Leithner Letter Nos. 12-13
26 December 2000 - January 26 2001

A Year to Remember

The end of one year and the beginning of the next is an appropriate time to reflect upon the outgoing year’s events, twists and turns, triumphs, trials and tribulations. It is also a time to place them into a broader context, consider their causes and consequences and plan for the new year. Alan Abelson, writing in Barron’s Online (4 December 2000), summarised the last year of the twentieth century in unambiguously dour terms: “as you’re undoubtedly and possibly painfully aware, 2000 is already memorable in Wall Street as the year the air began to whoosh out of the monster stock-market bubble and, after many a frustrating try, the year the bears finally ate Goldilocks. In fact, unless such portents as mounting claims for unemployment insurance and the latest downbeat readings on business from the purchasing managers are completely misleading, 2000 will go down as the beginning of the end of the most salutary and long-lived economic boom to grace this nation (and probably any other).”

A Mass Misallocation of Capital?

From the perspective of a value investor, it seems to me that 2000 was noteworthy in two respects. First, signs emerged that the latter half of the 1990s was a period during which staggering amounts of credit was created, misdirected – and in some instances squandered. Most notably, market participants allocated massive amounts of financial resources on very favourable terms towards entrepreneurs seeking to develop or commercialise ‘New Economy’ capital goods (i.e., computer, Internet and telecoms infrastructure; B2C, B2B, biological and other technologies; and other forms of intangible capital). In the past three years, for example, banks lent approximately $900 billion to the telecommunications sector alone; telecoms companies themselves raised further billions of equity; and the costs of ‘3G’ licenses and other infrastructure will during the next several years maintain telecoms’ hearty appetites for financial resources.

Notice, however, that what was never created cannot be destroyed. Accordingly, to the extent that this mass mobilisation of credit has not helped to create businesses which emit reliable streams of real earnings, wealth has neither disappeared nor been destroyed. Rather, unrealistic expectations (and in some instances millennial hubris), based upon soft credit rather than hard savings, are gradually being uncovered and belatedly corrected. 

Three developments have made these ‘malinvestments’ (if, indeed, that is what they turn out to be) possible. Central banks such as the Reserve Bank of Australia, U.S. Federal Reserve, etc., have enabled if not promoted the creation of historically-unprecedented amounts of credit; technological innovations, most notably the advent of the Internet, have encouraged the formation of firms with voracious appetites for debt and equity; and exaggerated expectations about these businesses – abetted by a wilfully blind eye towards history – have whetted many market participants’ appetites for risk. Signs of an unintended consequence of these patterns of behaviour – the production of quantities of ‘New Economy’ goods and services which exceeds consumers’ demand – began to appear during 2000. The ‘tech wrecks’ of April and October-November, it seems to me, were belated, very partial and therefore incomplete recognitions that the New Economy will not fulfil the millennially-optimistic assumptions about profits which its boosters ascribe to it.

The Appearance of Disquiet

Bearing this first point in mind, from the point of view of a value investor 2000 was noteworthy in a second respect. Market participants’ behaviour gradually ceased to be characterised by euphoria and greed and in some instances began to be characterised by disquiet and fear. An editorial in The New York Times (2 December) entitled ‘End of the Good Times’ epitomised this sentiment. It stated that “the party may be over. It is not yet clear whether the present U.S. economic slowdown will ultimately lead to a recession or is simply the ‘soft landing’ that Alan Greenspan has been plotting so carefully. But either way it spells the end of the economic nirvana of recent years – that potent concoction of extremely robust growth, low inflation [sic] and low unemployment. The universal sense of awe at the magical new economy is giving way to a sense of unease.”

The Times continued: “Bill Clinton owed much of his second-term political buoyancy to the same economic euphoria that turned Americans, at least in Alan Greenspan’s view, into a nation of irrationally exuberant investors. Millions piled into the stock market to profit from the tech-driven revolution, and at times seemed to turn the hope that the new economy had transcended the restraints of the business cycle into a self-fulfilling prophesy. But that euphoria has chilled greatly. Alan Greenspan may yet pull off a soft landing for the economy, as he did in the mid-1990s, ensuring continued, although less robust, growth. But things have been hard for investors, particularly those who had grown accustomed to the idea that it pays to speculate.”

Three Virtues

During 2000, then, hares (i.e., recklessly exuberant speculators and short-termers) ceased to bask without interruption in glory; conversely, and almost imperceptibly, tortoises (i.e., cautious, studious and long-term custodians of capital) ceased to be regarded universally as objects of derision. Accompanying this shift, if it is actually occurring, is a portentous, historically well-understood but presently- unappreciated development. The British economist and investor, Lord Keynes, expressed its essence in The Applied Theory of Money (1930). “If enterprise is afoot, wealth accumulates whatever may be happening to thrift; and if enterprise is asleep, wealth decays whatever thrift may be doing.” In certain quarters in Australia and New Zealand, and probably in other countries, enterprise is presently afoot and thrift wide awake. But not in the manner trumpeted relentlessly by boosters of the ‘New Economy.’ Quite the contrary: these two virtues are alive and well within a small number of well-managed and unheralded firms that are not New Economy market darlings and thus have not been lavished with financial resources on lenient terms.

It is the essential and irreplaceable role of the value investor to nurture these firms and promote these financial virtues; i.e., to ration capital, ensuring both that ethical, profitable and thrifty firms are backed with patient and long-term equity – and that firms which lack these attributes are denied it. In so doing value investors are a cornerstone of capitalism – not just because patience has its own intrinsic rewards, but also because the fruits of savings, combined with vigilance and the patient custodianship of capital, beget material abundance.

Looking into 2001

As in the past, this stance is likely to remain a minority stance. Whatever they might think and whatever the denizens of Wall Street, Martin Place and the financial media might lead them to believe, it seems to me that the mentality of most of today’s market participants continues to have much more in common with that of speculators than investors. This speculative mindset is characterised by an obsessive focus upon an asset’s current market price and short-term changes therein (“performance”); a lack of genuine and dispassionate interest in the operations of the business and other fundamental factors which underlie the security being traded; and very optimistic expectations – bordering upon conviction – about the extent to which the market prices of ‘their’ assets can and will continue to increase.

One of the many unfortunate consequences of this speculative mindset – the definition of an asset’s ‘performance’ in terms of the direction and magnitude of short-term changes in its price – reveals much that is trivial and obscures much that is relevant.

On this subject of short-term price volatility Alan Abelson (Barron’s Online, 4 December 2000) was also unambiguous: “what we’ve found most intriguing is that, until now, all this blood in the Street has evoked very little public outcry. We’ve experienced a kind of cruel and vast but silent mugging. Magazines like Time and Newsweek haven’t done their usual heavy-breathing treatments, nor have most newspapers, including The New York Times, made a front-page fuss about the decline and fall of Nasdaq. Nor are the networks running their usual inane specials. Moreover, until quite recently, mutual-fund shareholders have placidly watched their wealth withering. No crowds gathering in front of fund headquarters and, more tellingly, no rush to redeem their holdings. There are several possible explanations for this rather astonishing diffidence on the part of the financially wounded and the absence of hysteria in the press, both the electronic version and the genuine item. The distraction of the election that never ends. The fact that most everyone who wants one still has a job and a relatively high comfort level. Whatever the cause or combination of causes, that we’re in a bear market, and a vicious one, doesn’t seem to have sunk in yet.”

If Mr Abelson is correct, then 2001 will – in retrospect – be seen as a good year. Value investors, as custodians of capital, seek to buy quality financial assets at bargain prices. Leithner & Co. therefore likes gloom, doom, pessimism and despondency – not for their own sake but because they help to make good businesses available at sensible prices. Precisely because the Company is a net saver and therefore a net purchaser of financial assets, my preference for 2001 is that the quality of the investments we own (or seek to own) improves – but that the prices at which we are able to buy them decrease. Warren Buffett gets the last word: “Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”

A pleasant summer and prosperous 2001 to all.

Chris Leithner


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