The Dao of Capital 📚

Austrian Investing in a Distorted World

Hi everyone,

I’m writing today to share some of my favorite excerpts from the book The Dao of Capital: Austrian Investing in a Distorted World, by Mark Spitznagel, which I finished recently and have been thinking about ever since. If you’re not familiar with the Austrian School of economy or the writings of Mises, Böhm-Bawerk, & Rothbard, then it’s the perfect entry point.

Austrian economics has also become required reading for anyone interested in the crypto space, specifically Bitcoin and the ethos behind its most ardent followers. In fact, the rise of Bitcoin and the current influx of inflationary stimulus money being printed by the U.S. government has made Austrian economic theory more popular than ever. Austrian economists are also big advocates for entrepreneurship, and the role that inventors and business-creators play in a society. In many ways entrepreneurs embody the same ethos of risk-reward and invest in themselves and their vision in an Austrian manner.

Here, Spitznagel (founder and CIO of Universa Investments) takes a circuitous route through the topic of circuity. That is: why approaching objectives indirectly and through what he calls “roundabout” means is the way to achieve the most optimal outcomes. It’s a view shared by John Kay in his book Obliquity: Why Our Goals Are Best Achieved Indirectly, though Spitznagel focuses specifically in the realm of investment and capital allocation.

There is plenty of practical insight below, but I also urge you to check out the book at some point. It’s a stunner.

—Mark

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“At the outset, we must think of capital in a new way, as a verb, not a noun. Rather than an inanimate asset or piece of property, it constitutes an action, a means to an end—to build, to advance, to deploy the tools and instruments of a progressing economy. Indeed, capital is a process, or a method or path—what the ancient Chinese called the Dao.”

Throughout the book Spitznagel emphasizes the similarities between a Chinese philosophy, an Austrian school of economics, and the coniferous species of tree. All of their foundational strategies have to do with “the roundabout.” That is, the oblique and indirect way of achieving a result.

From an economics standpoint this leads to an appreciation for long-term gains at the cost of near-term losses, particularly when the gains allow for several multiples of returns. This also leads Austrian economists to emphasize the role of the entrepreneur in a society, as they are the personification of the roundabout risk-taker and the reaper of outsized reward when successful. The entrepreneur sees a future that no one else sees, or at least is looking at. They are willing to sacrifice immediate returns for long stretches of time in order to gain exposure to the inevitable upside when the future finally arrives:

“As evident and ubiquitous as this process is all around us, from the natural world of the boreal forest to the business world of the entrepreneur, all too often we fail to perceive it. We tend to see the destination, but somehow often miss the path. So, we end up playing the wrong game.”

Originally a trader working at the Chicago Board of Trade, Spitznagel was introduced to this idea of the roundabound and the appreciation of near-term losses by his mentor, the legendary trader Everett Klipp.

Klipp is the one who planted the seed (pun absolutely intended) in Spitnzagel’s mind about the Austrian approach to economics and the inherent nature of the humble pine tree:

“Since leaving the pit, however, one adage in particular took on greater meaning and resonated more deeply with me, despite its banality: ‘Anyone can see the pinecones in the tree. None can see the trees, none can foresee the forest in the pinecone.’

In this simplest of sayings, once again, was Klipp's great disdain for focusing only on the immediate, the tangible, the seen. And in it was also a dramatic story of struggle and conquest.”

In fact, the species that best embodies the Austrian approach of indirect means of conquest is the Austrian pine. In it we can see the entrepreneurial spirit of vision, grit, and sacrifice:

“A happy coincidence worth noting is that the Austrian pine, a subspecies of the European black pine, or Pinus nigra, seems particularly drawn to the craggiest of terrain, pushing into the most barren areas, just as the entrepreneur—the focus and hero of the Austrian tradition—pushes out to the areas overlooked and yet undiscovered by his brethren competitors.”

These aren’t strained metaphors. There are many clear parallels that Spitznagel goes to great length to unpack because he’s trying to emphasize the fact that the Austrian way of thinking is not only ancient, but captures something that nature figured out and leverages. Which is usually a good sign that an idea framework isn’t an invention so much as it’s an expression of a principle that is already proven to work:

“While conifers growing on the rocks may appear to be nature's outcasts, theirs is truly the false humility of the Daoist manipulator-sage: They withdraw to where others cannot go and then act when conditions suddenly shift and an opportune moment arises, such as after a wildfire. Then we can see the wei wuwei—or what we might call here "seeding by not seeding"—of the conifers: By growing on the rocks they avoid mal-seeding in the fertile areas and thus establish a defensive position that, in time, becomes an offensive vantage point from which they can disperse seeds to be wind-borne to the fire-cleared areas—the same fertile ground from which they originally retreated.”

This is not to say that the roundabout approach to survival should be the only way, but rather that it’s only by embracing imbalance (perhaps in modern economic terms: ‘volatility’) and uncertainty that one has any hope of arriving at a strategy that works:

“As we have seen, it is not that the forest would somehow be better off with only conifers and no angiosperms. Rather, a give and take, a search and discovery process, an adapted alertness to opportunities—and always emanating from the imbalances of states of rest—must be allowed to unfold naturally in order to create the most efficient balance of available resources between them.”

The word “strategy” was originally only ever associated with warfare and battle, dating back to Sun-Tzu and his classic treatise The Art of War. It wasn’t until the 1970’s when the word began to be used in a business context, as the Harvard Business School began to churn out textbooks and thought-leaders who set out to codify the world of markets, competition, and business dynamics:

Until then, it was Chinese and German military regimes who were most associated with the concept and pioneered some of the foundational concepts around game theory and conflict:

“Ask any student of military strategy what languages one must know to read the classics in the original and the answer will invariably be Chinese and German—the latter, I would also add, is singularly necessary for that of economics.”

It’s not until much later that Spitnznagel begins to tie his line of thinking back to more practical financial applications. Here, for example, you can start to see a distinction emerge that echoes one we here often: the difference between trading and investing:

“Only by waiting can that accelerated growth be realized. (For instance, you get more wood by letting a single tree grow for 15 years than by chopping down three five-year-old trees over the same period; however in the latter you get paid incrementally every five years, whereas in the former you get it all at the end.) Thus, before committing land to a forest that may take 15 years to mature enough for pulp and 25 years or longer for timber, one must appreciate that the benefits received in the future carry less value than the same benefits received in the present moment. Forestry is the textbook roundabout industry.”

But it’s when the topic turns to entrepreneurs specifically that the liveliness and optimism of the idea can really be felt.

Here’s as good an endorsement for attempting to start and grow a business as you’ll ever see. Austrian economists really do hold entrepreneurship in high regard, mostly due to a founder’s willingness to endure long periods of downside without losing enthusiasm or a clear sense of purpose:

“Entrepreneurs do not dabble, willy-nilly, in pursuits of fancy, chasing butterflies or endless real optionality; theirs is a practice of assuming an uncomfortable position in the difficult sunk costs required for the tools to achieve their clear goals. Even when their roundabout processes take them back to the drawing board countless times, to reinvent the very tools they need to produce their final goods, they are decidedly and determinedly purposeful. Nor do entrepreneurs pursue rainbows down some picturesquely meandering path because of serendipity, kismet, and chance. Their indirectness is always calculated; they know where they are going (though never knowing, of course, if they will actually get there), while keeping their minds open to the evaluation and modification of goals from what is learned along the way.”

At its core, the Austrian school of economics runs counter to many ingrained human tendencies, which may be why it hasn’t seen as much popular reception over the years. To go against intuition and emotion is difficult, human nature being what it is, and patience can be the most difficult thing of all for an investor:

“Austrian Investing, we must plan to do and then actually do the complete opposite of these ingrained time expectations; we must, instead, become strategically patient now—but not as the practice of some virtue toward realizing a platitude-laden future. Rather, we are patient now for the sole purpose of becoming intensely and rapaciously impatient later; though difficult to perceive, this is the teleological, causal arrow of time in roundabout investing.”

The nature of time is as pertinent in the world of investing as it is in so many dynamic disciplines involving movements. The Austrian tradition, and Austria’s capital of Vienna in particular, is linked to notions of time in its many forms:

“Böhm-Bawerk viewed economics and time as inextricably linked. Like time is to music (something close to the heart of any Viennese), it is the very canvas of capital and economics; it can be stretched, compressed, and distorted, with dramatic implications.”

This could be why age and maturity can be advantageous for an investor, since sheer survival reveals an ability to weather storms and withstand shocks. The downside risks of too hurried an approach—especially the hazardous “direct approach”—aren’t yet known firsthand to a young investor:

“The more developed the species, the deeper its depth of field, taking a teleological series of intermediate, interconnected steps as a necessary expedient for later competitive advantage. Similarly, older people are better at overcoming the impulsivity we associate with youth. Ironically, it is the young adult, in the deep end of the temporal pool, who lives like there is no tomorrow, while older folk who have far fewer actuarial years ahead are better able to make intertemporal choices that prepare for a future (perhaps that may very well exceed their own lifespan-thus thinking and acting for the benefit of intergenerational fitness and advantage).”

Another key attribute to the Austrian school is the way it has drawn conclusions and principles from the bottom-up—not a top-down theoretical model. It has a micro-economic bent and pays close attention to individual human behavior before extrapolation from there:

“What critics of the Austrians fail to appreciate is the importance of the idea, as highlighted in the title of Mises's book, that economics is undeniably the study of human action, which is highly subjective and cannot be reduced to data points and mathematical models.”

In fact, data and modeling are not things that the Austrian school trusts very much or looks to for answers, since they hold strong to the idea that history is not a map of what one should expect in the future (this echoes much of what Nassim Taleb has written in his Incerto collection, particularly the bestseller The Black Swan):

“At the heart of the Austrian methodology is healthy skepticism of data and, in particular, how economics (and, equivalently, investing) uses data to back-fit a story around spurious relationships found in the data (we call this data mining). Admittedly, we do take a peek at the data (as we will later in this book), but we do not rely upon statistical and historical information to form our understanding. In fact, I might go so far as to call myself an antiempiricist, because empiricism often creates illusions and obfuscates the true underlying mechanisms at work.”

“Although the future remains uncertain, the entrepreneur relies on "specific anticipative understanding," which "can be neither taught nor learned"; he does not focus on what was or is, but acts upon what he expects the future to be.”

By the end, Spitnagel finally lands on practical investment guidelines for the Austrian investor in today’s age. Part of it anchors around something called the Faustmann Ratio, which when low is a signal that represents a company that is robust enough to withstand a market downturn and still have the ability to spend and deploy capital after weaker firms have been cleared out:

“In addition to casting our net for firms with a high ROIC, we are also looking for firms with a low Faustmann ratio, meaning a low market capitalization (of common equity) over net worth (or invested capital plus cash minus debt and preferred equity) ratio. In Chapter 5, I explained that this Faustmann ratio is driven by the degree to which the ROIC exceeds the cost of that capital, so clearly one might expect high Faustmann ratios (where the whole is greater than the sum of its parts-or the sum of the factors of production) to accompany high ROICS.

In many ways, Austrian investing is a rival of the more popular and time-tested approach of value investing since the former pays closer attention to the overall market conditions through the Mises Stationarity Index, and can better perceive when value truly exists or when the illusion of value appears as a beneficiary of fragile economic conditions.

According to Spitznagel, the mysterious “reversion to the mean” is something that occurs because of a measurable distortion in the system—much like today’s artificial influx of money being printed by the U.S. federal reserve in response to the onset of a health crisis:

“The rigor and appeal of Austrian Investing is in the intuitive logic of its principles; even before we test, we know why our edge exists. For most value investors, even when they see the edge that their approach provides, they do not comprehend it-typically relying on mere nebulous long-term price mean reversions, and Graham famously called it "one of the mysteries of our business, and it is a mystery to me as well as everybody else"; they thus remain susceptible to being swept away by the next seemingly attractive investment scheme and distorted environment to come along (as even Graham himself was in the late 1920s).”

“When considered as a somewhat noisy and tweaked version of Austrian Investing, perhaps value investing's mystery can be put to rest: Production that leads to entrepreneurial profit is an exceedingly roundabout process, which takes time and capital, and thus patience in acquiring the indirect means of that process; we should not expect such entrepreneurial profit to be easy or even desirable as it starts the process (and made even less desirable by monetary distortion). To those who understand and can thus suffer through the process go the spoils of capitalism.”

“Anything worth doing takes time.” To try to artificially rush the road to prosperity is to violate the natural equilibrium that exists to prevent catastrophic collapses from occurring in the first place. It should be through the roundabout method that aims are achieved:

“The great artists and entrepreneurs (and economists) have well understood that anything worth doing takes time and so have their polar opposites, the military strategists, thus giving us the spectrum of the very creators and destroyers of civilization. Each in his own way has followed the common thread of intertemporal exchange (as explained in Chapter 3), the patient pursuit of an intermediate state, the efficacy of which furthers the realization of a desired final state. And so, achievement of one's eventual Zweck only comes after much effort, moving from Ziel to Ziel, along with a good deal of waiting, even to the point of testing the limits of one's perseverance.”

These principles extend naturally, like so many good ideas in a given domain, to the art of living. Here, we have a philosophy that seeks out obstacles and derives advantage from loss:

“Sisu, though, like shi, does not apply only to martial or even investment strategy, but also much more broadly to living one's life with purpose and tenacity. It is also a reminder of inner strength that enables one to carry on in spite of difficulty and obstacles, speaking as it does of character-and character building.”

An oblique, roundabout approach to life (and investing) isn’t nearly as attractive since so much of the time is spent not achieving, winning, or succeeding. But the journey is the thing and the approach is the way. The Dao.

Few appreciate the roundabout, because we only see the final product or result, the end of an interval and process, and not the means, the winding path that produced it.”

The Dao of Capital is a great read, and I highly recommend it if these highlights struck a chord with you. The book’s cross-disciplinary wandering through trees and Eastern philosophy and Finnish mythology was also the perfect manifestation of the roundabout nature of the message.

If you have any thoughts or ideas as a result of this letter I’d love to hear it, so feel free to comment or reply!

Thanks,

Mark