There is an old joke that captures well one of the central errors of our time. It goes like this:
Two economists are walking through the countryside when they spot a pile of cow manure. One turns to the other and says, “I’ll give you fifty thousand dollars if you eat a spoonful.” The colleague contemplates the utility function, accepts the challenge and consumes the filth. A mile later, they find a second pile. The second economist, eager to settle the score, offers the first the same deal. The first agrees, eats the spoonful, and wins his money back.
As they walk on, both physically sick and financially neutral, one laments, “We have accomplished nothing.”
The other shakes his head. “On the contrary,” he replies. “We just generated one hundred thousand dollars of economic activity. GDP is up!”
While the parable is a tad crass, it perfectly captures what the Polish economist Michał Kalecki famously described as the fatal flaw of his discipline. “Economics,” he remarked, “is the science of confusing stocks with flows.”
That’s never been more true than it is today.
We celebrate activity for its own sake, mistaking the mere movement of money for the creation of wealth. Whether in the halls of central banks or the boardrooms of public companies, the obsession is identical. We fixate on the flow, such as the income statement and the quarterly GDP print, while dangerously neglecting the stock: the capital base and its productive capacity.
Yet, as Irving Fisher established over a century ago in The Nature of Capital and Income, the flow is merely the stream; the stock is the lake. You cannot have the former without the latter, yet modern financial commentary often attempts precisely that. It praises the speed of the water while ignoring the draining of the reservoir.
When we prioritize the flow over the stock, we fall into a philosophical trap that Kenneth Boulding described as the “Cowboy Economy,” a system that recklessly worships consumption and throughput. We assume that working and spending are virtues in and of themselves.
They are most definitely not.
We work and spend only because we desire the fruits of labour. If we could possess the harvest without the toil, we would obviously do so.
As Boulding argued, true prosperity is not the maximisation of consumption (ie flow), but the nurturing and growth of high-quality capital stock with the least possible exertion. A nation or a company becomes richer not when it spends more, but when it deepens its capacity to produce. It becomes richer when it builds the factories, the software, the energy systems, and the institutions that enable abundance.
For the investor, this distinction offers a profound edge. The market, driven by the cowboy mentality of the income statement, often rewards companies that are effectively strip-mining their future to fund a temporary earnings boost. However, the sophisticated investor places emphasis on the balance sheet and asks a different question. Is this flow sustainable, and can it be extended by a careful management of the capital base?
As investors, we must look past the headline metrics that the market obsessively tracks, such as revenues, profits, and cash flows, important though they are. And we must also realise that two companies could possess a virtually identical set of assets and liabilities, yet produce very different flows. This discrepancy forces us to investigate the quality of the engine rather than just the speed of the car.
It forces us to understand that genuine growth and increasing profits are not necessarily the same thing. You can grow the productive capacity of an economy or company even if GDP or profits drop over a specific period. Likewise, cash flows can increase materially while the capital base is depleted, such as when a company fires its key people, runs down its inventory with heavy discounting, and takes on debt.
It is entirely possible for a company to deliver increasing profits, for a time, but if the underlying cash flows do not exceed the cost of the stock required to produce them, it is not growing. It is merely burning fuel.
A good example of all of this may be undie manufacturer Step One (ASX:STP), which garnered a bit of chatter on the forums this week (see below). Interpretations will vary, and the picture is likely more complicated than will be asserted here, but it could be argued that much of the revenue growth in recent years was mainly due to promotional intensity and heavy discounting, as the company departed from its focus on product quality and brand reputation. The very stock that were the foundations of its earlier success.
Contrast this with, say, AI-Media (ASX:AIM) which has deliberately wound back its traditional services business, at the expense of near-term revenues, as it bulked up its investment in technology and laid the foundations for greater future flows.
None of this is to suggest, however, that you can know everything of importance by simply scrutinising the balance sheet. Much of the engine of value creation lies in human capital, management ingenuity, brand reputation, and organisational culture. These are the invisible but crucial assets that the rules of accounting fail to capture. But these factors do leave footprints that the careful investor can track, perhaps most notably in things like margins and return on capital/equity.
And then there’s the rather fuzzy, though not unimportant, ‘gut instincts’ we develop as entrepreneurs and investors as to what qualities tend to engender success. There’s no formula here, other than the slow accrual of wisdom and refined pattern recognition one gains through prolonged (and often bitter) experience.
The point is, a company or nation becomes richer not when it spends more, but when it deepens its capital base. And not just in a strict accounting sense, but in the broadest conception of the term.
GDP growth and quarterly earnings beats sound good — and oftentimes genuinely are — but they are shallow and myopic measures that distract from what really matters. Sometimes they reveal little more than churn, and are therefore only as productive as two geniuses eating a pile of bullshit.
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