With Stocks, Outflows Are Your Friend

A great deal of attention is focused on growing tech companies like the “FAANG” stocks. Obviously, businesses can generate great returns just by growing in size. More income leads to a higher stock price. In times like these, it’s tempting to think that building a huge market cap is the only successful business strategy. But it’s worth remembering there’s another source of shareholder return.

Fund Flows vs. Stock Flows

With equity funds and ETFs, inflows generally cause a rise in stock prices. When investors pour cash into funds, the fund managers must put that cash to work by buying stocks. The resulting increase in demand causes stock prices to rise. Inflows are a good thing, outflows are bad. Simple concept, right?

But inflows into equity funds do not mean there are inflows into stocks. When an equity fund buys a stock on the open market, cash is exchanged with the seller. Unless there are newly-issued shares, there is no net inflow to the business.

Take a look at the below chart from Bloomberg. It shows that the biggest buyers of stocks recently have been corporations making repurchases:

Like inflows into equity funds, buybacks usually cause stock prices to rise. At first glance, one might think all these buybacks represent a cash inflow. Like an investor buying shares of a mutual fund, aren’t buybacks just inflows into the stock?

Actually, no. A company uses cash to purchase its stock from other holders. Those holders receive cash, and the company effectively “retires” the shares from the public market. With a buyback, cash comes out of the company’s balance sheet and into the hands of investors. Buybacks are cash outflows from a stock.

People sometimes assume a rising price means money is flowing into a stock, and a falling price means money is flowing out. But every trade has a buyer and a seller. The price movements of a stock do not represent flows into or out of the business. The stock market can continue to rise while cash is flowing out.

And for shareholders, well-timed cash outflows can be very, very good. Some of the most consistent, highest-performing stocks in the last century have delivered returns through cash outflows. Take a look at this chart of Altria’s stock price (white) and its shares outstanding (green):

From March 1990 to today, billions of dollars in cash flowed out of the company. Altria paid consistent, rising dividends, and simultaneously reduced its share count by 32% through repurchases. The market cap grew by 243%, but the total return for investors was 9,095%. By comparison, the S&P 500 returned 1,161% over that time.

This is not an endorsement of Altria’s products (tobacco) or its stock going forward. But it’s worth remembering that growing a huge market cap, as the FAANG stocks have done, is not the only way to produce gaudy shareholder returns. Sometimes companies just know when to push cash in your pocket.

Systematic vs. Discretionary Decision-Making

Corey Hoffstein shared some of his thoughts on investment philosophy this week. He explains his preference for systematic over discretionary approaches to investing. Because “any disciplined approach can be systematized,” he believes, there’s little reason rely on a discretionary manager who could break from discipline. Systematic approaches can be back-tested and applied to hypothetical scenarios, he argues, so there is a more robust track record to analyze than with a discretionary manager.

I sympathize with this idea generally, but as always, it depends. Some type of disciplined, systematic process is crucial, but the question is the best place to draw the line.

Of course, any systematic approach or model is first created by a discretionary process. Even if the model is built with a sophisticated piece of software that can self-optimize, it was originally programmed by a human, and in most cases, humans continue to troubleshoot and monitor it. It is up to humans to decide when to modify a systematic strategy, and when to abandon one rules-based approach for another.

In the same sense, most discretionary managers incorporate systematic techniques into their process. This could be a simple stock screen or an advanced model – but if the manager makes idiosyncratic, overriding decisions, it’s a discretionary approach.

In many ways, these debates between systematic and discretionary investors are a matter of cognitive style. Different people think differently, and there are successful investors in both camps. My view is that the key is knowing yourself, your strengths, and more importantly, your weaknesses. The first section of this piece by Cliff Asness describes how smart people sometimes speak in “different languages” when it comes to investing.

Personally, I prefer a discretionary approach, using rules-based techniques as decision tools. I’m skeptical of many back-tested or stress-tested systematic approaches, but not because I think they can’t work. It’s because: (1) from my perspective, the “arms race” between quantitative strategies means any back-tested approach may be ineffective in the future. And (2) because systematic approaches can miss or misinterpret the extremes of human behavior. There are great quantitative investors, but I recognize my lack of skill in that domain.

As with many other choices, the “best” answer is probably different for different investors. As Asness writes, quantitative and qualitative investors agree on a great deal, they sometimes just speak in different languages.

The Beauty in Simplicity

I’m back in the US from a multi-week hiatus. While traveling, I learned two things: I would gain 30 pounds if I lived in Europe, and Swiss trains make Amtrak look like an oxcart.

Along with catching up on the latest Presidential tweets and Jeff Bezos’ continued shock and awe campaign, I saw an interview with a writer I admire.

Morgan Housel of The Collaborative Fund (formerly of the WSJ and Motley Fool) revealed that, other than cash and his home, he keeps his investments in a bare-bones portfolio of two securities: the Vaguard Total Stock Market Index Fund (VTI) and Berkshire Hathaway (BRK.B).

I absolutely love this. I’m not suggesting this should be everyone’s portfolio, but there is an undeniable appeal in the simplicity of this approach. Housel gets equity diversification through the index fund and additional exposure to an individual stock. He has found two securities he believes will compound wealth over time and bought those, plain and simple.

He explains that this extreme simplicity is intended to manage behavioral risk. Because he knows investors tend to “buy and sell at the worst possible times” and “change their allocations based on emotional hunches”, Housel believes his simple approach can help limit his own mistakes. If he’s only thinking about two securities, he will be less likely to trade one for the wrong reasons.

Housel is making an admission of bias that’s rare among financial commentators and would be practically unheard of for a pundit on TV. The greatest challenge in investing is knowing yourself, and by using this simple approach, Housel admits his own faults. It’s also just a good idea, it’s inspired me to reexamine my own portfolio.

When in doubt, here’s a rule of thumb: be more inclined to trust people who admit their own weaknesses. Distrust the advice of those who don’t.


In a previous post, I demonstrated that the volatility of an all-stock portfolio isn’t necessarily bad for a young investor. Just for fun, here’s how a 50/50 portfolio of the Vanguard Total Stock Market Index Fund and BRK.B would have performed during the time period I studied:

Why Holding Bitcoin is Pure Speculation

The surging price of bitcoin grabs a lot of attention. But it also raises questions about the nature of money and currency. What gives a currency its value?

The Elements of Money and Currency

Money is a medium of exchange. In a way, money is fiction; everything depends on people believing in its value. If enough people agree, anything can potentially be used as money—people have been known to use seashells, salt, grain, and even giant stone disks. Each of these options have drawbacks, of course. Seashells can weather and break. Grain can rot. Giant stone disks are hard to tote around in your pocket. Coins and paper money help solve these problems.

Currency is any widely-circulating form of money. The dollar, pound, and yen are state currencies. Gold is often considered a currency. Bitcoin, ripple, ethereum, and other alt-coins could also be considered currencies. You can exchange modern currencies in physical form, as you do with cash, or in electronic form, via credit cards, payment apps, or cryptocurrencies.

But what constitutes a useful currency? What attributes do we want for the currency we use every day? First and foremost, you need general acceptance. People must agree to accept the currency as payment. This agreement can come through legal means (when the government declares it legal tender), or through organic means (when people decide on their own, like with bitcoin).

Second, you want price stability. You need a reasonable sense of what your money will buy tomorrow, next month, and next year.

If you have hyperinflation, you have no faith in your currency’s purchasing power. Your incentive is to spend or exchange your currency as fast as possible. Many emerging countries (Yugoslavia, North Korea, Zimbabwe) have experienced currency hyperinflation.

If you have deflation, everyone’s incentive is to hoard the currency. If there is no incentive to spend or invest, economic growth stalls. Along with the Great Depression, the United States saw several deflationary periods in the 19th century such as the panics of 1837 and 1873.

A Real-World Experiment

I recall an interesting story that helps illustrate the difference between useful and ineffective currencies. The podcast Planet Money did an episode called Libertarian Summer Camp about a festival for government skeptics. For a few days, festival-goers were completely self-sufficient—they sold food and beer without licenses, traded goods, and discussed abolishing the IRS. They also engaged in a small-scale economic experiment, conducting daily business using silver and gold instead of the U.S. dollar.

It was clear that as everyday currencies, precious metals have some drawbacks. First, it’s hard to pay in small increments. If you want an omelet for breakfast, you need to measure out little shavings of silver. You need to carry around a scale, and unless you trust everyone you’re doing business with, you may have to test each bit of metal for purity. Paper money and electronic payments like credit cards and cryptocurrencies solve this physical problem.

But there’s another big drawback—the prices are volatile. This month, an omelet might cost 0.22oz of silver, but next month, it could be 30% more. Today it’s one price, but tomorrow, who knows? So how did the libertarians solve the volatility problem? They used their smartphones to look up the price of silver (in dollars, of course).

This is a silly anecdote, but the point is that price stability is extremely important for a useful currency. Because precious metals don’t have price stability, people need a stable reference currency (like USD) to decide what to pay. Not knowing what your money will buy tomorrow is not a good quality in a currency.

Mechanism for Price Stability

For decades, the U.S. dollar has exhibited strong price stability compared to other currencies. If you hold dollars, you aren’t worried about day-to-day volatility in your purchasing power. If you save money for a car, you have faith you’ll be able to afford it when it comes time to buy. You aren’t worried the car will cost $15,000 today, $20,000 tomorrow, and $5,000 a few weeks later.

The dollar’s price stability is aided by the central bank through monetary policy. To combat inflation, the Fed decreases the money supply. To combat deflation, the Fed increases it.

With gold, silver, and bitcoin, there is no central bank. If you distrust the government, the lack of a central bank may be a selling-point. But it doesn’t do much for price stability. If you own ten bitcoins or a pound of gold, what can you expect to buy with them next year? What about tomorrow? The lack of a mechanism for price stability is a major disadvantage. Without price stability, gold and Bitcoin are not effective as modern currencies.

Bitcoin and Source of Value

Bitcoin has no intrinsic value. You can’t eat it, use it to build things, or even look at it. It’s a virtual currency that exists in a virtual space—a decentralized ledger called blockchain. Its price is determined entirely by the market, and there is no government or central bank that can influence it. If people want to exchange bitcoin for $10 each, they can. If they exchange it for $1M each, so be it.

Blockchain, the distributed database bitcoin uses, is a useful payment system. It is anonymous, secure, and fast. To use blockchain for payments, you can convert dollars to bitcoin. The seller can instantly convert it back. Payment companies like Coinbase and Stripe already do this. There is no need to hold the bitcoin for more than a few seconds, so you can avoid the volatility risk.

Coinbase promotes avoiding bitcoin volatility.

Many people confuse bitcoin (the currency) with blockchain (the database). Because blockchain is a great payment system, people say, bitcoin must be valuable. But what imbues bitcoin with a specific value? Why should we assume $10, $100, or $1M is “correct”?

Some people claim it’s supply and demand—because bitcoin has a finite supply, the price of bitcoin will simply increase with demand. But if we can use bitcoin for payments without holding it for more than an instant, where is the stable source of demand? Demand comes from people wanting to hold bitcoin, not just use it for payments.

Another concern is the growing number of “altcoins.” Here is a list of the top 100 cryptocurrencies, by market cap. The higher the market price of bitcoin goes, the greater the incentive to create and trade alternatives.

Why Hold Bitcoin Long Term?

For months, I’ve been asking cryptocurrency fans for answers to this question. What are the benefits of holding bitcoin, besides speculation? I hear plenty of good reasons for the merits of blockchain, but never the merits of bitcoin as a currency. As far as I can tell, the only reason to hold bitcoin for any length of time is the belief that its price will rise.

This is absolutely fine, if you want to speculate. If you think bitcoin will trade for $1M in five years, it might make sense to own some. But I wouldn’t bet the farm. It’s an asset with no intrinsic value, no physical form, and no mechanism for price stability. Blockchain gets well-deserved hype, but this does not mean Bitcoin has any predictable value. Maybe bitcoin will trade for $1M someday, but not for any reason other than human behavior.


My inspiration for writing this piece was a concerning post last week from someone I’ve known a long time:

Late May Links

I’m working on a piece about Bitcoin, money, and the necessary qualities of an effective currency. But for now, here are some gems from the past few weeks:

Josh Brown on the inanity of cheering on a crash (“throwing spaghetti against the wall”).

Why Monish Pabrai regrets selling Ferrari.

Shane Parrish on seeking out disconfirming evidence.

Ben Carlson on barriers to entry in the investment business.

Robert St. George on information intensity in equity investing.