More on value

Cash-flow investing is a bet on something much more solid, but it takes work to do it right and some real knowledge of a person, a real estate market, or an industry. Because it forces the exchange of useful knowledge about how complicated things work, it builds social capital and in the end it’s much more secure. Asset based investing is ignorant of lots of important stuff and deeply asocial (the data you need is a bunch of numbers going across a Bloomberg screen) and turns out to be flaky.

What makes an IOU worth anything? As Peter R. Fisher points out in a very interesting op-ed in the WaPo this morning, the likelihood that it will be redeemed can have two very different sources, which he describes as asset-based and cash-flow-based underwriting. Asset-based security is based on something the borrower promises to give you if he can’t or doesn’t pay what he promised. This could be a house, or a bunch of common stock, or a box of tulip bulbs. To make the loan, the lender has to believe the price others will pay for the asset will increase or at least stand still, but doesn’t have to make any judgment about the borrower (except that he won’t split for Brazil with the asset in his suitcase). So you’re putting money out on assumptions about the behavior of zillions of people you haven’t met and know nothing about, with no attention to the character of the borrower himself. This seems odd: the “behavior of zillions of people” is not, in the end, like the “behavior of zillions of gas molecules” on which we bet our lives every time we fly. Stupid gas molecules, good; stupid investors, bad.

Cash-flow security is based on the lender’s expectation that the borrower will create enough new value (that others will pay for; no escape from risk, just managing it) to pay off the loan. A business loan to an entrepreneur, or an investment in his new project, is cash-flow based: the borrower has to tell the lender a story, with sufficient evidence, about how he will succeed in the enterprise. There’s no existing asset to seize – a couple of laptops and some second-hand furniture? – so the loan is a judgment about capacity. Buying stock in a big company, or lending to it, is actually similar: stock prices reflect an expectation of future capacity to create value, not an evaluation of liquidation asset value unless things are already in the toilet.

Fisher says finance has evolved from mainly cash-flow to mainly asset based, and why this matters. Current asset value lending is a bet on a market making a judgment as ill-informed about the flow of value to be expected as yours: that McMansion a two-hour commute from the city may have just sold in a frenzy for $2m, but can it really provide housing services each year whose net present value is $2m? And shouldn’t the buyer’s job prospects have something to do with your risk? Art prices display this nuttiness: a ten million dollar painting has to be worth thousands of dollars an hour to look at (how many people can crowd around a painting and get anything out of it? How many actually ever do, for anything but the Mona Lisa?) eight hours a day forever, or the price is nothing but a bigger fool bet.

Cash-flow investing is a bet on something much more solid, but it takes work to do it right and some real knowledge of a person, a real estate market, or an industry. Because it forces the exchange of useful knowledge about how complicated things work, it builds social capital and in the end it’s much more secure. Asset based investing is ignorant of lots of important stuff and deeply asocial (the data you need is a bunch of numbers going across a Bloomberg screen) and turns out to be flaky.

Author: Michael O'Hare

Professor of Public Policy at the Goldman School of Public Policy, University of California, Berkeley, Michael O'Hare was raised in New York City and trained at Harvard as an architect and structural engineer. Diverted from an honest career designing buildings by the offer of a job in which he could think about anything he wanted to and spend his time with very smart and curious young people, he fell among economists and such like, and continues to benefit from their generosity with on-the-job social science training. He has followed the process and principles of design into "nonphysical environments" such as production processes in organizations, regulation, and information management and published a variety of research in environmental policy, government policy towards the arts, and management, with special interests in energy, facility siting, information and perceptions in public choice and work environments, and policy design. His current research is focused on transportation biofuels and their effects on global land use, food security, and international trade; regulatory policy in the face of scientific uncertainty; and, after a three-decade hiatus, on NIMBY conflicts afflicting high speed rail right-of-way and nuclear waste disposal sites. He is also a regular writer on pedagogy, especially teaching in professional education, and co-edited the "Curriculum and Case Notes" section of the Journal of Policy Analysis and Management. Between faculty appointments at the MIT Department of Urban Studies and Planning and the John F. Kennedy School of Government at Harvard, he was director of policy analysis at the Massachusetts Executive Office of Environmental Affairs. He has had visiting appointments at Università Bocconi in Milan and the National University of Singapore and teaches regularly in the Goldman School's executive (mid-career) programs. At GSPP, O'Hare has taught a studio course in Program and Policy Design, Arts and Cultural Policy, Public Management, the pedagogy course for graduate student instructors, Quantitative Methods, Environmental Policy, and the introduction to public policy for its undergraduate minor, which he supervises. Generally, he considers himself the school's resident expert in any subject in which there is no such thing as real expertise (a recent project concerned the governance and design of California county fairs), but is secure in the distinction of being the only faculty member with a metal lathe in his basement and a 4×5 Ebony view camera. At the moment, he would rather be making something with his hands than writing this blurb.