What We’re Reading (Week Ending 09 January 2022) - 09 Jan 2022
Reading helps us learn about the world and it is a really important aspect of investing. The legendary Charlie Munger even goes so far as to say that “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.” We (the co-founders of Compounder Fund) read widely across a range of topics, including investing, business, technology, and the world in general. We want to regularly share the best articles we’ve come across recently. Here they are (for the week ending 09 January 2022):
1. We may finally be able to test one of Stephen Hawking’s most far-out ideas – Paul Sutter
In the 1970s, Hawking proposed that dark matter, the invisible substance that makes up most matter in the cosmos, may be made of black holes formed in the earliest moments of the Big Bang.
Now, three astronomers have developed a theory that explains not only the existence of dark matter, but also the appearance of the largest black holes in the universe…
…Dark matter makes up over 80% of all the matter in the universe, but it doesn’t directly interact with light in any way. It just floats around being massive, affecting the gravity within galaxies.
It’s tempting to think that black holes might be responsible for this elusive stuff. After all, black holes are famously dark, so filling a galaxy with black holes could theoretically explain all the observations of dark matter.
Unfortunately, in the modern universe, black holes form only after massive stars die, then collapse under the weight of their own gravity. So making black holes requires many stars — which requires a bunch of normal matter.Scientists know how much normal matter is in the universe from calculations of the early universe, where the first hydrogen and helium formed. And there simply isn’t enough normal matter to make all the dark matter astronomers have observed.
That’s where Hawking came in. In 1971, he suggested that black holes formed in the chaotic environment of the earliest moments of the Big Bang. There, pockets of matter could spontaneously reach the densities needed to make black holes, flooding the cosmos with them well before the first stars twinkled. Hawking suggested that these “primordial” black holes might be responsible for dark matter. While the idea was interesting, most astrophysicists focused instead on finding a new subatomic particle to explain dark matter.
What’s more, models of primordial black hole formation ran into observational issues. If too many formed in the early universe, they changed the picture of the leftover radiation from the early universe, known as the cosmic microwave background (CMB). That meant the theory only worked when the number and size of ancient black holes were fairly limited, or it would conflict with measurements of the CMB. .
The idea was revived in 2015 when the Laser Interferometer Gravitational-Wave Observatory found its first pair of colliding black holes. The two black holes were much larger than expected, and one way to explain their large mass was to say they formed in the early universe, not in the hearts of dying stars.
2. Orlando Bravo – The Art of Software Buyouts – Patrick O’Shaughnessy and Orlando Bravo
[00:09:54] Patrick: Would you take us all the way back to the very first deal? I think Prophet 21 was the name of the firm that you did in the software world. I want to start there, because obviously, this has become an absolute dominant trend in the world of investing, of businesses, et cetera. But back then, when you did your first one 22 years ago, it was a very different situation. I think the evolution from then to now is really important for people to understand. Talk us through the unique dynamics of that deal, how you came to it, how you got the idea, how it was financed. I know that was very different back then. I would love to hear the story of the first technology software deal that you did.
[00:10:30] Orlando: Prophet 21 was a deal that our team originated because we had an investment team at the time after the dot-com bubble burst in 2000. We were looking to do something different than all of private equity, really. We were searching for it. Carl Thoma, my mentor, was open-minded enough to allow us to do that. The theme that we had at the time was you can buy software maintenance streams… remember, it was all on-premise two years ago… you can buy software maintenance streams less expensively than almost any other form of recurring revenue in different industries, media, radio, which was popular then, transaction processing, and that quality of that revenue is even more sticky than those categories. Now, the challenge was that that universe, which is a challenge today, by the way, but the challenge then, having us not done that before, was that these companies were unprofitable, especially coming out of that bust that happened in the year 2000. We had to say, theoretically, with 90% gross margins, these businesses can be high cashflow generative, and therefore good candidates for a fundamental control-type investing.
In doing our work, we came across Prophet 21. The company was for sale. We were able to succeed, actually, without much competition. That was interesting. It was one of those unusual deals where there was not that much competition, even though there were players starting in the software industry back then that were very good and had similar ideas as we had. It was interesting, because that company had never made money before. Now, it wasn’t losing all kinds of money. It was close to break-even, so management did care about that. That wasn’t a completely irrelevant concept to them. Secondly, the company had never done a lateral acquisition and the company had inconsistent performance. We bought the business and part of the reason was the price looked great at around two times maintenance revenue, one times two. Imagine, remember those days.
[00:12:37] Patrick: Charming.
[00:12:39] Orlando: Exactly, those were the days. We decided through meeting the person that became chairman of our operating committee, that the best approach was to back existing management for all the reasons that I mentioned before that existing management has. They really wanted to win, but have them work with our operating partner in terms of improving that company. Of course, three years later, you end up with a success story, a five margin, good growth, six software acquisitions, and it was a great investment. That experience really made us very passionate about the possibility of working with existing management that deeply cares about that business, that doesn’t move from company to company, that lives in that environment. They provided software for small and mid-market distributors, so they knew all the distribution customers, they knew the culture, they knew how they talk, how they trade, how you have to discount it. They know that world and were good at it. If you can marry that with an operational approach… as my partner would always say, “Everybody needs somebody to learn from”… if you can marry that with what we would bring, you would not only have the possibility of great success, but also it was a good approach to doing business. It felt really good. Then we did a second deal, and the same thing happened with existing management, and then a third one and so on and so forth, so we quickly developed this as our mission.
[00:14:02] Patrick: I’d love to zoom out and talk about the software industry, maybe even the enterprise SaaS-specific sector of it, where you’ve done a lot of your work and some of the weird features of it. You mentioned some of these businesses have 90% gross margins. Everyone herald’s software as like the best business model ever, but I think the average public market business, or maybe even the private market ones, they lose a lot of money still. Obviously, there’re reasons for that, but I’d love you to just walk through what seems like a huge dissonance between the average SaaS company and the type of company that you’re trying to run and manage.
[00:14:34] Orlando: There is no difference in the business model between that average and what we’re looking to do. In essence, when you see us buy control of the business, we are underwriting our plan, not what is going on in that company. In many cases, we’re buying break-even businesses or businesses that may be losing money. That’s not the way it’s going to be run in partnership with management going forward, because the model would break and you couldn’t support some debt into that transaction, which is highly creative. The challenge is for the market inefficiency here is that public investors who are extremely smart, creative, highly-educated, and great, for some reason they believe that “investing in growth” is the same and goes hand-in-hand with losing money and having a negative margin. Those two concepts are completely different. They many times have nothing to do with one another, and many times high profitability leads to higher growth because what high profits means, really, is that first you have operating management that innovates correctly, that runs those different functional areas in a way that is operationally sound. They measure all their activities. They look at inputs versus outputs. They readjust to what is working. Being highly profitable also means that you have a good enough product and you’re charging a price for that product that allows you to produce that profitability, where for example, the yearly increase in the value of that product merits a price increase that is higher than your labor inflation, a key point today in this inflationary world. If you do that really, really well and you provide so much value to your customers that you capture some of that in your price, and every day you become better at your operations because you learn from the past and you’re actually measuring this, it means that you have more money to invest in tactical growth, which is sales and marketing or distribution and more money to invest in strategic growth, which is product development, R&D and new initiatives.
See, when you’re highly profitable and you’re growing very fast, it also means that management is making the right investment decisions in growth. You’re an investor. You see all kinds of different sales channels. Well, if you lose money and you can lose money, sure, you’ll try it all. You’ll try direct sales, channel sales, inside sales, web sales, marketing. You can try all kinds of marketing plays. When you’re really profitable, it means you’re doing the right ones that fit your product and your business and what your customers need. The same thing is in R&D. You could have 20 R&D initiatives, and if one works and you grow really fast, that’s great. But how about the other 19? I can get really passionate about this. The other fallacy that I see with investors in this space is saying, “Well, this company’s growing really fast now. It’s 200 million in ARR, which is plenty of scale by the way to run it profitably, and I’m going to model what management told me, which was a 30% operating margin in year four. I understand why they’re losing a lot of money now is they’re growing at 50%.” But see, the operating world doesn’t work that way. That company in year four is not all of a sudden going to change how they plan, how they think about initiatives, how they tell their direct reports what’s important and what’s not. It just doesn’t work that way. They’ll never get there. You’ve got to start now to get there.
[00:18:23] Patrick: What do you think most explains… I think I have these numbers roughly right… the average SaaS company, maybe in the category has a slightly negative EBITDA margin, losing money on an EBITDA basis? I think probably your portfolio is closer to 35 or 40% EBITDA margin today. That’s a huge gap. What are the major explanations that make up that 40%? I mean, you’ve started to talk around some of the attitude differences, but literally, where do you think that change in margin most comes from versus the average SaaS company out there that’s loss-making?
[00:18:54] Orlando: I think that comes from investors really incenting management teams, just on top line. We work in a free market, capitalist, incentive-based system. If you’re running a company and your investors tell you, “I don’t care about the bottom line at all. Go grow revenues as quickly as you can,” that’s the directive from the shareholders and that’s what’s most likely going to happen. Now, those investors, at what point in time did they become indoctrinated with this business model? We could have a philosophical discussion about that.
[00:19:29] Patrick: Yeah. I’d love to hear.
[00:19:30] Orlando: Right. Is it that early-on VCs, teach these companies that way in order for them to, of course, grow in winning their markets? That’s the great thing to do, but also by doing that, do these companies need to raise more money and therefore there’s more room for investors to get the equity and then so on and so forth? It’s very interesting. One of the things that’s just so important to say is we believe in both high growth and high margin, and they’re not mutually exclusive. One actually drives the other, because when you also get growth, you should drop to the bottom line a higher margin than your existing margin in your business. In software where you have the marginal cost of your product is nearly zero, you do have to provide support, and of course, you have to pay for the distribution.
3. 10 Lessons from 2021 – Michael Batnick
Investors don’t necessarily get better with experience because markets are adaptive, unlike most of our learning environments. I won’t ever touch a stove again on purpose because I know it’s hot. I won’t go in a cold shower because I know it’s cold. But “I won’t ever buy stocks again when the CAPE ratio is above 25 because I remember 1999” is not the same thing.
To quote myself, “The greatest lesson we can learn from history is that those who learn too much from it are doomed to draw parallels where none exist.”
Skeptics sounds smart. Optimists make money. As I said at the top of this post, my reflections and lessons of this year are a time capsule of the current environment. An environment that might change as soon as I hit publish. Sure doom and gloomers will look like soothsayers from time to time, but I don’t know anybody who got rich fading the human spirit. Don’t short capitalism.
It’s easy to be a knee-jerk skeptic. In fact, that will probably serve an investor well. Shiny objects can be dangerous. But a healthier attitude, especially in a bull market, is to be knee-jerk curious. “Metaverse? What’s that? Sounds dumb, but maybe it’s worth investigating.”…
…Avoid extremes. Never go all in or all out. Both lead to extreme thinking, which leads to extremely bad outcomes. It’s one thing to say, “crap, I guess I can’t handle a portfolio of 80% stocks, I’ll dial it back to 60%.” It’s a whole other thing to say, “crap, I can’t handle the volatility. I’m gonna go to cash until things settle down.” One person is going to survive the ups and the downs and the other person isn’t.
4. DAOs, DACs, DAs and More: An Incomplete Terminology Guide – Vitalik Buterin
Here, we get into what is perhaps the holy grail, the thing that has the murkiest definition of all: decentralized autonomous organizations, and their corporate subclass, decentralized autonomous corporations (or, more recently, “companies”). The ideal of a decentralized autonomous organization is easy to describe: it is an entity that lives on the internet and exists autonomously, but also heavily relies on hiring individuals to perform certain tasks that the automaton itself cannot do.
Given the above, the important part of the definition is actually to focus on what a DAO is not, and what is not a DAO and is instead either a DO, a DA or an automated agent/AI. First of all, let’s consider DAs. The main difference between a DA and a DAO is that a DAO has internal capital; that is, a DAO contains some kind of internal property that is valuable in some way, and it has the ability to use that property as a mechanism for rewarding certain activities. BitTorrent has no internal property, and Bitcloud/Maidsafe-like systems have reputation but that reputation is not a saleable asset. Bitcoin and Namecoin, on the other hand, do. However, plain old DOs also have internal capital, as do autonomous agents.
Second, we can look at DOs. The obvious difference between a DO and a DAO, and the one inherent in the language, is the word “autonomous”; that is, in a DO the humans are the ones making the decisions, and a DAO is something that, in some fashion, makes decisions for itself. This is a surprisingly tricky distinction to define because, as dictatorships are always keen to point out, there is really no difference between a certain set of actors making decisions directly and that set of actors controlling all of the information through which decisions are made. In Bitcoin, a 51% attack between a small number of mining pools can make the blockchain reverse transactions, and in a hypothetical decentralized autonomous corporation the providers of the data inputs can all collude to make the DAC think that sending all of its money to1FxkfJQLJTXpW6QmxGT6oF43ZH959ns8Cq constitutes paying for a million nodes’ worth of computing power for ten years. However, there is obviously a meaningful distinction between the two, and so we do need to define it.
My own effort at defining the difference is as follows. DOs and DAOs are both vulnerable to collusion attacks, where (in the best case) a majority or (in worse cases) a significant percentage of a certain type of members collude to specifically direct the D*O’s activity. However, the difference is this: in a DAO collusion attacks are treated as a bug, whereas in a DO they are a feature. In a democracy, for example, the whole point is that a plurality of members choose what they like best and that solution gets executed; in Bitcoin’s on the other hand, the “default” behavior that happens when everyone acts according to individual interest without any desire for a specific outcome is the intent, and a 51% attack to favor a specific blockchain is an aberration. This appeal to social consensus is similar to the definition of a government: if a local gang starts charging a property tax to all shopowners, it may even get away with it in certain parts of the world, but no significant portion of the population will treat it as legitimate, whereas if a government starts doing the same the public response will be tilted in the other direction.
5. In the Middle of Transition: 2022 Semiconductor Outlook – Doug (Fabricated Knowledge)
The semiconductor market for years has been characterized by booms and busts… Historically, the boom-bust cycles are primarily driven by supply.
The core reason for this is that capacity additions are extremely lumpy and adding new capacity via a fab came with huge fixed costs, and then very low variable costs, especially in sub-sectors like memory. The incentives were obvious. If you had a new fab, you could use your marginal cost advantage to offer a cheaper product and, in the process, blow up the total profit pool. In many ways, this was the story of the ~80s-90s memory market…
…But of course, things changed. Moore’s law slowed down and the rising cost of making semiconductors from both the fabrication and design perspective has forced consolidation and more rational industry competition. Why blow up the profit pool of your entire industry when the magnitude of costs is reaching tens of billions of dollars? Why not add capacity in a more disciplined manner given that you know what your competitors are doing? This is exactly what’s happening in memory, the most hyper-cyclical part of the industry. Most of the more mature semiconductor segments have already started to focus on their own product fiefdoms. With little competition head to head and only at the margins. Consolidation also helped quite a bit.
Another large driver as software eating the world and semiconductors being used in more and larger parts of the economy. Our cars and our homes took more semiconductors, and of course, our phones became much more integral parts of our lives. We went from essentially one market in the 1990s (PCs) to multiple end markets today…
…The important thing is that each of these cycles are happening independently. For example, phones are starting to slow down in volume as the average life of a phone increases, while automotive companies are just starting to ramp EV and ADAS content in their cars.
This is a simple expression of the law of large numbers. If semiconductors have a positive growth relationship it would mean that the bigger the number of different markets that are not correlated, the closer the aggregate results will approach the underlying trend. Each new diversifier will lower the volatility of just a single market’s results. I think that’s happening today.
So back to the path of cyclical to secular growth and what it would look like. Especially for a cyclical industry, each time there’s a year of sustained strong results there’s an expectation of a reversal to the mean. As bullish as I am, I don’t have the guts to say, “growth only, no down years.” That kind of statement is insane to make if you’re in the business of having reasonable accurate projections given the historical base rate.
But right now, we have clear indications of new demand streams from AI, new industries, and the broader slowing of Moore’s law. We also have more disciplined and consolidated supply, and despite the crazy capacity additions that have already taken place, the industry continues to grow. Semiconductors seem to have swapped from a supply-driven industry to a demand-driven industry since the pandemic. That, to me, is the big key of what the cyclical-to-secular market would look like. Additionally, semiconductors actually grew through a recession, which is pretty telling for the secular argument.
If there were ever a scenario of an historically cyclical and supply-driven market shifting into a secularly growing, demand-driven market, we’re living in it. Students of history know that each year there should be a supply-driven correction at some point, but each year the balance of supply and demand looks to be in demand’s favor. So, while we think that the continued and consistent supply additions will eventually turn the market, demand continues to outweigh supply additions.
If this sounds familiar, it’s because it’s pretty much the regime we’ve been living under since 2020. The chip shortage was originally expected to abate or turn around by the end of 2021 and that looks like it won’t happen. Now it’s expected to end in 2023, but it’s not like there hasn’t been a huge capacity addition since last year. The supply-demand crossover always seems to be just one year away. What’s happening? Why haven’t the recent capacity additions relieved the supply-chain crisis? An exchange that I thought was pretty enlightening was this conversation on the Q3 2021 ASML earnings call, answering an analyst’s question:
“Yes, Sandeep. I mean you’ve been around a long time and you asked the million-dollar question. So — and the real answer is we don’t know. We have some indications and some ideas. And yes, you are absolutely right, the wafer out capacity today is a big — is a lot larger than it was in Q4 2020. That’s true. And still, we see these shortages. Now I spoke to a very large customer and basically asked the same question.
And I actually said, Peter, we don’t know either. Because somehow we haven’t been able to connect all the dots that actually are the underlying drivers for this demand.”
This sounds like an anecdote in favor of the shift towards a demand-driven market. Each year, massive supply is added, yet demand continues to simply outweigh it. That would be what the “secular growth” case would look like for me, and in some ways we’re in the perfect expression of that transition. We’re in the middle of it.
6. Does Not Compute – Morgan Housel
Investor Jim Grant once said:
To suppose that the value of a common stock is determined purely by a corporation’s earnings discounted by the relevant interest rates and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen to the defense of Joseph Stalin and believed Orson Welles when he told them over the radio that the Martians had landed.
That’s always been the case. And it will always be the case.
One way to think about this is that there are always two sides to every investment: The number and the story. Every investment price, every market valuation, is just a number from today multiplied by a story about tomorrow.
The numbers are easy to measure, easy to track, easy to formulate. They’re getting easier as almost everyone has cheap access to information.
But the stories are often bizarre reflections of people’s hopes, dreams, fears, insecurities, and tribal affiliations. And they’re getting more bizarre as social media amplifies the most emotionally appealing views.
A few recent examples of how powerful this can be:
Lehman Brothers was in great shape on September 10th, 2008. Its Tier 1 capital ratio – a measure of a bank’s ability to endure loss – was 11.7%. That was higher than the previous quarter. Higher than Goldman Sachs. Higher than Bank of America. It was more capital than Lehman had in 2007, when the banking industry was about as strong as it had ever been.
Seventy-two hours later it was bankrupt.
The only thing that changed during those three days was investors’ faith in the company. One day they believed in the company. The next they didn’t and stopped buying the debt that funded Lehman’s balance sheet.
That faith is the only thing that mattered. But it was the one thing that was hard to quantify, hard to model, hard to predict, and didn’t compute in a traditional valuation model.
GameStop was the opposite. The statistics showed it was on the edge of bankruptcy in 2020. Then it became a cultural obsession on reddit, the stock surged, the company raised a ton of money, and now it’s worth $11 billion.
7. TIP410: The Changing World Order w/ Ray Dalio – William Green and Ray Dalio
William Green (00:11:23):
You make some slightly chilling predictions about the US without being definitive because, obviously, these are probabilistic bets. For example, I think at one point you say, “I think that the odds of the US devolving into a civil war type dynamic within the next 10 years are around 30%.” You say that’s related to the high risk of internal conflict, the kind of politic polarization and anger that we’re seeing in the country. You also talk about the rivalry with China and say that the probability of a big war in the next 10 years is 35%. I was both struck by the way that you think the importance of thinking probabilistically, which is something that’s always struck me when I interview great investors, whether it’s Joel Greenblatt or Howard Marks, this sense that nothing is black and white. It’s always betting on probabilities, which clearly is something that you’ve been a master of over the decades.
William Green (00:12:17):
But also I was very struck by actually the seriousness of those claims. I wondered if you could talk about that gravity because you say, for example, that the US really is in danger of tipping over one way or the other. It’s that you say it’s, “The world’s leading power is on the brink and could tip one way or the other.” Can you give us a sense, digging into firstly the debt issue and the printing of money, why this is such a precarious position to be in? Because I’m no economist and I sort of need the idiot’s guide to why this is such a treacherous financial situation to be in.
Ray Dalio (00:12:53):
Maybe I can describe the typical cycle and then pull it out. I won’t go through all of the 18 measures, if that’s okay. I think it’ll create the template. There are internal orders and there are external orders, and what I mean by an order is a system of operating. Usually, internal orders are written by constitutions and external orders are written by treaties and so on, and they follow a war typically. Let’s say World War II. There’s a war. After the war, there are winners and losers. The winners get together and they determine the order, the system. For example, the system in 1944 they determined the Bretton Woods monetary system with the dollar at the center and gold at the center. It was an American world order because the United States had 80% of the world’s gold, it accounted for half the world’s economy and it had the monopoly on nuclear weapons, which was dominant.
Ray Dalio (00:14:06):
So the United States was dominant in all ways and the center of it, the reason United Nations is in New York and the IMF and the World Bank are in Washington because we began the American world order dominated that way. That’s an example. But if you go back to other cases, the Treaty of Versailles was the prior world order. In order words, a war and then a resolution of that war and then new rules as to who did what. If you keep going back, you will see that there are those world orders that just go back, the Peace of Westphalia in something like 1668 or something. Each system then creates a new system and a new world order, and then that happens also internal orders like, let’s say, revolution.
Ray Dalio (00:14:57):
The Chinese domestic order began in 1949. They had a civil war and then they started their domestic order in 1949. There’s a cycle, and the way the cycle works typically is after the war there’s a peace. The peace comes because there’s a dominant power that no one wants to fight, and also everybody’s so sick of war and then so you usually have a period of peace, often quite an extended period of peace. And there’s the consolidation of power by the new leader and then the development of a system that allows development because you wiped out a lot of the old. You wiped out the old debts, you wiped out many of the old things, but you’re in the process of wiping them out and new start. Then that begins the arc of the period of peace and prosperity and productivity.
Ray Dalio (00:15:53):
For example, the Second Industrial Revolution was that kind of period, the post World War II period was that kind of a period in which there’s competition, things working hard and there’s a rise in living standards. Those rise in living standard, particularly work well in a capitalist economy. Capitalism was really, that I mean markets, stock market and so on, was invented by the Dutch. It’s a way of creating buying power to enable, let’s say, entrepreneurs to be able to do well but it distributes wealth indifferently so that it creates a larger wealth gap. Over a period of time, it creates a larger opportunity gap because there’s a tendency of those who gained well to be in a favored position.
Ray Dalio (00:16:47):
For example, their children can get education that poor children can’t get or they might have more influence and so on, and so you get larger gaps and those gaps also can represent opportunity gaps and so on. There’s a tendency also toward debt and capital market valuations to keep rising, so debt rises in relation to income because debt is buying power but there’s… If you pay it back in hard dollars or hard whatever the currency is, then that’s a problem. So you see it rise. All of these cycles, you see debt rise relative to income and that’s because it’s better to have spending power like we had this last cycle, send out the checks and send out the money. You’re sending out buying power. That is so much easier to do and favorable to do than to restrict it and to contain it. That’s what raises debt relative to income and raises that so that you produce a debt cycle.
Ray Dalio (00:17:55):
Go back to Old Testament and they’ll about the 50 year cycle and the Year of Jubilee and so on. But these cycles have gone on for a long time, and so these wealth gaps grow, level sort of indebtedness grow. Also what happens is the competitiveness as they get richer, the competitiveness declines because… It declines first because people, as they get richer they become more expensive in the world, they want to work less hard and also they gather more competition. Let’s say, for example, the Dutch built ships that were the best to go around the world and collect riches, but the British learned from that and hired Dutch ship builders to build ships or inexpensively and better ships by learning from them. So others become more competitive.
Ray Dalio (00:18:52):
Also, when they do very well at the top they typically become dominant in world trade. The Dutch accounted for 25% of world trade. As a result, they bring their currency and the currency that’s then commonly used around the world becomes a world currency, which we call a reserve currency. When they have that currency, then that becomes also something that people want to save it so those in other countries will want to buy that currency, which means lend and so that they will lend to countries, which tends to make them get more into debt. It’s a great privilege, they call it the exorbitant privilege, to be able to borrow money because you the reserve currency, but it does get you deeper into debt in your own currency. That sows the seeds again for problems.
Ray Dalio (00:19:48):
There’s a political system that also operates with this kind of cycle, which is the political system rewards spending and it doesn’t penalize debt. Nobody pays attention to how much debt you get into, they pay attention to what they receive. When they get more stimulation, that produces it so there’s a tendency to have that which raises the living standard over the short run but also produces the indebtedness for the long run. So that when you get, let’s say, in the top of that cycle you can see living standards are really at their highest, they’re very high. You start to see the complexion of the finances deteriorate, you see the competitiveness deteriorate and so on. People also behave differently.
Ray Dalio (00:20:38):
There is an age cycle. Those who went through the war and went through the Depression have a different psychology than those who are now the next generation, so as this passes on so then you have newer generation operating that, they know really to enjoy life more, devote attention to other things and so on. So competitiveness starts to decrease while the indebtedness… But it’s a very good feeling position to be in, but that sows the seeds. Then when you have excessive levels of indebtedness… When you have the gaps and the excessive level of indebtedness and you have the bad finances… Because when you have that borrowing, the debt, then it’s bad for the owners of the debt. Right now you have very negative real interest rates, in other words inflation adjusted interest rates so it doesn’t make any sense to hold the debt, those assets. Then you see the movement to other things and so on.
Ray Dalio (00:21:42):
Then when you have the large wealth gaps that enters into it at the same time as you have internal conflict and external conflict. When that gets… The cycle’s described in detail in the book, but you start to see political polarity and the rise of populism of the left and populism of the right becomes extreme and progressively more extreme. As a result, you no longer can be in the middle. In other words they say, “Pick a side and fight.” And the media and the politics work together to enrage people and to make them more inclined to fight. Of course, that generation didn’t go through war. Because they didn’t go through war, they’re more inclined to fight and everybody is cheering the fighter who will fight for their side.
Ray Dalio (00:22:33):
In history, it shows that when the causes that people are behind are more important to them than the system, the system is in jeopardy, which is the case now. That progresses and you have either an internal conflict, you have a financial problem [inaudible 00:22:50]. Now other things matter. You asked about the cycle because there are other things like education and civility. A long leading economic indicator is the quality of education, but education is not just understanding history and memorizing or knowing how to do math and such things, it’s also education in civility, how people behave with each other, the idea of all of those. As there’s better education, there’s better productivity that follows.
Ray Dalio (00:23:21):
There are a number of measures that I include in there. For example, infrastructure investing, how you’re improving your infrastructure, there’s measures of the military strength. When they go internationally, they need a stronger military to protect their supply lines and all of that. All of those… There’s 18 different measures that you can see, and you can see what the numbers were and are of those types of things to make up the arc, but the arc is basically along those lines until you get to the irreconcilable differences, whether they’re internal or external, and you get to the financial problems. That’s why I’m saying… I think just by the measures that’s where we are. If we take the very simple financial, is the amount of money that somebody’s earning greater than the amount that they’re spending? Are their assets better than their liabilities?
Ray Dalio (00:24:19):
That’s true for individuals, companies and countries because that country’s an aggregate of those. You can look at the financial condition. When you get to the printing of money stage, you are very late in the cycle. That’s a concerning thing. You have that financial piece together with the internal conflict or, let’s say, internal order and disorder piece. There’s a chapter on internal order and disorder, explains the cycle. Then there’s the external order and disorder, but it’s made up of a number of those other things like education, quality of leadership and so on.
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