assets.  Capitalists create, develop, deploy, acquire, and own productive assets.  Productive assets are businesses and enterprises, plants, property and equipment, vehicles and machines, mines, wells, forests, farmland, vineyards and orchards, ports, toll roads, rails, and also intellectual property like patents and processes, trademarks and copyrights, recipes and formulae, skills, data, algorithms, contacts and relationships.  Bonds (or loans) are also capital because they produce a (fixed) income stream in the form of interest and they represent a call on the cash flow stream of productive assets.  Commercial real estate is capital because it produces an income stream in the form of rent.  Contractual rights that produce income in the form of royalties or residuals also qualify as capital.  Capital is not consumed, although it may depreciate if left unattended.  Capital increases when the income stream it produces is growing.

As a rule: If it produces – it’s capital!  If it’s idle – it’s merely potential capital.  For example, cash is idle.

  • Cash is not capital. Cash becomes capital when it is converted into something productive or when it is part of the working capital of a productive enterprise.  Cash does provide the benefit of optionality: i.e. cash preserves the option to take advantage of opportunities to create or acquire productive assets.
  • Commodities are not capital. Raw materials like metals or oil and other commodities are inputs.  Typically they are consumed; they do not produce.  But even if they are eventually put to productive use, commodities in their raw form are not capital. Crude materials are idle and are only potential capital.
  • Gold is not capital. Gold has almost no productive uses.  It is almost always raw and idle.  Therefore, it is of no interest to capitalists.  Gold is the ultimate “pet rock”!  Gold may serve as a hedge against global or national catastrophe, but it is unproductive and should not be viewed as an investment.
  • Currencies are not capital because they do not produce.  Currencies, regardless of whether they are government-issued fiat currencies or “crypto” currencies are not productive.  Currencies, when they function well, are stable stores of value and convenient media of exchange, but they do not produce and therefore they do not qualify as capital.
  • Your Home is not capital.  Your home is where you live.  Your house or apartment does not produce cash flow.  On the contrary, your home consumes cash flow in the form of maintenance, insurance, real estate taxes, etc.  Buying a home might turn out to be a hedge against inflation, and a home might appreciate (or depreciate if left unattended) but you should not regard the purchase of a home as an investment.  The utility and pleasure you derive from living there should be your primary (or only) consideration.  You can convert your home into capital by taking in boarders or renting it out.

What is investing?  Investing is converting your retained earnings (i.e. savings) into capital by creating or acquiring productive assets or shares in productive assets and enterprises.  Investing is distinct from speculating or gambling which is risking retained earnings on a (generally random) outcome.  Betting on a price change is speculating, not investing.  For example, buying gold in expectation (i.e. hope) of a price rise is speculating, not investing.  Buying a gold mine or buying shares in a mining company is investing.  If the asset yields a product – that’s capital!  And creating or acquiring that asset, owning it, cultivating it, collecting its income stream, and holding it long enough for the market to revalue its (hopefully growing) cash flow stream – that’s investing!

What makes a successful investment?  When choosing productive assets and enterprises to acquire, look for consistent recurring cash flow streams with visible prospects for growth.  Assets are valued based on their discounted future cash flow streams.  So the reliability and the trajectory of the cash flow are the key variables.  The discount rate (or interest rate) is the other key variable.  Many factors go into estimating future cash flow, but the most important one is management.  Very few assets run themselves.  Capital assets require maintenance and promotion, and to grow they usually require improvements and strategic decision-making.  All of these are the functions of management, and any productive enterprise will fare only as well as it is managed.  So always focus first on management.  Valuing an asset based on its future cash flow is called capitalizing cash flow.  This is the work of the capitalist!

When capitalizing a cash flow stream the most important endogenous variable is management.  The most important exogenous variable is the level and direction of the Discount Rate.  The discount rate depends mostly on the level and direction of inflation.  Inflation drives the discount rate and it is the enemy of valuation.  This is easily demonstrated mathematically.  It is much more difficult to achieve real capital appreciation in a high or rising discount rate environment.   So beware of adverse discount rates.  But that’s another subject entirely.

To summarize:  1) Think long term, 2) Diversify by asset class, economic sector, and vintage, 3) Diversify your sources of income, 4) Invest in durable productive enterprises with excellent management and visible growth prospects, and 5) Discount future cash flow.  Success shall surely follow.

Cheers!

Ed Sonderling

Tuesday July 23, 2019

Thank you Ed,
Harry Newton

  • Paul Livingston

    The federal income/payroll tax system undermines, discourages and punishes capitalism with its wealth creation that improves the standard of living for the country. Th present tax code also supports, encourages and rewards socialism that is focused on wealth distribution that leads to a stronger ruling class that destroys the country. The solution is replace the present tax system to collect the same tax total with a progressive national sales/consumption tax with only one tax break that helps most those who need the most help. The solution is a fair tax that is real/true tax reform and would also repeal the 16th Amendment (direct taxation). The solution is the FAIRtax bill now in Congress, HR 25. Learn more, contribute and join the cause at bigsolution.org

    • Tom from CA

      Sure fairtax eliminates some frauds but would bring others, for example, the “prebates” would be the largest cash welfare system in history – you don’t think fraud would be rampant there? Also, fairtax would encourage the largest “underground” tax-free economy in history (IMO).

      Look, fairtax and the like are simply different ways to arrange deck chairs on the Titanic. The problem is not so much how the government extracts wealth from it’s citizens, but how much.

      • Dman

        All but a few states already collect “state sales tax” at purchase. So a “fed sales tax” is obviously doable. A few years ago The Wall Street Journal published articles saying that 30-33% of the U.S. economy was underground. Certainly there are considerations with implementing a FairTax but without a doubt it is the only way to go moving forward.

        and……End The Fed!!!

        Trump will get it all done, and probably in his second term, hopefully he will also “Zero Out” all Cap Gains Taxes too.

    • Omer Acikel

      Paul, let me ask you a simple question: So currently there is no “ruling class” in the “capitalist” US with current tax code? I am not sure what kind of chain of events will generate “ruling class” in a socialist environment as you claim. BTW we are already paying sales taxes at state level on top of state income tax in CA. Please when you support a solution, stop throwing false claims without footing. If you think the current updated tax code is not pro investor/corporate and punishes “capitalism”, I say as small business owner, you are very wrong. BTW US has never been and never will be a true capitalism as long as fat cats, especially head of what Harry calls cockroach corporations/banks, cry “too big to fail” when they screw things up. It is a show and people just play it as long as it lasts until the next fall.