I recently had the pleasure of a delightful hour-long conversation with George Gilder, the influential supply-side economist who helped launch and shape the Reagan revolution with his book Wealth and Poverty, the tech revolution with his books Microcosm, the connectivity revolution with his book Telecosm, and perhaps a new revolution in economic and financial theory with his new bookKnowledge and Power. To listen to the full interview on-line click here.
Part of the discussion centered around ways in which the publicly traded markets have increasingly devolved into a world of noise, rather than information, and that portion of our talk has been transcribed below.
Jerry: “I’m going to go back to something you said earlier about venture capital being this great generator of growth. In the era of sort of “good governance” – sort of government interference in markets, where everything is about decreasing the amount of disclosure to make sure that nobody gets some alleged unfair advantage, does that make the private equity player, particularly venture capital, does that give that form of investment a strong advantage over what arms-length public investments have become?”
George: “I agree. I mean, the whole goal of the SEC and all these fair-disclosure laws and insider trading rules is to create what they call a ‘level playing field.’ But a level playing field by definition is a playing field with no information in it. The result is that most of the returns in the economy, most of the profits, migrate to the legal insider traders. And the legal inside traders are venture capitalists and private equity companies that are dealing in whole companies — and thus are permitted to have intimate knowledge of every investment they make — and conglomerates like Berkshire Hathaway and General Electric. Which aren’t truly companies in a usual sense; they’re aggregations of assets that are acquired through intimate inside knowledge. So, most of the returns in the economy go where inside trading and inside knowledge is permitted, and meanwhile the public is pushed to the random walk down Wall Street. They’re mostly advised to do index funds, and essentially what the government tells the public is, “Don’t invest in anything you know about.” That’s the rule. And the government has other recommendations: “Invest in our lotteries, where no one has a better chance than you.”
Jerry: “Yeah. That’s the ultimate outsider investment. If you take insider trading rules to their natural extreme, the lottery is the best exemplar of that – ‘nobody knows anything’.”
George: “And that’s what everybody’s advising you to do: To buy index funds. John Bogle is a great hero for defining a mode of investment with no possibility of information in it.”
Jerry: “And therefore no alpha, no over-performance.”
George: “No alpha, no upside….
Jerry: “Just equilibrium returns. I’m sorry, I didn’t mean to interrupt you. I’m riffing with you; I’m having trouble keeping my mouth shut because you’re setting off ideas –“
George: “Yeah, but you really formulate them well, Jerry.”
Jerry: “Thank you, thank you. So I interviewed Burt Malkiel, the “random walk guy” himself at one point, and I said, “Well, what about Berkshire Hathaway?” And he said, “Good luck,” maybe, or something. You’re saying no; that a conglomerate that can buy a whole company, whether it’s big enough, like Berkshire Hathaway, to buy a whole publicly traded, or maybe you’re just a venture capital and you can buy a whole small company or a big part of it, has an inherent advantage because they can become an expert, and they can actually reinvest not just their money but their expertise in giving guidance to the enterprise.”
George: “That’s right, and they can understand every detail of the enterprise and its innovation. Thus, they can align knowledge and power; the power of capital with entrepreneurial knowledge inherent in the enterprise. And that creates all the wealth in this society, whether it’s – Warren Buffett can do it, GE can do it, John Doerr can do it, whoever it is – that is, venture capitalists can do it. But the SEC wants to be sure that nobody in the public makes any money.”
Jerry: “Other than the heat death, entropy, average equilibrium return of a cap-weighted index.”
George: “And if everybody invested that way, of course there’d be no information in the index. In the end, the economy would suffer from gambler’s ruin. Gambler’s ruin is the destiny of all random investment. The random walk down Wall Street ends with gambler’s ruin”
Jerry: “I see. And I guess cap-weighting, a passive cap-weighted investment is always, by its very definition, backward-looking.”
George: “Yeah. Oh, it’s all backwards-looking. That’s the problem. Because it’s all based on, well — Peter Drucker used to say that, “No one knows less about your company than your CFO.” What he meant was that the CFO is necessarily focused on the past and, as much research has shown, past results don’t guarantee future results. They are not serially correlated. Profits earnings, growth, innovation, is not serially correlated.”
Jerry: “Yeah. In fact, I think a lot of the research I’ve seen shows almost a negative correlation. This is the innovators dilemma, right? That past over-performers tend to be future under-performers, because they’re not set up for the next wave of disruptive innovation.”
George: "Yeah. That’s correct. And it really is — it’s a knowledge system, all the way.”