How did Menger gave me the key to invest rationally
Carl Menger is in my opinion the most important author in history. Its thoughts changed completely how I invest, and why I invest.
In 1871 he wrote the best book about economics, which completely disrupted the basics of this science, that we inherited from Adam Smith in the Wealth of Nations.
Adam Smith in the Wealth of Nations defined (i) value in use, and (ii) value in exchange, making the assumption that there were 2 kinds of value.
The value in use refers to the utility that something has. Which is fixed, it cannot be changed. For example, you can use a pen to write, but the pen cannot learn to fly. The pen can be used for several things, but its frontier of possibilities cannot be changed without external impacts.
Then, you have value in exchange, which is the amount of good and services that you can exchange for something. It is basically a fancy way to say market price.
When Menger saw this theory, I think that he thought (what whoever with a little of common sense would have though) Adam Smith was complicating things more than what was needed, and he was completely wrong.
Menger in contrary to Adam Smith said that value is not something objective, it was subjective and depends on what are the individual circumstances of the economical agent whose point of view we are studying.
But before getting into that topic, let’s explain first what Menger wrote in his book.
Menger in first place, started thinking about utility, in order to discuss the classic economic theory from Adam Smith. Menger thought that everything was subject to the law of cause and effect, and said that the things that are in a causal relation with the satisfaction of needs, where the things that were useful. This was his definition of utility. So, with that definition he came to the conclusion of what was the object of study for the economists, “the goods”.
Menger said that the goods were the things that had that causal relation with needs satisfaction and the things that the humans could employ to satisfy those needs, coming to the conclusion that there should be 4 conditions for something to be a good:
There should be a need.
There should be a causal relation between the need and the thing.
Men should know that this relation exists.
Men can employ this thing to satisfy their needs.
As an investor, you could see that basically it is the same to build a successful company. It needs to satisfy its clients needs, and clients should be able to know and employ that your offering will solve their needs. But before getting into that, let me continue explaining Menger thoughts.
When Menger started to analyze this subject, he first started to analyze its different variables.
The first subject around goods that he analyzed was about “when does this causal relation exists?” Then he saw that there was 2 kind of goods, (i) first order goods, and (ii) higher order goods. First order goods are the ones that satisfy this relation instantly (or directly), for example, bread will satisfy my hunger. Higher order goods are the ones that satisfy the need indirectly, or how he says “in a mediate manner”, for example, following the example from before, the bread flour would be a superior order. The goods would be named by how many steps are those far from the satisfaction of the need, that is why first order goods are the ones that immediately satisfy needs (the bread flour would be second order good, and the machine that you use to make bread flour would be third order goods).
Then, after classifying the goods by its order, he will find that there are two laws that every good will follow:
The quality of goods of a higher order as good is conditioned by the fact that we must also have their corresponding complementary goods. For example, the bread flour is conditioned by the other goods that we need to use to make it actual bread.
The quality of goods of a higher order is conditioned by the quality of the corresponding goods of the lower order. For example, the bread flour would not exist if the actual bread doesn’t.
Then, he asked himself how does time impact goods. At first, he concluded that higher order goods need of time to satisfy needs, if not, those would be first order goods. Secondly, higher order goods quality as goods are not conditioned by present needs, those are conditioned by future needs according to the time-space needed to end the production process of the first order need and determined by the human expectations from the moment that the production process is started (does it sounds familiar?). And third, the degree of uncertainty depends on the knowledge that men have of the elements needed for this production process.
Menger came to the conclusion that economic growth existed as higher order goods were conquered. The difference between a rich and a poor country was due to the amount of higher order goods developed, the more higher order goods you have, the richer the country is. The reason why is that is because higher order goods are just a more efficient way of producing inferior order goods (that’s why we use lithography to increase logic chips productivity, or a tractor to make the crop).
After realizing that higher order goods are the key to achieve economic growth, Menger also realized that in order to achieve that economic growth, this economic growth will also depend on the forecasting ability that men have. Men accuracy on forecasting (i) when will their needs appear, and (ii) how many goods do they have in the present, to build a consistent plan to achieve the final production correctly, and before the needs appear.
But Menger realized that depending on the needs and the quantity of goods available we could face 3 possibilities:
The need > quantity of goods available.
The need < quantity of goods available.
The need = quantity of goods available.
Those 3 possibilities will determine 2 different outcomes, (i) when there is enough amount of goods to satisfy all the need, and (ii) when there is not sufficient quantity of goods. So Menger differentiate between (i) economic goods (when the quantity available does not satisfy the need), and (ii) non-economic goods (when the quantity available satisfy the need). Menger discover that it is why private property is needed, so we could exchange goods that satisfy needs that we already have satisfied with goods that we need. So, the market will act as the invisible hand that Adam Smith wrote about, driven by the demand of the different needs that men have.
With that, Menger noticed that in reality, the economy is the human activity aimed at achieving the aforementioned goals, and the goods that are in the quantitative relationship described above (need > available quantity), and that constitute its exclusive object, are called economic goods. So, wealth is, therefore, a measure of the degree of plenitude with which a person who develops his economic activity on an equal footing with others can satisfy his needs.
So with all that reasoning, we can conclude that value is something subjective, if economic agents become aware that the possibility of satisfying a need depends more or less fully on the availability of a partial quantity of the goods in question or, respectively, on the specific quantitative relationship in which these goods are found, then such goods acquire for these men the meaning that we call value. And therefore, the value of goods is based on the relationship of the goods to our individual needs, not on the goods themselves. That is, the value of goods changes according to the individual circumstances of each person. Therefore, value is not something inherent to goods, it is not an intrinsic quality of them. It is a judgment that economic agents make about the significance that the goods they have available have for the preservation of their life and well-being. Value is subjective, and depends on each person.
Then, Menger theorized around how exchanges are materialized to propose a formal theory around prices formation. He said, that in order to materialize an exchange, every agent that is participating in that exchange should get a benefit, if not, why are they doing the exchange? So, he noticed that free market was something that benefits the economic agents, and it is driven by its needs.
Then, to summarize all his theory and not making that article very long, he studied how prices were created. What he said was that prices are the result of a exchange where the bidder has a subjective valuation lower than the buyer.
While I am writing that article in the train to Madrid in my mobile phone, I am just appreciating how great is this author. Don’t you?
The most useful thing that you as an investor could get from this author is that the market price of a public company is the result from the lowest bid with the highest ask that are driven by personal and individual circumstances of each agent. So your job as an investor is to analyze and detect if those agents have a low valuation based on its subjective expectations and individual knowledge that they have vs yours. This is also what most intelligent investors say, buy the fear and sell the greed.
The second thing that you could appreciate is that the business that will get the best compound rate in the world are the ones that are led by people who have the ability to predict with accuracy what goods are going to be the ones that have the biggest quantitative relation between their need and the quantity available, and are the ones in the best competitive position to develop higher order goods for this need.
The third learning that I got from Menger was that the “Efficient Market Hypothesis” is bullshit! The market do not valuate assets in an efficient way! There is not an objective valuation, so we cannot talk about efficient valuation. There are infinite subjective valuations depending on the circumstances of every individual agent that is participating in the market. So, our job is to find out which needs is the market underestimating and which ones are overvalued from our point of view.
After learning all this economic theory, as a financial professional, I have noticed that the needs in financial markets are determined by the subjective expectations of the free cash flows that an agent expects to receive from the asset that they own. So, what we should look for as investors, is to find the biggest gaps between our subjective valuation and bidders valuations.