#17 An economic framework for investing: the Austrian School
A model on how to understand human actions and become better investors
You do not need a PhD in economics to understand and analyze the strategy of a company, read its financial statements or assess the incentive system for the management team of a company. Actually, it is better if you do not have a PhD. However, it is convenient to have a conceptual framework that allows establishing a basic conception of what drives economic actions.
In this post I explain how the Austrian School of Economics changed everything. How it influenced me to see and analyze human actions from a different perspective. Not only in life, but to become a better investor.
Welcome to Edelweiss Capital Research! If you are new here, join us to receive investment analyses in 10 slides, economic pills, and investing frameworks by subscribing below:
The Austrian School of economics is a historical process. It is the result of the accumulation of non-normative economic knowledge experienced in the last 5 centuries of history, from the Spanish scholastic monks of the School of Salamanca in the 16th century to the present day. However, the formal beginning of the Austrian school dates back to Carl Menger in Vienna after the publication of his Grundsätze der Volkswirtschaftslehre (Principles of economy) in 1871.
Economic principles & fundamental investing applications
What struck me the most about the Austrians is that they completely flee from all mathematical formulaic content. The Austrian school studies human action. Human beings are heterogeneous, diverse and governed by a series of different and individual incentives. How can you model that behavior in equations? It's stupid! The economy is not a pure science, it is not governed by immutable physical principles that are repeated under the same circumstances. No man ever steps in the same river twice, for it's not the same river and he's not the same man.
Below I describe what I consider the 4 most important principles of the Austrian School and the 11 investing applications I get from them.
1. Entrepreneurship and practical knowledge
Entrepreneurship is conceived as the process underlying any human action (Mises, 2012). It is the core on which the entire study of the Austrian economy occurs. Human beings tend to continuously perceive and discover new relevant practical information that interests them. Therefore, if there is freedom regarding the achievement of that ends and interests, human nature will act as an incentive (Huerta de Soto, 2010). Conversely, coercive restrictions of a legal or institutional nature will restrain entrepreneurship, information creation and hence, progress.
The entrepreneur process continuously creates new information that did not exist before (i.e. researchers find an application for a material that was useless). This information is transmitted throughout the market. The economic agents involved learn how to act depending on each other's needs (i.e. the owners of the land where this material is found can sell to industrial groups that want to commercialize these new applications. To extract it, other companies will have to create new extractive methods. And finally, customers will benefit from these new applications that will make their life easier). Knowledge and, therefore, wealth, arise when one becomes aware of a situation of mismatch or lack of coordination that exists between several agents. This, and no other, is the core process, as wonderful as it is simple and effective, that makes life in society possible (Huerta de Soto, 2008). Knowledge and wealth are not finite. New wealth can be created out of thin air!
Investing application #1: Incentives
Investing is an art. Markets try to foresee the future. It is clear to me I cannot foresee the future, but I can understand incentives. And incentives move the world. Since I realized the importance of them, the study of the management teams changed completely. I look for great capital allocators, of course, but it is not enough. I want them also completely aligned with my interest. I want them to avoid short term profitability to enhance future wealth creation for the company. And for that, there is nothing better than when most of their wealth is within the company (founders, family owners or even long term operators with real skin in the game)
Investing application #2: Entrepreneurial investing
The value of a company comes ultimately from the value it is going to provide to consumers. Better said, the subjective value the consumers will give to the goods or services provided. Companies have to anticipate future consumer needs. A good investor has to do exactly the same. Put himself in the consumer's skin and try to find companies that provide a differentiated and more value for the money I pay for its products (Quintana, 2016).
Investing application #3: Decentralisation
Knowledge is dispersed. It is very difficult (impossible) for a central entity to foresee needs and allocate resources efficiently. Companies operating decentralized might have an edge to be more dynamic to understand and serve better its customers needs, ultimately creating more value.
Investing application #4: Rejection of neoclassical finance theory
The restrictive assumptions that underpin the concepts of a perfect frictionless market, and the implications flowing from them, run contrary to the principles of Austrian economics. A realistic investment analysis is characterized by its inaccuracy (Rapp, 2017). Future can not be modeled because new information is being created continuously. The efficient markets theory, modern portfolio theories and the capital asset pricing model (CAPM) models a market environment characterized by a permanent value-price-congruence where risk is directly associated with volatility!
2. Economic calculation
The information generated in the entrepreneurial process is precisely what makes possible economic calculation, understood as any judgment of value regarding different alternatives or courses of action. Economic calculation is done in monetary terms and pays a special attention to time preference. Additionally, monetary prices are subject to change because the conditions that produce them are perpetually changing (Mises, 2012). Without the free exercise of entrepreneurship within the context of a free market economy, the information necessary for each actor to properly calculate or estimate the value of each alternative course of action is not created, and therefore, economic calculation is impossible (Huerta de Soto, 2010). This is one of the main principles why Mises foresaw the fall of every socialist/communist regime already in 1922.
However, we face day by day the intervention of the price and time preference of the most important asset of all. The manipulation of the currency, controlling interest rates with the central bank’s monetary policies, generates significant distortions in the credit market, inadequate capital allocation and financial bubbles. All those factors have as a final consequence the economic cycles. Same as with governments, central bankers do not have any singular wisdom to determine the monetary conditions or the appropriate interest rate. And this is not the only problem, they are subject to political and personal servitudes that make their independence impossible when making decisions. In truth, an interest rate formed by the decisions of all the players in the market would more adequately reflect the needs of the moment (Huerta de Soto, 2012). If the amount of money in circulation was not artificially increased, the natural state of a healthy economy would be deflationary. Productivity increases allow more goods to be produced with the same money. This is a positive thing for the consumer, who benefits from the continuous relative drop in prices against wages, as has happened with all technological devices in the last decades.
Investing application #5: Rule of law
It might sound idealistic nowadays, but ideally, I try to invest in countries where the rule of law is protected. Where a free market and property rights are values well considered in the society. Free societies flourish naturally. But it is a dream. We are living in societies who are going towards more intervention. Many criticize China correctly, but tend to oversee what is happening in the west.
Investment application #6: Discount rates
Böhm-Bawerk (1889) explained that interest rates are individually subjective, since each one of us has different liquidity times. The discount rate used in any valuation model is therefore, not the weighted average cost of capital (WACC) of the company, but your individual cost of opportunity. WACC might be useful for capital budgeting within a company, but definitely not for investors.
Investing application #7: Costs, prices and pricing power
Prices are formed depending on what consumers are willing to pay for the products/services. Prices determine costs, and not the other way around, as many believe. Products whose costs are not assumed by buyers cease eventually to be produced. Furthermore, production costs are subjective and variable. Costs are constantly changing as market circumstances change or technological development occurs (Böhm-Bawerk, 2016). This concept is highly ignored in our society, even by the majority of economists. Investors would do good if they do not forget the order. The world works differently when one understands this. Consequently, companies providing a higher perceived value will have more chances to charge higher prices (pricing power) and stay profitable in the long term. It is important for that reason to avoid regulated companies or whose prices might be regulated by governments to solve some transitory issues (housing, energy or banks).
3. Markets
The market economy is the social system based on the division of labor under the private ownership of the means of production. Production, quality and quantities are determined by consumer’s needs. By definition, there should be no coercion nor regulation in the functioning of the market. Capitalists and entrepreneurs can only succeed in providing better services to the consumers and competence is given by a free access to the means of production. Customer is the king in a free market.
Wealth inequality is an essential feature of the market economy. Rewarding an individual's effort based on the value provided is an incentive for everyone to exercise their abilities to the fullest. The only source for profit will come from the ability to better anticipate future consumer demand than others.
Inequality is not to be seen from a shortsighted perspective of rich and poor. The accumulation of wealth through savings involves an investment in capital goods: when the economic calculation is done efficiently, this capital allocation will be reflected automatically in a productivity increase. Eventually, and in the long term, all these improvements will generate wage increases, lower prices, and a better quality of life for the overall society.
In the imaginary construction of a stationary economy, the total sum of profits must equal to the total sum of losses. But this stationary economic state is a constant mistake in the history of economic thought. The economy, the market and society are in a continuous process of change and wealth creation. Only by seeing this, it is possible to understand the coordinating tendency that exists in the dynamic processes of the market.
Investing application #8: Competitive advantages
Markets and competition are fierceless and tend to make a commodity of any product. Competence tends to bring down benefits to the cost of capital and many times, even lower. It is imperative then for companies to thrive to achieve certain competitive advantages to escape this rat race. As investors, we have to look for these companies.
Investing application #9: Free markets are positive-sum games
Another widespread fallacy in our society is that in the stock market for one to win money, another has to lose it. Marxism and the exploitation theory keep harming our societies. Commerce, markets and the stock markets are positive-sum games. Wealth is not given. New wealth is continuously being created. Without Jeff Bezos, our world would be a poorer and worse place. Amazon has made it more efficient for people to receive products at home. Consumers do not have to spend time going to different places to buy. This time, they can spend productively. Furthermore, they can even save massive amounts of energy that they would have required to go to the different stores. Additionally, Amazon has created more jobs than any other company in the world. Ultimately, Amazon shareholders have been rewarded for their capital. There might be some losers in the game (small stores, car companies, etc), but overall, scarce capital is allocated more efficiently to create value for society.
Investing application #10 Patience. Markets tend to be efficient in the long term
We live in a impatience society. We need immediate satisfaction and returns. Important things in life take time. The Austrian explanation of the production process, as that of immediate sacrifice to develop a deeper productive capacity and increase productivity, has time as an essential element (Böhm-Bawerk, 2016). It is an accepted statement by mainstream economic thinking that markets often fail: imperfect competition, externalities, public goods, etc. And therefore, markets must be corrected and hence, regulated by governments. However, it is not very clear what the market error may be when it comes from people who freely pursue their goals, with their successes and their mistakes. But, even if there were, how do we know that the solution is better than the error? In fact, the solution will ultimately be proposed by people very similar to the others, with their own mistakes. Furthermore, intervention normally comes with legal arbitrariness: justice is not the same for everyone anymore (Hayek, 2007). Think about it, governments pretend to solve market inefficiencies with sum-zero measures. They take from minorities to give it to the majorities. Not by creating new wealth. Why? Once more, incentives. Politicians have elections every 4 years. They simply do not have the time, so they prefer to steal from some to give it to others. No matter what to achieve their ultimate goal: ensuring their permanence in power.
4. Society
All the previous mechanisms make society a dynamic structure which is spontaneous and highly complex. It comprises millions and millions of people with an infinite range of constantly changing goals, tastes, valuations, and practical knowledge (Huerta de Soto, 2008, p. 36).
Austrian economists consider that the essential objective of economic science is to analyze how, thanks to the spontaneous social order, society takes advantage of an enormous volume of practical information, not centrally available but scattered and disseminated among millions of individuals.
Investing application #11: Investing is an individual process
Complex mathematical models are badly received by Austrian economists alike because they consider their application to be overemphasized (Rapp, 2017). Wall Street models are always based on simplified assumptions, such as steady future benefits. Society cannot be modeled, nor the future. Due to their personalities alone, all the great adherents of the Austrian School were counter-cyclical in their outlook: they stood out from the masses, and stoically endured being ignored, ridiculed and persecuted (Taghizadeghan, 2016). Investing with a long-term horizon is hard and might have its ups and downs. Stay true to yourself. Make your study and hang it there.
The Austrian economists have always been far from the system mainstream. You can guess why. In the Austrian School of Economics we will not find any magic formula to predict the market price of a company in one year, nor what will happen with the inflation in the upcoming months. No immediate satisfaction for our knowledge needs and information desires. Instead, we will read sensible and lucid men who study human behavior and provide reasonable explanations of events in the long term. ECONOMY with capital letters.
If you enjoyed this piece, please give it a like, subscribe, and share!
Thanks for reading Edelweiss Capital Research! Subscribe for free to receive new posts and support our work.
If you want to stay in touch with more frequent economic/investing-related content, give us a follow on Twitter @Edelweiss_Cap. We are happy to receive suggestions on how we can improve our work.
References
Böhm-Bawerk, E. v., 1889. Capital and Interest: A Critical History of Economical Theory.
García Paramés, F., 2018. Investing for the Long Term. UK: Wiley Finance.
Graham, B., 1949. The Intelligent Investor. New York.
Hayek, F., 1972. Individualism and Economic Order. Chicago: Gateway Edition, Henry Regnery.
Huerta de Soto, J., 2008. The Austrian School: Market Order and Entrepreneurial Creativity. UK: Edward Elgar Publishing.
Menger, C., 1871. Principios de Economía Política.
Mises, L. v., 1949. Human Action: A Treatise on Economics.
Rapp, D. J., Olbrich, M. & Venitz, C. (2017) Value Investing's Compatibility with Austrian Economics — Truth or Myth? Quarterly Journal of Austrian Economics 20, no. 1 (Spring 2017): 3–28
Quintana, E. (2016) Value Investing: Una fundamentación teórica desde el punto de vista de la Escuela Austriaca de Economía.
Taghizadeghan, R., Stöferle, R., Valek, M. & Blasnik, H. (2016) Austrian School for Investors: Austrian Investing between Inflation and Deflation. Mises.at