think throw away think

Debt is evil.

Debt is good.

It all depends ….

I think about debt the following way and I feel like it helps me harness the goodness of debt while mitigating its evilness.

What is debt?

Debt is money borrowed from a party who does not have a better alternative use for it in the near or (often) long term.  It is money the lender has earmarked for later consumption (otherwise it would be spent now), and so to derive value from the forgone consumption, the person who has the money “sells it” to party who wants to “consume or use” cash now, but does not have it.  The “cost” of that money is to give it back in the future along with interest to compensate the lender for her forgone consumption and the risk she took that she might not get it back when she lent it.

So debt is what is created when a person who has money, but a later consumption preference, gives that money to someone who doesn’t have money, but has an immediate consumption preference.

But what happens to the borrower over time?  The borrower must earmarks future monies earned to pay back the debt (i.e. they will forgo future consumption in order to pay back funds to the person they borrowed from).

Are you following?  This is the key point.

DEBT PULLS CONSUMPTION FROM THE FUTURE INTO THE PRESENT.

As a borrower, whatever you consume today is consumption you’ll forgo in the future.

When a whole bunch of people borrow money at once, a whole bunch of future consumption is brought into the present.

One reason that group debt binges are so bad (when everyone pulls their consumption into the present by borrowing), is that in the future they’ll all have to forgo consumption together as they pay the debt back.  If everyone consumes at the same time (pulling future consumption into the NOW), one, they drive up prices of commodities and assets and labor today, and, two, in the future they will all NOT be consuming at the same time and drive down prices of commodities, assets and labor.  As labor demand drops in the future, and as the price of assets drop in the future, it makes it harder to pay back the debt from all the previous consumption, and leads to bankruptcy.

This is often called a boom/bust cycle.   And they are destructive to society.

We don’t want debt spikes.  We want smooth debt patterns that aren’t lumpy, where not too much consumption is pulled into the present.

Knowing that, I get VERY CAUTIOUS when there’s a lot of people borrowing money at the same time because I know that a lot of the business the binge is generating now will result in a bust later.  I don’t want to commit to business that is ephemeral.

On the flip side, if I don’t get into debt when everyone else is, but instead live within my means and save, then when the bust occurs and labor, assets, and commodities get cheap, I load up.

I’m not perfect and I make debt-related mistakes, but by keeping in mind what debt is and how it affects present and future consumption patterns we have kept our company out of trouble first during the tech boom/bust and later during the housing boom/bust because we were cautious when everyone else was reckless.  After the busts, we were aggressive in expansion when others were hunkering down.

I don’t want to see boom/bust cycles in our economy, but so long as there’s a central bank manipulating interest rates, I have to live with them and plan accordingly.  I hope you will choose to “run against the herd” so that instead of going over the cliff during debt-binge booms, you sleep well at night.

In fact, at our company when we discuss investing in expansion we have a “sleep at night” test.  If any expansion move would cause any of us to lose sleep at night, we just don’t do it.   That means we don’t do things just because everyone else does.

Manage the risks and the rewards take care of themselves.

I define Risk is “a potentiality which, if actualized, presents an adversarial outcome for the enterprise.”

Risk Management, for me, consists of “working in a systematic way to reduce the probability that those adverse potentialities occur.”

At Scrapbook.com we manage risk in a systematic way.  Risk management isn’t something that’s ever “done”.   We manage our risk cyclically in that we go through our risk management processes in order, and then once we’ve gone through them, we do them again, and again, and again, ad infinitum.  Over time, I came up with the areas of risk we manage, and then made an acronym out of them which captures the cyclicality of the risk management process:

CIRCLES.

C – Customer Experience

I – Inventory

R – Resources (Human)

C – Capital Structure

L – Liquidity and Legal (these really don’t have anything to do with each other, but I didn’t like the way CIRCLLES looked!)

E – Expenses

S – Sales

There are things our company does daily, weekly, monthly, and yearly, in each of these categories.  For example, here’s one specific thing (of dozens, or even hundreds) we do in each category.

Customer Experience – Perform website navigation audits.  We test the site for broken links, unclear or incorrect language, general functioning of apps, bug testing, etc. and fix any problems areas immediately to mitigate the chance that a potential customer will abandon our site because they do not “trust” it do to our carelessness or because they are frustrated because they cannot find what they’re looking for.

Inventory – Review supplier fulfillment metrics and take action when they’re out of whack.  We want our suppliers to keep us stocked at all times.  Our internal algorithms tell us when we need to order product in order to keep levels in stock.  These algorithms depend on fulfillment consistencies from suppliers.  We don’t care so much that they ship slow or fast (though we prefer fast) – our algorithms can adjust to that – but we do care that they are consistent because if they are not, our algorithms can’t tell us the right quantities to buy and when to buy them, and therefore we’ll end up either over or under stocked.  If we’re overstocked it is tying up capital we can use elsewhere.  If we are under-stocked, we lose sales.  So, in a very real sense, our suppliers can cost us money by tying up our resources inefficiently and losing us chances to serve a customer.  If we are seeing inconsistency with a supplier, we’ll either put them on notice to improve, or we’ll move business away from them and toward more consistent companies (even up to the point of discontinuing business with a supplier).

Resources (Human) – Review employee turnover.  Employees leave because they are either unhappy, or they have better opportunities elsewhere.  When employees leave, all their experience and knowledge walks out the door with them.  Training new employees and getting them up to speed is very costly for us.  When employee turnover ticks up, we seek out the cause and nip it in the bud.

Capital Structure – Review the capital stack and maximize the returns to equity without taking on undue debt.  Low-interest debt is “good” because by using it we can – among other things – extract equity from the company (through recapitalization), lower taxable earnings (b/c we can expense interest payments), and lever the return that the remaining equity sees (capture spreads between the cost of the debt and the return on the invested capital).   Debt is “bad” because repayment terms are not flexible and because it requires collateralizing productive assets, putting their ownership at risk if we fail to comply with the debt terms.  Too much debt can hamstring or burden an organization.  We constantly review our ratio of debt to equity against our current and projected needs, and adjust accordingly.

Liquidity – Monitor the ratio of sales to cash and as sales increase, increase cash on hand.  Increasing sales means that inventory needs will increase.  Inventory increases mean accounts payable increases.  Accounts payable increases means increasing cash on hand in order to keep the inventory turns from being interrupted.  So many retail businesses are tempted to extract cash when sales go up (“We’re making so much money!  Let’s pull out money out from the business and buy a yacht!”), yet that’s the worst thing they can do – they INCREASE risk.  Growth requires financing.  Many retail companies grow themselves right out of business.  By increasing liquidity and resisting the urge to extract cash while growth is occurring, businesses REDUCE risk.  This also means that you have to strike a careful balance between how much of your retained earnings you allocate to inventory and how much you retain to ensure you can keep your payables turning and keep your product in stock.  We have a ratio of sales to cash that is ideal for the smooth functioning of our business and we are disciplined about maintaining it.

Legal – Keep a list of legal obligations and comply with them; keep a list of counter-party obligations and require compliance .  When you sign any contract with any person or business, you are obligating yourself to some performance, and so are they.  In order to ensure that you do not put your business at risk by breaching an agreement, keep a list of all the contractual agreements you’ve made and comply with them.  Also, to ensure that you do not put your business at risk by contractual parties failing to comply with their side of the agreement, keep a list of what they’ve agreed to do.  If they do not comply, pursue legal remedies as appropriate.  Failure to do so may be much more costly than allowing their non-compliance to hurt your business.  (A quick anecdote about my failure to record others’ legal obligations.  I executed a contract some time ago, and in the contract there was some language that after three years time the counter-party was to pay us $8,000.  I neglected to note this.  Three and a half years later, I was reviewing the contract and noticed this clause that I had forgotten about and the counter-party had not complied with.  I wrote the counter-party and they immediately paid us [as they were in breach of the contract], yet my failure to note this in the first place meant our business went six months without $8,000 it should have had.  Had I not re-reviewed the contract … well, let’s not go there …  The point is, the counter-party exposed themselves to legal risk by not complying with the contract, but I exposed us to financial risk by not taking the necessary steps to ensure counter-party compliance in a timely way).

Expenses – Constantly review expenses to ensure that they are both necessary and in line with the market.  This process never ends.  We look at every expense as an “investments” and define what the “return” on that investment will consist of (i.e. what value comes back to us for having the cash outflow …).  We ask, “If we eliminated this expense, what value would be lost?”  And then we also ask, “If we increased this expense, what would be the increase in value?”  By looking at expenses as investments in value (and we note that some value is intangible but ultimately should feed into a tangible value return), you start thinking like an investor and act as a more careful steward of your resources.

Sales – Are we making more sales or making less sales, and what are we “giving up” to make them?  Profit is the difference between the value you add to the world (in the form of revenue that people reward you with for giving them a good or service) and the value you take from the world, (or the resources you consume to deliver your good or service, i.e., expenses).  You have to make sure that you aren’t delivering goods and services that are providing less value to the world than the value they’re consuming to do so.  By looking closely at those sales and making sure they’re net-value adds, you’ll lower failure risk for the business.  I like to say that I can generate a billion dollars in revenue tomorrow, just give me a billion and one dollars to spend on it today!  What’s a lot tougher than that is to take $9 of investment/expense and turn it into $10 of value.  That’s the trick!

I hope this post is helpful and that you can take CIRCLES and implement it into your organization, thinking systematically about the adverse outcomes that can affect you.  Put into place a cyclical system that helps you monitor and mitigate those adverse potentialities.

John Hussman’s weekly market commentary is a must-read for me every Monday morning.  His insights on markets, the business climate, governments, and even things such as autism and health and fitness enrich my life.   His economic tutorials have helped me be a better decision maker.

If everyone in the world read Hussman’s commentary every week, a lot misery would be spared us.  Time and time again he lays out what a common sense course would be for a given issue, business, or government, while predicting what will happen if the common sense approach is not taken.  He’s not a professional prognosticator, but his views are almost always vindicated.

I just want to publicly express gratitude and admiration for Hussman, and the best way I can repay him for what he’s given me is to share him with you.

If you want to be productive and perform at a high level, you have to understand what value is and how it’s created.  You need to understand this so that you spend your time on the most valuable things.

What gives a thing it’s value?

Frequently, each of us says things like:

“Wow, that’s valuable!”

“I value my (insert name of possession ['car!'] or state ['happiness!'] ) very much.”

“I value our friendship.”

We say these phrases like we think we know what they mean! And, really, we do. But when asked to articulate what it is exactly that gives a thing its value, can we say it?

And what makes one thing more valuable than other?

Clearly water is more valuable than diamonds, but why does a gallon of water cost a fraction of the price of a ten carat diamond?

Surely, value is subjective. That is, the value of something will vary from person to person. One man’s trash is another man’s treasure.

But why is that?

I think that a short note called, “Where Do Profits Come From?” by John Hussman can help us think about this.

The fundamental law of economics is that profits always go to those resources which are both scarce and useful. The value of those things which are scarce and in demand will tend to rise, relative to the value of those things which are abundant and less desired …. Profits are always earned by providing those things which are scarce and useful to others. Profits…reflect service to others. ”

Two key concepts in understanding value.   Scarcity.  Usefulness.

Let’s define them with some quick and dirty definitions.

Scarce = hard to come by; not infinitely available.

Useful = something desired, the employment of which improves living; alternatively, a thing is useful if, when possessing it, ones life it improved thereby

Now, let’s plot some items on a graph that have different quantities of scarcity and usefulness. The coordinates are scarcity on the X-axis and usefulness on the Y-axis. The higher the numbers on the axes, the more scarce and the more useful a thing is. Where they intersect we can locate a point of value.

I took 14 things in my life that I valued and then ranked them according to their usefulness to me, and their relative scarcity (or availability).  Then I plotted them on a graph.  You can try this exercise with yourself.

The upper right hand quadrant is where the most value will usually be found. In the lower left hand quadrant we’ll almost always find the things we value least.

So that explains the water vs. diamonds paradox. Water is far more useful that diamonds, but it is so abundant that in most areas of the world it doesn’t even move the meter on the “scarce” axis. However, to mine and then cut and polish a diamond takes real work. Beautiful diamonds are scarce, and they do have value as jewelry or as cutting tools.

Things that are more valuable (i.e. both scarce and useful) cost more!

Now, how can you use this knowledge to improve your lot in life?

If we can produce something that is both scarce and useful, it will be valuable to us and to others.

Think about your own life, your talents, your skills, your interests.

What can you offer to others that is both scarce and useful?

If you can find it, or develop it, you are well on your way to having a comfortable life. Need to get better at what you do so that it will be more useful? See the post “How to Get Better at Anything.”

If you haven’t yet chosen a profession, or would like to pursue a new one, you might look at providing a service that is very useful to a great number of people and where there will be supply constraint (whether because skills take time or great sacrifice to develop of because of some external constraint like discouraging regulations).

So, since you want to create value in your life in and in the lives of others, you must always be aware of scarcity and usefulness.

If you have a family, have children, I want you to think about what your family/children value in you.

You know what’s scarce in a spouse’s/parent’s life, especially a working one?

Time.

You know what useful to a child or spouse? Spending time with them. There’s a reason it’s called “spending” time, because when it’s gone it’s gone. Time is the most scarce good!

Want your child to value you? Spend quality time with her.

Want your spouse to value you? Spend quality time with him.

What are some of the things you value in your life?  Can you identify why it’s useful to you and how scarce it is? Does it give you any insights into the way you see yourself and your environment?