Power of Constraints
If we look at the origin of species, most of them emerge due to various constraints by nature. The evolution of Homo Sapiens is filled with constant struggles - the struggles to eat and not being eaten, the combat to bad weather, and the endeavor to explore new lands.
Despite those limits, humans have been expanding the boundary of constraints for thousand of years - each time, the species got stronger and wiser. So in many ways, those constraints are good, with long term benefits - they are a source of learning, and ultimately a source of power.
I’m thinking about this topic this morning as we are approaching the end of 2020, a year when -
a) the US Treasury has printed close $4 trillion “new money” (while the US still carries $25 trillion national debts); [1]
b) the Fed interest rate is kept at near 0% and seemingly will remain so in the foreseeable future;
c) The stock market has been rallying for the most part of the year with a surprising amount of new IPOs and even more billion-dollar SPACs up and coming. [2]
What all this means is that we are in the midst of a “capital frenzy” - the 0% yield capital will be searching for and rushing to quick returns. Surely, great companies will continue to thrive under this environment, amassing more resources.
But will it sustain? Are there enough great companies to make better use of this capital?
We all know what happens when both investors and management start “solving problems” with just money. Just look at the dotcom bust and then the subprime financial crisis. In that, investors forgo the discipline of a proper asset valuation and the management buries their heads in an increasing burn rate while ignoring the first principle of value creation.
Some will make quick money but all will suffer.
What I do worry, is that, when capital is cheap, we lose the power of constraints. And ultimately the quality of investments and returns tend to deteriorate. [3]
[1] To be clear, I’m not arguing that the measure should not be done. It’s a necessary response to save small businesses and the economy. For the post’s purpose, we are only considering the aftereffects of those measures.
[2] As an investor, one should be very happy about the b) and c) - because it means cheaper capital and more exit options for investments. We will also talk about SPAC in a separate post.
[3] Great companies are built on the power of constraints. Apple, with a $2 trillion market cap today, received its first venture investment of $500K (in exchange for 15% equity). Adjusted by inflation, that would be around $2M today.