The wooly-headed economist Henri de Saint-Simon (1760-1825) divided humanity into two classes: the laboring classes (which included merchants and industrial management) and the idling class, who should be suppressed. Investors were included in the idling class, as Saint-Simon failed to recognize the importance of capital allocation in economic development. Keynes, with his “euthanasia of the rentiers” had a similar blind spot. It is time to refute these deluded thinkers: investors have a key role, even the most important role in the economy, and their intelligence and knowledge cannot be assumed and must be worked for.
In my Industrial Revolution studies, I recently came upon a good example of the downside of foolish investors: early French railway development. Since the traditional landed classes and long-term asset holders had little money left after the 1789 Revolution and were any case disgruntled by the 1830 Revolution and the anti-legitimist July monarchy, the French capital markets were in the 1830s controlled by nouveaux riches Paris bankers, mostly Jewish as it happens, but nouveaux riches financiers exist in all eras and from all ethnic backgrounds. The two most prominent Paris financiers under the July Monarchy were James de Rothschild and the Pereire brothers, both of which groups had set up in Paris in the same recent year, 1823. The emphasis in the Paris markets was thus even more on trading profits and fast-buck schemes than in most periods of history.
The first railway in France was a sensible initial venture of 12 miles, including as shareholders both Rothschild and the Pereires, between Paris and the suburb of Saint-Germain, opened in May 1837, and readily feasible seven years after the 31-mile Liverpool and Manchester Railway had opened. Even this suffered from a horrendous cost overrun, from an estimated 3.9 million francs to 11 million, demonstrating that nobody with railway engineering competence was included in the management of the venture, which was created by bankers to make a splash on the Paris Bourse.
Buoyed by the overall success of Paris-Saint Germain, the Paris bankers did not proceed to the logical next step, connecting major French industrial centers. Instead, they created not one but two 11-mile railways between Paris and Versailles, one on the left bank and one on the right bank of the Seine, which were floated competitively on the Exchange. Since there was no economic purpose to a Paris-Versailles line beyond Sunday joyrides for the Paris middle classes, these projects descended into large losses and a complex series of lawsuits, at the end of which the Rothschild Right Bank line took over the Left Bank line.
This crashed the market appetite for French railways. Only the passage in 1842 of a Railway Law guaranteeing a state building subsidy of 50,000 francs per mile, state ownership, and concessions to railway developers of only 36 years got the market moving again. A Rothschild-led group constructed a Nord line from Paris to Lille, opened only in 1846 and connecting with a Belgian line to Lille that had been awaiting its arrival for four years. An early crash on this line then wrecked its speculative share profit on the Bourse and prevented significant further railway development until the Second Empire in the 1850s.
Away from Paris, the Bourse and the speculative bankers, another French railway development had already shown how it should have been done. The well-established Koechlin family, in the textile business in Mulhouse since the 15th century, had diversified their machinery operations into building railway equipment, and in 1838 began the development of a regional line from Strasbourg to Basel, 87 miles long and completed in 1842, before the Nord line had even begun. Financed privately without state subsidy and built by people who knew what they were doing, this line was an immediate success.
The saga of early French railway development thus demonstrates perfectly the need for long-term highly intelligent investors, with a long-term strategic orientation and knowledge of the businesses in which they invest. Such investors not only optimize their own wealth but ensure the optimal economic development of the economy as a whole. It is a lesson that, with the occasional Warren Buffett exception, has been sadly neglected over the last two centuries of capitalism.
The need for intelligent investors has been obscured by the infamous Efficient Market Hypothesis and the fad for indexed investment, which now threatens to overwhelm the publicly-traded stock market. By definition, investment which is indexed is investment in which the allocation of resources is purely random, without any application of intelligence. That is very troubling for the future of the global economy; investment allocated at random is most unlikely to produce growth and improve living standards.
In addition to randomly allocated investment, there remains a vast amount of badly allocated investment, by trading-oriented investors with short time horizons and little understanding of the businesses in which they invest. This is especially true in the hedge fund and private equity fund space, where participants appear to believe that the Efficient Market Hypothesis does not apply to them because of their inherent superiority. In reality, if the Efficient Market Hypothesis applies to public company investment, it must apply to private equity investment – both, after all, involve investment in private sector corporations — with the exception that superior returns can be achieved for a time on private equity investments in a period of declining or ultra-low interest rates (such as 2020-21) through aggressive use of leverage. If the Efficient Market Hypothesis were true, the entire private equity sector would simply be a rent-extraction device for scoring gigantic fees from dozy pension funds or other institutions.
Since that would be unthinkable, the Efficient Market Hypothesis must be false (analysis of returns in public markets that are not biased by academic economists’ hatred of the rich, successful and individualistic suggests this also!) In that case, it becomes essential to minimize the percentage of assets that are managed by the stupid, the ignorant, the short-termist and the dishonest, and maximize the share of assets that are invested according to sound long-term principles by superior intellects with deep knowledge of the industries in which they are investing.
The success of Warren Buffett in the first 40 years of his career (until about 1990) underlines the economic utility of this approach. By intelligent, long-termist investment, following deep study of the companies and industries concerned, Buffett not only made himself one of the richest people in America, he also greatly aided the companies in which he invested, such as GEICO, the Washington Post and Coca-Cola. Only after Buffett became truly famous with political connections among the rent-seeking Democrats, and third parties could benefit by associating his name with their activities, did Buffett succumb to mediocrity in his investment performance and cease creating wealth at the same rate (though some of his deals, such as the acquisition of Burlington Northern Santa Fe Corporation at the bottom of the market in 2009-10, were still outstanding).
The prevalence of random or incompetent investors in the world’s stock markets has increased in recent years, and very likely bears part of the responsibility for the universal collapse in productivity growth since 2007. Even worse is the allocation of capital by government, which puts political considerations, often utterly spurious, far ahead of potential market return or project viability. If capital is not allocated intelligently, then unintelligent investments must proliferate and overall productivity and welfare must decline.
This long-term disaster has many fathers; the proliferation of regulation and the prevalence of artificially low interest rates must also bear some of the blame for our productivity blight. Nevertheless, an increase in the intelligence, industry knowledge and long-term orientation of investors will inevitably benefit the global economy, reducing the number of dozy investments like the two Paris-Versailles lines and increasing the number of intelligently thought-through investments undertaken by people with genuine expertise, such as the line from Strasbourg to Basel.
The industries in which we invest and the techniques used to analyze investments have changed, but the fundamentals of efficient capital allocation remain the same. Ditch the false god of indexation and retrain the short-term-oriented market operators to focus on long-term investment analysis. That way, we will finally start funding the best projects and make ourselves richer.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)