Dao of Capital

Book by Mark Spitznagel

Review & Article by GlobalMacroForex

I’m a huge fan of Mark Spitznagel, and I’m a bull for this book.  There is such a wealth of information in it, so I’ll only be able to cover a small part of it.  But I highly recommend the book so you can learn the rest.  Mr. Spitznagel’s hedge fund focuses on tail risk “black swans” (also called short volatility), meaning his fund makes bets the market will crash in an extreme event (that would show up as a far left tail in a standard normal statistical distribution). 

The importance of Patience

One theme throughout Mr. Spitznagel’s book is the value of patience and long-term thinking.  He gives the example of two types of trees that grow – conifers and angiosperm.  The conifer starts off at a slower pace by developing strong roots and thick bark in the early stages.  Initially, the angiosperm overtakes the conifer’s growth but the angiosperm’s lead is given up when the conifer gets amazing growth in the later stages, thanks to its early intense development.

So although it might not be an immediate payoff, the conifer wins in the long run.  Throughout the book, Mr. Spitznagel references this theme of having the patience for long-term results.  He refers to this as the roundabout, referring to something that isn’t the most direct path.

Sptiznagel encourages investors at all times to be like the conifer, building strong roots and thick bark before proceeding.  He points out how many people in the professional asset management industry suffer from hyperbolic time, discounting or extremely concentrated time preference.  They require high returns and high earnings right now, which blinds their ability to think long term.

When Bubbles Pop

Spitznagel, as most others of the Austrian investing school, believes the Federal Reserve causes bubbles in the market by providing cheap liquidity that then is mal-invested.  He recommends watching the Tobin’s Equity Q Ratio produced by the Federal Reserve’s flow of funds balance sheet.  This ratio is total corporate equity divided by total corporate US net worth.  Although it’s called Tobin’s Q by the Fed who publishes the number, Mr. Spitznagel in the book refers to this as the Mises Index, after Ludwig von Mises – one of the fathers of Austrian economics.

Essentially this ratio is showing how much the equity market is calculating US companies are worth, compared with the actual cost to replace the assets of those companies.  It’s like a Price-to-Book value index for all stocks computed by the Fed using full replacement cost.

The following is a chart from Advisor’s Perspectives compares the S&P500 to the Tobin Q Ratio:

Mr. Spitznagel recommends avoiding investing when the Tobin Q/Mises Index is above 1.0 because it’s indicative of a bubble.

High Return Value Equities

Spitznagel stresses the importance of investing in equities at a good price and a high return on invested capital.  Return on Invested Capital (ROIC) is how much money the company earns for each dollar of investment it makes in its business.  So the formula is:

EBIT / Total Capital to get the EBIT

This total capital includes plants and equipment, cost of goods sold, and short-term capital.  In addition to a ROIC screen, Spitznagel recommends an EBIT/Enterprise Value screen.  This is like a P/E but it makes the number neutral to the company’s debt situation.  If one uses a P/E ratio, a highly indebted company might appear cheap.  Enterprise value allows one to more easily compare companies with different capital structures.

Enterprise Value = Equity market capitalization plus Debt minus Cash

Enterprise value reflects the value left if one liquidated a company’s assets, paid down its debt, and took the remaining net equity in cash.   Combining the ROIC strategy with an EBIT/Enterprise value ratio, Mr. Spitznagel shows you how investments will grow like the conifer against the angiosperm.  (The conifer grows slower at first, but then will win in the end.)

Conclusion

There’s a wealth of knowledge in this book, and I highly recommend it.  The book provides specifics on why Spitznagel’s strategies work with statistics on backtesting their results.  In addition, there are other techniques presented, such as Mr. Spitznagel’s techniques to hedge against bubbly markets with options and lessons to be learned from early capitalists.  There are not many Austrian economics books that present practical hands-on application to these types of theories, so pick up a copy and cherish the author’s insights.