Back in the old days, horse traders were the equivalent of used car salesmen today.

Their business model was to buy horses cheap and sell them high. Reputable horse traders dealing with knowledgeable buyers were as close to a fair transaction as you could get. But in reality there were many not so reputable sellers and often buyers didn't have all of the skills or knowledge to price a horse correctly; buyer beware. As the saying goes, "a fool and his money are soon parted."

When you start or buy a business there are two ways of making money when you sell it.

  • Type 1 – Build a business that generates something of value and focus on making a decent profit whether or not you are growing. If you want to sell the business, you will get some multiple of the profit you are consistently generating (assuming the buyer can continue to make profit).
  • Type 2 – Build a business that has the appearance of being good (growing fast) but is not making real profit, and hope someone else will buy it based on the appearance of success or optimistically, they have a way in mind of turning things around. Ultimately, a company losing money cannot last forever.

The first type of company is doing two things of value for society beyond creating wealth for the owners: it is generating something of real value thereby increasing the real productivity of the world and it is creating lasting employment. A buyer can expect this to continue.

The second type of business is a valid way of making money in our world as well. It just is not generating as much (if any) real and sustainable value. In a perfect world with a reasonably honest seller and a well informed and knowledgeable buyer, both are getting the deal they wanted so they both win.

Where this all falls apart is that often:

  • The seller is not honest,
  • The buyer is not well informed or knowledgeable.

When I buy a stock on the market and sell it for a profit later; I am not actually creating anything of value. The underlying business is (or not). If the underlying company is not a business that actually builds value, then really, I am selling to the greater fool. This bubble eventually pops and lots of people end up losing money. This is a win/lose situation. The anonymity of the public market just hides us from the fool instead of staring them in the face.

The problem in my mind is that the type 2 company inherently forms an environment that creates dishonest sellers by its very nature.

If I am selling a company that has not made a profit since its inception and has no expectation of doing so, then I am a horse trader selling a nag as a horse fit for nobles, it about creating an illusion.

As time goes on, and the bubbles get bigger, people get greedy or fearful. They could run out of money before they can sell or they could make a lot more money by not sharing the entire truth. See where this is going.

You start out not sharing the entire truth and justify it as marketing; just a little spin on reality. Then next year you bend the truth just a touch. Then to keep your numbers up you downright start lying to investors, customers and shareholders.

Not so amazingly, people are attracted to this model because it proposes you can get rich quick without creating anything of lasting value. You just have to have the right spin. You need to be a really good horse trader.

To make matters worse, there are a whole lot of people (investors, investment bankers, lawyers, etc.) who will support this model because they too will make a pile of money based on the greater fool theory. They are generally protected by the systems they have helped create.

I am not saying you can't stay ethical with a type two company and strive to sell fairly to a knowledgeable buyer… I am just saying the temptation is very high to stray. To eventually sell to a greater fool.

The problem is, the great fool is the public. It is your neighbor. It is your parents. It is your children. It is the average investor who does not have access to the same information that the insiders and institutional investors have. They are the people relying on the stock market to make their savings grow so they can retire. Yes, there are greedy buyers too and many should know better.

In the old days they often hung unscrupulous horse traders if they got too bad a reputation. But far more likely, the traders took their money and left town before people found out or could take action. This happens all the time in type 2 companies.

In the meantime, buyer beware, that horse you are buying for an unbelievable price (hoping it will go up) is likely a nag and eventually someone is going to wise up.

I think the better approach is to create a business that generates real value over the long term. Via its products and services to its customers and by creating sustainable profits for its shareholders. This should be the plan out of the gate.

I think this is better for the owners too; it keeps you one of the honest horse traders.

(This post was in part inspired by the current run up on Internet and Social Media stocks and the rantings of people on Twitter like @dhh. I doubt we as a society will ever really learn from history and I sometimes wonder how many more times the governments can bail us out; we are the governments' bankers people.)