In my last blog post, I mentioned that largely individual disregard for negative externalities and high risks was a major cause of the financial crisis of 2007-2010 in which institutions engaging in trading complicated CDO (collateralized debt obligations), ABS (asset backed securities) and other similar synthetic financial ‘products’ managed to derail the entire global financial landscape forcing governments to step in and clean up the mess left by high risk, short-term oriented financial strategies. For an industry which lauds free-market principles, government intervention must have been a real blow to the strict belief in ‘market fundamentalism’. An article by Joseph Stieglitz, renowned economist, which asserts the relevance of Keynesian economic policies today also mentions the “incompetence of financial institutions in assessing risk and creditworthiness” – functions which should be paramount to any monetary lending activities.
While I will focus on the importance of reevaluating Keynesian policies over supply-side economics in a future post, I’m going to make the rest of this post be about niches of the finance industry which do focus on the long-term, try to assess external risks and creditworthiness meticulously, and why more of such practices are useful for any macro-economy.
This niche that I am talking about are institutions and individuals engaging in value investing – investing in stocks and equity based on their perceived intrinsic value and a future rise in this value. Benjamin Graham was one of the prominent founders and proponents of the theory of value investing beginning in 1928, and he was also the mentor of the most famous and successful value investor today – Warren Buffet (Buffet has ventured into the exotic credit derivatives world too, but for the most part he has been a value investor).
While value investing offers significantly less returns than high risk trading, the lower individual risk also corresponds with lower losses and ultimately lower risk to the external financial environment. The great upside to this investment strategy though is that it incentivizes investment in firms with perceived high value (optimistic future prospects (vision), stable management etc) and also provides incentives to firms to engage in activities which raise their value. If a high value is associated to firms with a perceived net positive on the world, then this form of investing can be considered a representative of the compromise of individual- and group-interest for the realization of both private profits and community profits (i.e. economic growth, more jobs, technological development etc). Examples of where the value investing mentality has made tremendous impact is in start-up technology companies. Companies such as Facebook and Google have through initial funding based on (at least some) value investing principles grown into organizations with widespread positive social impact (just think of the recent Arab revolutions), and in the case of Google have already churned out massive profits.
With the boom in internet companies and increasing interest in renewable energy, value investing in the form of increased venture capital and growth capital should lead the way and signal to other large financial institutions (such as investment banks with private equity departments) that value investing can yield long-term private profits and social profits too.