Saturday, February 27, 2010

One Possible Future - Ari Paul

I’ve discussed the challenges facing the US, EU, and China many times. Today I’ll discuss some possible outcomes to their problems and how we can position for (or at least hedge against) these possible futures. When discussing anything beyond the immediate future, we always need to maintain a great deal of humility. So, view these less as predictions than as possibilities.

As I read experts debating the future of the European Union, they seem to talk past one another. The EU bulls basically argue that the EU is politically committed to maintaining unity and will do whatever it takes to avoid dissolution. There are some extreme bears who argue that a break up is inevitable, but most simply argue that the EU is unsustainable given its current labor dynamics. An outcome that would thread the needle between many of the smartest bulls and bears is for the Euro is devalue significantly but remain intact. The heart of the problem of the PIIGS (Portugal, Italy, Ireland, Greece, Spain) is that their labor is uncompetitive both compared to other EU members and the world. If the Euro fell by 25% vs all other currencies, this would cure half the problem. The PIIGS would then be competitive relative to the rest of the world, although intra-EU disparities would remain. The result would be that Germany would become super-competitive and likely start accumulating large reserves. That would eventually cause problems, but they would be less pressing and less severe.

What about China? China’s artificially cheap currency has caused a trade imbalance with the US, but it has kept inflation in check despite massive credit growth. If China revalues its currency upward, that could eliminate the trade gap by increasing Chinese consumption, but that same consumption could cause severe inflation. The inflation would probably be most severe for domestic Chinese assets like real estate and equities that are only listed domestically. Alternatively China could have a deflationary collapse, but the threat of severe inflation makes me disinclined to short anything Chinese, even real estate assets that are already at bubble values.

Now for the US. Bernanke’s latest play has been to secretively shift money printing powers to Fannie Mae and Freddie Mac. The Federal Reserve will wind down its mortgage purchases in March, but Fannie and Freddie have been granted an infinite cash line and have stated they may increase their mortgage purchases. These mortgage purchases are very similar to money printing because they raise real estate prices (or prevent further collapse), and keep interest rates artificially low in all sectors of the economy. They are also a giant subsidy to banks because they provide generous risk free profits; the banks are continuing to make home loans to uncreditworthy borrowers, but they then sell the loan to Fannie for a profit. Fannie recognizes a loss on the loan, but gets a capital injection from the treasury or a free loan from the fed. What this means is that even if we experience a double dip recession, the constant money printing may continue to inflate asset values (or at least soften the collapse). Because of the risk of severe inflation mitigating an equity collapse, I like hedging my large short equity position with a small long agricultural commodity position. Why agricultural commodities instead of gold or oil? I believe the secular fundamentals of agriculture are very strong, and unlike gold, these commodities are less obviously pricing in significant inflation. In other words, I’m getting a less direct inflation hedge but at a much better price.

Wednesday, February 17, 2010

How to Read Financial Statements – An Overview (Part 1) - Alpha

In this issue:
1) Principles of Reading Financial Statements
2) Types of Financial Statements and Where to Get Them
3) Financial Statements are Marketing Documents
4) Haggis is Much Worse than Spinach (Reading Recommendations)

My advice to small-time savers: “Avoid stocks.” I tell them to buy CDs or diversified bond funds from Vanguard or Pimco, such as: BND, BIV, BVV, VBMFX, VIPSX, or PTTAX. For many, buying a stock index fund is a poor idea. You need a sense of whether the stock market is over- or under-valued before you buy – the price you pay matters. Over the very long run (30 years or longer), a stock index like the S&P 500 (SPY for the fund) will likely outperform a bond fund, but there is no guarantee for this. Also most investors are mortals with shorter investment horizons and nerves of jelly, who can’t psychologically take large losses. So I suggest bond funds instead of stock funds. For the few who want to get their hands dirty and directly own stocks, bonds, or ETFs, it’s essential to: i) have a decent business sense, ii) learn how to read financial statements and value securities. Since the conversation in Risk Over Reward is about thinking about investing, I will share some of our thoughts on “How to Read Financial Statements” over a series. This series will be a starting point for curious people to teach themselves how to read financial statements.

The first letter in the series begins with principles and high-level exposure. The remaining ones will go into the dirty details of the statements themselves.

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1) Principles of Reading Financial Statements
Before jumping into the types of statements and what they mean, I offer some basic principles below.

A bird in the hand is worth two in the bush. Investors read corporate financial statements to buy securities and make money. They invest $1 today to get $2 tomorrow. More specifically, the investor Ben Graham believed stocks should return twice (2x) what investment grade bonds did to be worth the extra risk. That basic tenet is ignored in today’s “Cult of the Equities,” but it will return. To evaluate any security (bond or stock), Warren Buffett stated his formula in his Berkshire Hathaway annual letter in 2000:

Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was "a bird in the hand is worth two in the bush." To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.

Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component usually a plus, sometimes a minus, in the value equation.

Alas, though Aesop’s proposition and the third variable that is, interest rates are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.

Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let’s call this phenomenon the IBT Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights.

At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.

Now, speculation in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it, is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities, that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

Principal-agent problems stink. When you (the principal) hire someone else to work for you (the agent), the agent’s self interest may differ from yours - her actions may help her and hurt you instead of benefitting you. It’s a conflict of interest. The classic example is corporate management (RJR Nabisco is just one case). Executives often spend money on perks, like corporate jets and celebrity sponsorships, instead of paying dividends to shareholders or buying back stock. This is still a huge problem. You can buy undervalued stock in a profitable, healthy business and never make money. If investors lack control, managers eat their cake. That’s why bond investors get covenants and why shrewd stock investors get board seats – to protect themselves with control. There’s only one way to know how faithful or greedy managers are: read the financial statements. The problem is that the managers are the ones making the statements, and they pay the accounting firms to “audit” them. Perhaps the principle here is: “Trust, but verify.” You will have to watch for common accounting shenanigans.

Bounded rationality forces humility. Human beings aren’t rational much of the time. The limits of cognition, time, and energy can rob one of understanding or lead one to make poor decisions. This means some financial statements are too difficult to understand, like General Electric (GE). Others are black boxes and impossible to understand, like Citigroup (C). I generally put these in the “too difficult” pile, after spending a frustrating few hours trying to understand them. Even for simpler, “bread and butter” companies like Chipotle (CMG), items like capital expenditures can be difficult to project. Finally, as Warren Buffett points out above, many businesses are too unstable; you just can’t understand them, let alone value them. Bounded rationality forces you to stick to your circle of competence (the small circle in which you know much more about something than most people know).

A representation of reality isn’t reality. Financial statements are a representation of reality, of a company’s economic and financial health. But don’t get confused. The numbers aren’t reality. Just as pictures of the Great Pyramids can be crudely or subtly doctored in the lab, so can financial statements. Too often, people assume “facts” like numbers and numerical tables in financial statements are true. Sometimes the numbers are wrong due to fraud and mistakes. Other times, they are true in a narrow context but misleading in a broader one. Also, a snapshot at a point in time can be misleading. Many large broker-dealer banks, for example, do massive financial transactions before a quarter’s end to make their balance sheets look cleaner and healthier on the last day of the quarter (the reporting day). They undo this a few days into the new quarter and go on with their sordid, risky business. So: be skeptical.

You can’t buy breakfast with earnings. Cash flows matter more than earnings. Under the accounting rules of GAAP and IFRS, “accrual earnings” are supposed to present the economic substance of a company’s performance. Accrual earnings are useful to know but are overemphasized by Wall Street and dumber investors. Companies can manipulate earnings easily, but it’s tougher to manipulate cash flows (Enron made a valiant effort). Shrewd hedge fund investors and savvy managers care about one thing: free cash flows, that is, cash flows that can be taken out of the company to pay investors. Or as Coke’s former CEO Roberto Goizueta had stitched on a pillow: “The one with the biggest cash flow wins.”

Numbers without context are meaningless.
All the numbers in financial statements are measured in reference to something else. By themselves, numbers mean little to nothing. So a newspaper could blare that Coke earned $2 per share this quarter and Pepsi earned $2.50. Does that mean that Pepsi is “better?” Not at all. Perhaps Coke’s stock is trading at $20 but Pepsi’s stock is trading at $50, so Coke is giving a 10% earnings yield and Pepsi is giving a 5% earnings yield. Maybe Pepsi is taking on much more debt and risk to get its higher earnings, and the company could implode and wipe out all the shareholder value. Or maybe Pepsi stuffed its channels to increase current sales and profits at the expense of future ones. Or maybe all else is equal but Coke has much higher earnings growth rates and will overtake Pepsi soon. The point is that a single number means little. The significance of the number comes from the multiple possible contexts in which you examine it.

Treasuries are your measuring stick. All financial assets are measured in reference to the yield being offered by 10-year US Treasuries, what investors call the risk-free rate. Without a measuring stick, it’s impossible to know whether the earnings and cash flows a company generates, relative to assets, book value, or market value, are high or low. Some investors prefer to use 10-year German Bunds (Bundesanleihen are the government bonds of the Federal Republic of Germany). All investors compare the yields (earnings, cash flow, dividends) from corporate financial statements to those from government bonds. Bond investors do this explicitly with spread and OAS calculations. Stock investors do this with P/E capitalization rates and the discount rates in cash flow models. The latest US Treasury and German Bund rates are here:

Bond Yields and Rates from Bloomberg

2) Types of Financial Statements and Where to Get Them
The rules that govern how companies prepare and present their financial statements come from either:
i) Generally Accepted Accounting Principles (GAAP), set by an American organization, FASB, in Connecticut; or,
ii) International Financial Reporting Standards (IFRS), set by an international organization, IASB, in London. Learn more about the IFRS here.

For decades, all American companies had to follow GAAP due to SEC rules. In the last decade, many international companies have been switching to IFRS and the SEC has slowly encouraged American companies to switch to IFRS. The two standards are fairly close and will converge into one, the IFRS, by 2015.

In today’s internet driven world, you can access financial statements in two ways:

i) Directly from a corporation’s Investor Relations website: For Coke’s latest annual report, use Google with the search term “Coke Investor Relations.” It will take you here (and the tab on the left will take you to their reports):

ii) Indirectly from the SEC’s EDGAR database:
The SEC requires all companies to file a range of financial statements in its online, EDGAR database. EDGAR is a gold mine of “neutral” financial statements (just black and white “facts” – no marketing pictures, spin, and such). Any serious investor has to become familiar with it. You can find EDGAR here (you should bookmark it – it’s the place on the web I visit most often):

Searching by the company’s name or ticker symbol (KO for Coke), takes you to a place where you can directly access the filing, or filter the results by a filing type:

The SEC has numerous types of filings, which I rank by tiers based on their importance.

Tier-1: Annual and quarterly statements, prospectuses

10-K – Annual reports. The best general description of a business and its performance; verified by an independent, outside auditor.
10-Q – Quarterly reports. Not as long and descriptive as the annual and un-audited, but offered quarterly.
S-1 and/or 424 – Registration forms and prospectuses for new securities. Every time a company offers new securities it has to release one of these, and they are a treasure trove of information.

Tier-2: Other statements

DEF14A – The proxy statement - it has information on executive compensation and perks, along with other control and ownership information.
8-K – Events or changes between quarterly reports – contains material information about events between quarters. Often bond indentures and their covenants are hidden away in these reports.
144 – Proposed sale of securities. This lets you know what other securities a company is selling every quarter to the primary market.
4 – Insider trading. This contains information on insider sales and purchases.
20-F – Annual report for a foreign company. If a foreign company’s stock trades in the US as an ADR, it must file with the SEC.
6-F – Quarterly report for a foreign company.

This list isn’t exhaustive. I regularly use about 5 to 7 other reports not mentioned above, but I’d rather not discuss them as they’re less well known and I like the lack of competition. These tend to be niche reports only of concern to investment professionals, so don’t worry about them. For a full listing of all SEC reports and examples of them, see this list: SEC Filings Types

3) Financial Statements are Marketing Documents

One thing about Bloomberg and all the secondary information databases: they lull investors into thinking that what’s on the screen is correct, true, and “real.” This is where I refer people back to the principle that “A representation of reality isn’t reality.” More specifically:

carefully presented, often audited, over-lawyered,
created by a company’s management
(stocks, bonds, loans, etc., but please don’t read the fine print or footnotes).

Anytime someone is a selling you a bill of goods, my admonition is: Caveat emptor (buyer beware).

I have found that paranoid and skeptical people who verify, verify, and verify tend to be the best investors. So an attitude of skepticism is called for, as management will often know more than you do about their company and its industry. It’s a situation of information asymmetry. They know more. You’re a sucker with money. A sucker with money often ends up just a sucker.

Besides an overlay of skepticism (even for EDGAR documents), you need to remember that there are multiple users of financial statements, including:

• Lenders and bond buyers (Creditors): They don’t care about earnings per share, book values, or P/E ratios. They want to get their money back with interest; they use covenants to manipulate management. After a careful balance sheet analysis, creditors look at coverage and try to measure the risk of default and loss-given default (LGD).
• Shareholders: They care about the traditional analysis ratios and metrics. In the last few decades, shareholder primacy and the “Cult of the Equities” have led financial statements to be targeted toward shareholders (witness income statements, with EPS on the bottom, but not coverage ratios). While dividends and other payouts became démodé in the nineties and aughties (buybacks were the exception), payouts to shareholders will come back into fashion.
• Recruiters and consultants: They want consulting gigs to assess companies and industries, hire away the best managers, and generally milk the cash cow that a large corporation is.
• Managers: They are always selling others on something. They want raises from shareholders via the compensation committee (and they use consultants to justify outrageous pay). They want cheap capital from the bond markets. They want competitors and regulators to leave them alone. They want workers to be more productive and accept less salary and fewer benefits. Managers are the ones who make the marketing documents we call financial statements.
• Competitors: They want a scoop on profitable lines of business and profit margins so they can perhaps come in to compete. Managers want to conceal sensitive information, but generally err on the side of concealing information helpful to investors.
• Government Regulators: They want to make sure a company is “safe”: safe products for consumer goods, a safe balance sheet for banks and insurance companies, or safe regulatory compliance, such paying the right amount of taxes (IRS agents start with financial statements).

So financial statements tend to be long and disjointed. They are sophisticated, technical, marketing documents for multiple audiences. You shouldn’t read them like a novel, from beginning to end. Instead, focus on the sections important to you. The next letter in the series goes into details.

4) Haggis is Much Worse than Spinach (Reading Recommendations)

Now to the reading list. Warren Buffett called accounting the “spinach” for investors. No one really likes accounting, but eating it makes you better at understanding businesses and allocating capital. His analogy fails for me because I like spinach – it cooks rather well in many dishes. I would say that learning how to be a better reader of financial statements is more like eating haggis, which is Scottish oatmeal mixed with sheep's 'pluck' (heart, liver and lungs), minced with onion, suet, spices, and salt.

The following books aren’t easy, but they’re where you should turn after this series for a much fuller, self-education:

First Course - Philosophy
1) Benjamin Graham, Security Analysis (Sixth Edition – Commentary from Seth Klarman, James Grant, and Bruce Greenwald) (I recommend reading all the editions, First to Fourth, to learn how to think).
2) Leopold Bernstein, Analysis of Financial Statements
3) Warren Buffett (ed. Lawrence Cunningham), The Essays of Warren Buffett

Second Course – Technical Skills
4) Martin Fridson and Fernando Alvarez, Financial Statement Analysis
5) Charles Mulford and Eugene Comiskey, Creative Cash Flow Reporting
6) Raymond Suutari, Business Strategy and Security Analysis

Third Course – Detecting Manipulation and Fraud

7) Howard Schilit, Financial Shenanigans (2nd Edition)
8) Kathryn Staley, The Art of Short Selling
9) Joseph Wells, Fraud Casebook: Lessons from the Bad Side of Business

Fourth Course – Putting Everything Together
10) The Certified Financial Analyst (CFA) Course of Study: It’s a great starting point for accounting, statistics, and valuation. I’ve taken the course and exams and I highly recommend them.

For more recommendations, see this list: Investment Classics.

The skill of reading financial statements to understand businesses is a self-taught skill. Others can prod you in a certain direction. But it takes time, practice, skeptical thinking, perseverance, and even more practice (the ten thousandth financial statement you read will be the first you understand). Ultimately it’s up to you.

Your experienced and ignorant investor,
Copyright 2010 Risk Over Reward. All Rights Reserved

You have permission to publish this article electronically or in print as long as the following is included:

Risk over Reward: A conversation about intelligent investing – we discuss the nature of risk and uncertainty, macroeconomics, security valuation, and how to think about markets and invest profitably -

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Is the Venture Capital Model Dead? Yes - Alpha

Venture capital has always been an investment field for dreamers and suckers. VCs and entrepreneurs get caught up in building flashy products and transforming industries. But they often forget one thing: profitability. Solid companies like Zappos, Facebook, and Starent are the exceptions in 2009 that grabbed attention. Then the truth sets in. It has been 12 years since the venture industry has returned more cash than it has plowed into investments, according to the National Venture Capital Association (NVCA). Yet bovine limited partners keep putting money into venture capital. The industry is now managing ~$250bn, up from $64bn in 1997.

Yes, the last ten years for the VC industry has been dismal, with one dollar taken in 2001 returning 38 cents and having 62 cents in leftover “residual” value (RVPI, marked by accountants paid by the VCs), for a grand sum of one dollar in early 2010. Can I be a VC and take your money on those terms? I’ll be glad to take $100mn in 2001 and give you $38mn today, with a promise to give you $62mn later!

NVCA Industry Data Shows Horrible Performance

The venture capital business model is simple. An early stage VC may have a portfolio of 10-15 companies, expecting 1-2 to generate massive returns, 2-6 to break even (barely getting their money out), and the remaining 7-12 to go bust. Late stage VCs should have more successes, but at lower expected returns. Below is a table showing promised returns and expected time frames.

The Truth Above is Much Worse Than the Promises Here

VCs like to talk about the big attention-getting deals, the 10-baggers and such. Yet they take advantage of your “anchor bias” as an investor (a limited partner in their funds), by focusing on the one star in a single previous fund, the salient star, while hiding the fact that the annualized return of the total fund is dismal (remember, you get the fund’s returns, not the star’s returns). VCs then talk vaguely about world-transforming trends, like the internet, cloud services, RNA interference technology and such. Finally comes the big leap: the assumption that world-changing technology will result in healthy, risk-adjusted returns for passive limited partners in the VC funds. Ain’t gonna happen. For a specific example, see how Tim Draper’s DFJ used Baidu and Skype in its marketing materials but delivered dismal returns to investors.

For those who want a primer on limited partner economics, here are more details about the numbers behind a venture capital fund’s returns: Primer on VC Business Model.

And there are plenty of industry stats here: NVCA Industry Statistics.

Again, look beyond the headline grabbing individual companies and look to fund’s total returns, or to the industry’s total returns. It’s a dismal place to be, as the figures below (from a prominent East Coast venture capital firm) show.

Two comments on the slides:

i) The 1980-89 returns were horrible compared to the much safer S&P 500. 2000-09 returns were worse than the dismal returns of the S&P500. Really, the brief period of positive returns in the 1990s came from what we all agree was a tech bubble. A few solid companies were born (Google, Yahoo, eBay), but more money was plunged into wasted projects.

ii) If the VCs are counting on an IPO window to redeem them, they’re screwed. Most IPOs today are coming from Asia and China, which are a small portion of VC dollars (they also tend to be larger, industrial concerns). The handful or North American tech IPOs, like OpenTable and Rosetta Stone, were solid companies run by growth fund operators and not traditional VCs.

I do believe there are a few “venture magicians” that can generate high returns for the risk taken: Mike Moritz, Ram Shriram, and Danny Rimer, to name a few (Vinod Khosla and John Doerr are TBD for the aughties, as their best returns were in the 1990s). Yet I’m doubtful about many VCs, even those that make magazine lists like the Forbes Midas List, when you take all their investments into account and calculate an annualized return.

Over the next few years, you will see a few big VC successes, like Facebook, Yelp, and possibly a123 Systems (still waiting on profitability). While the individual companies are seductive (and maybe the single fund that invested in them at the right valuation), the VC industry is a dead one. It’s where capital goes to die. While the industry dies, many current VCs realize this, and I’ve started to see partner-level resumes from big name venture capital firms hit the mailboxes of tech companies and other investment firms around Silicon Valley. (I won’t point fingers, but it’s embarrassing).

Investors (potential limited partners) in venture capital funds should heed Warren Buffett’s advice:
“If a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”
For a particularly funny story, post-Webvan, see how investors turned $193 million into $7 million.

Translation: Ditch the VC commitments and invest your money in real companies, building things to make profits (not counting on an IPO cash-out window or an M&A exit).

One big test of the VC industry will be the latest $2.5bn NEA fund, which raised one out of six dollars for the industry in 2009, compared to a bond market benchmark (comparing VCs to a negative stock market isn’t much of a hurdle).

Reference Note:
To understand the VC industry better, I recommend three books:
eBoys (on Benchmark Capital and the salient superstar investment)

Creative Capital (on the VC industry founder Georges Doriot and the long view on the industry)

Startup (on a failed startup and what the majority of VC-backed companies look like)

Monday, February 8, 2010

Economic Fundamentals: Money - Ari Paul

In this issue:
1. Wealth is Not Money, Money is Not Wealth
2. Gold and Other “Real” Money
3. Fiat (paper) Money
4. What is Money Really For?
5. Money Mismanagement

Economics is a strange science where even some of the most basic and critical tenets are still debated at the highest level. In this series of newsletters I'm going to build up a comprehensive understanding of economics. I'll try to present the most prominent theories and humbly offer my own synthesis. The stronger understanding we gain will be directly useful in navigating the world of investing.

1. Wealth is Not Money, Money is Not Wealth
We generally think of money as a way of measuring and storing wealth; this is accurate at the individual level but very wrong at the societal level. The world's wealth is determined by how much the world produces. The world consumes what it produces. If the world is producing 40 million cars a year, that's how many cars the people of the world can buy. If the amount of money that people have doubles, they still can't buy any more cars than are being produced. If half of everyone's money vanishes, we'll still be able to buy the same number of cars, the price of each car will simply drop.
Economists define wealth as “the ability to consume.” The world can consume exactly what it produces. Money is a way of measuring this production, but whether it’s measured in dollars, euros, or yuan, the number of cars produced is unchanged. Similarly, if we devalue the dollar, each car may cost more dollars, but the number of cars (and thus global wealth) is unchanged.

2. Gold and Other “Real” Money
The earliest human economies were based on barter; I’ll trade you a few gallons of cow’s milk for your chicken. Using precious metals as money was a drastic improvement - the metals are limited in supply thus making counterfeiting difficult, they are fungible (meaning the coins were interchangeable with one another), and they were far easier to carry around than chickens. Money greased the wheels of business.
Precious metals are of limited supply and therefore have properties of a commodity. For example, at any given time there is only so much gold around. When gold is used as currency, it is both “money” and a commodity that has its own supply and demand characteristics independent of its use as money. As people become wealthier they may desire more gold jewelry and increase their stores of gold. If the supply of gold cannot rise quickly, this may cause the price of other goods to drop in relation to gold. For example, yesterday it cost me 1 ounce of gold to buy a goat, but now that the farmer wants to hold more gold as jewelry he may only charge me only half an ounce of gold since he desires the gold more than before. The goat has not become any less valuable, but it costs less in terms of gold.
Under the economic system of “mercantilism” countries believed that accumulating gold made them wealthy. They exported usable goods like silk and spice to other countries and stockpiled their new gold. One advantage that comes from exporting is the development of domestic infrastructure, so this did produce some benefits, but ultimately money is only useful if you buy something with it. Imagine that Portugal keeps exporting clothes to Brazil in exchange for gold. Eventually Brazil runs out of gold. Now what? Portugal's clothing industry is devastated because they don't have anyone to sell to, and the gold is nearly worthless because no one has anything to export to Portugal in exchange for the gold. This is almost exactly what's happening right now with China and the USA. For a decade China sent us toys and furniture and we sent them US dollars. China is sitting on $4 trillion US dollars and they have few options. China can't spend that money because we don't produce enough goods to send them $4 trillion worth of product. The most likely outcome is that China will keep sending us products for dollars but the dollar will devalue vs the Yuan, so effectively we'll be paying China less and less for the same goods over time, and the dollars we've already given them will be worth less.

3. Fiat (paper) Money
Today “money” is defined by the government. Like it or not, you must pay your taxes in US dollars. Most of the “money” that exists today is not physical currency, but numbers in banks' computers. It is impossible for the government to run out of money since most money is simply a number in a computer system controlled by the Federal Reserve. All banks and even the US Treasury have accounts with the Federal Reserve. When the Federal Reserve wants to increase the money supply, they simply increase the number in the account of the Treasury or a bank. Usually the Federal Reserve will require that a bank give the Reserve treasury notes in exchange for the new money, but not always.
It's critical to note that the Federal Reserve does not need to receive anything in exchange for the newly printed money. There are two separate actions occurring. The first is that the Federal Reserve creates money out of thin air by electronically increasing the number in an account, and the second independent action is the Reserve collects securities. The purpose of collecting securities (which the Reserve sometimes chooses not to do) is to limit inflation and prevent moral hazard. Through these actions, the Federal Reserve directly controls the monetary base.
Money is also created by the fractional reserve banking system. When you deposit $100 in your checking account, your bank can loan out some percentage of that money, let's say 90%. Now the bank loans Jon $90. Then Jon deposits the $90, and the bank loans Frank $81. At this point, you still have your $100 (in your checking account), Jon has $90 in his checking account, and Frank has $81 in cash. Through this system, money has been created. The amount of money that gets created is dependent primarily on two things – the required reserves (the percentage of each deposit the bank cannot loan out), and the velocity of money (how quickly every dollar is spent and deposited). The way that the banking system creates money is not intuitive and most people need to read several examples before understanding it. Wikipedia has a good entry on the subject:
In the last 15 years, many new forms of “money” have been created that have no reserves. For example, savings accounts and money market accounts have 0% reserves. The bank can loan out the entire $100 of each $100 deposit. Theoretically, a hundred dollars could become a trillion dollars if it was deposited and loaned out fast enough over and over. Realistically, the pace of money creation is limited by the demand for loans from businesses and consumers, the supply of loans by banks, and the technical limitations on the time required to initiate a new loan.

4. What is Money Really For?
Money is a way of allocating capital efficiently and rewarding productive behavior. By “keeping score”, we effectively give greater control of the economy to people who produce things that society wants. For example, Ingvar Kamprad, the founder of Ikea, became very wealthy by selling home furnishings of higher quality and at a lower price than competitors. As Kamprad succeeded and his money grew, he was able to make ever larger investments and open new stores. In contrast, Kamprad’s inefficient competitors were likely to run out of money and be unable to sap society's resources. The most capable managers and investors gain greater influence and they are incentivized to be as good at their jobs as they possibly can be.

5. Money Mismanagement
When the money supply is mismanaged, there are side effects that inhibit wealth creation. For example, under severe inflation, banks are reluctant to make loans because the value of the money they lend out may decrease substantially by the time they get it back. Similarly, businesses are reluctant to borrow at the extremely high interest rates that are likely to prevail. As a result, there is less investment in future production.
When the government engages in unproductive spending, they are reducing the efficiency of the economy by wasting human and physical capital. For example, Ingvar Kamprad runs his stores more efficiently than any of his competitors, so he can then hire more people and continuously increase production. Kamprad’s efficiency means that he can sell more furniture than anyone else using the same number of workers and stores. If the government creates new money and builds new stores (or subsidizes other stores), the managers of those other companies will not make as good use of the country's resources. Instead of each worker selling 10 chairs a day, they may only sell 8. As a result, the total number of chairs produced in the world will decrease and we will be poorer for it.
Another example of a mismanaged money supply is when the money supply is not allowed to grow. For much of the 19th century, we effectively used precious metals as money. The supply of the metals grew slower than the production of goods. The result was deflation. Under deflation, consumers expect prices to continue dropping over time so they delay purchases. Businesses are reluctant to invest in new production because if the prices of their goods continue to drop, they may not earn a return on the investment. Deflation frequently causes a cycle of high unemployment and slow wealth creation.
Economists generally agree that to optimize wealth creation, we want a slow and stable growth in the money supply. This can be a challenge for the Federal Reserve, since as we discussed earlier, money is also created by banks. During recessions or the bursting of asset bubbles, bank lending may suddenly drop precipitously requiring strong Federal Reserve intervention to maintain a stable money supply. Finally, there can also be political pressure on the Federal Reserve to increase the money supply faster to create higher short-term growth and reduce unemployment.