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Leithner Letter No. 17
26 May 2001

To suppose that the value of a common stock is determined purely by a corporation’s earnings discounted by the relevant interest rates and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen to the defence of Joseph Stalin and believed Orson Welles when he told them over the radio that the Martians had landed. 

James Grant
Minding Mr Market: Ten Years on Wall Street With
Grant’s Interest Rate Observer

Berkshire’s 2001 Annual General Meeting

The 2001 Annual Meeting of Berkshire Hathaway, Inc., took place on 28 April. (An account of its 2000 AGM appeared in Letter 5). Like the company itself, whose commitment to shareholders and ability to create wealth on their behalf has few if any equals, this gathering is unique. It attracts a majority of the company’s owners; its formalities are concluded extremely quickly (normally within 10 minutes); and after the formalities there ensues an informal question-and-answer session which lasts several hours. Berkshire’s Chairman (Warren Buffett) and Vice-Chairman (Charles Munger) answer these questions. Perhaps most unusually and admirably, they do so clearly, completely and frankly.

In contrast to the 2000 AGM, some Australian newspapers noted this year’s meeting. The Australian (30 April), for example, briefly mentioned it within an article about Berkshire’s desire to invest in the U.S. utility industry. The Australian Financial Review published three reports – including one on its front page (30 April). The lead article stated that Berkshire’s “emphasis on business morality, transparency and long-term investing” had been vindicated and thereby “constituted a victory of old-fashioned American capitalism over the excesses of the late 1990s technology boom.” A second article emphasised Mr Buffett’s view, stated during the meeting, that investors should reduce significantly their expectations about the results which investments might generate in the future. 

Interestingly, also on 30 April The Wall Street Journal published the results of a survey, financed by the Institute of Psychology and Markets, of American investors’ short- and long-term expectations. With respect to the next 12 months, it found that 5% of the survey’s respondents expected no return; 10% of respondents expected returns of 1-5%; 23% expected returns of 5-10%; 33% expected returns of 10-20% and 6% expected returns of 20% or more. With respect to the next ten years, the ISM survey found that 1% of respondents expected no return; 3% of respondents expected returns of 1-5%; 12% expected returns of 5-10%; 41% expected returns of 10-20% and 20% expected returns of 20% or more (the percentages do not sum to 100% because some respondents did not answer these questions are were unsure of their response). Over both short and long periods, then, a plurality expect that their investments will return approximately 15%.

How realistic is this? In its lead article The AFR’s correspondent at Berkshire’s AGM reported that “superannuation funds are fooling themselves into believing they can achieve high growth from their investments over the long term, according to. Mr Buffett.” He and Mr Munger “criticised the funds management consulting industry. for allowing companies and their superannuation funds to assume they would generate average returns of 9 per cent. ‘I think corporate profits are safe to run 5 to 6 per cent [of GDP] over the next two decades, but anyone who thinks you will make 15 per cent is living in a dream world’ Mr Buffett said.” Similarly, “the probability [that Berkshire achieves] 15 per cent growth in earnings over an extended period of years is so close to zero it’s not worth calculating.” 

Consciously or not, Mr Buffett’s outlook – or one similar to it – has lately been adopted by a range of Australian investment institutions. Yet they and their compatriots in the press must surely know that Mr Buffett’s position on this subject is hardly new. Indeed, in a series of speeches collated by and published in Fortune magazine in November 1999 he detailed not just this cautious outlook and the premises which substantiate it – he also drew attention to the implausible premises upon which optimists must rely in order to justify their ebullient expectations. Hence a disturbing point: had institutional investors and journalists widely publicised and acted upon Buffett’s view when it was first uttered (i.e., during the ‘high tech’ mania and thus when their clients and readers might have benefited most from them), some of their clients and readers might have been spared the anguish and loss of capital which the ‘tech wreck’ subsequently meted out to them. Alas, in 1999 Buffett and Munger were widely regarded as passé (Berkshire’s 2000 AGM, it should be remembered, merited nary a mention in the Australian press); further, what both have called ‘the institutional imperative’ precludes views and behaviour which diverge sharply from those of one’s peers – no matter how nonsensical those views, behaviour and ‘wisdom’ appear to be. 

Academia in the Dock

Given the Australian journalists’ limited coverage of Berkshire’s 2001 AGM, a range of important points also expressed at the meeting went unreported. Hence the notes taken by Whitney Tilson of Tilson Capital Partners LLC, who attended the meeting, are well worth reading. Mr Tilson cautions that his notes, reconstructed from 24 pages of rapid scribbling over several hours, are not a transcript and therefore should not be regarded as verbatim quotes. Yet as an accessible and relatively complete description of the meeting they are nonetheless valuable. 

From Mr Tilson’s notes emerges another theme. Not only, as Mr Munger was quoted in The AFR Weekend Edition (5-6 May), is “pension fund accounting. drifting into scandal by making careless business investment assumptions”: more generally, the ideas, concepts and tools upon which investment institutions, economists and business journalists rely, and which derive ultimately from the mainstream (‘neoclassical’) economics taught at universities and business schools, do more harm than good.

Value investors ground their analyses in simple mathematics, clear logic and hard evidence. (As the preface to the first edition of Graham and Dodd’s Security Analysis put it, “we are concerned chiefly with concepts, methods, standards, principles, and above all with logical reasoning.”) They therefore tend to distrust the advanced mathematics, statistical models and computations which underlie contemporary financial analysis. Benjamin Graham was unequivocal: elsewhere he stated that “in 44 years of Wall Street experience and study I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever [calculus] is brought in, or higher algebra, you could take it as a warning signal that the operator is trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment.” Mssrs Buffett and Munger have uttered similar sentiments.

In this context, other – and unreported – points they made at Berkshire’s 2001 AGM provide considerable food for thought:

  • Academics’ Teaching of Investment Principles and Practices “What you’d really want in a course is how to value a business, because if you don’t know how to value a business, you don’t know how to value a stock. But very few professors know how to value a business, so they teach that nobody knows anything. The teaching of investing is pretty pathetic.”

  • Investment Risk and Risk Management “Using [a stock’s] volatility as a measure of risk is nuts. Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return. Some great businesses have very volatile returns – for example, See’s [a candy company owned by Berkshire] usually loses money in two quarters of each year – and some terrible businesses can have steady results” (Munger) “How can professors spread this? I’ve been waiting for this craziness to end for decades. It’s been dented, but it’s still out there.” (Buffett) “If someone starts talking to you about beta, zip up your pocketbook.”

  • The Weighted Average Cost of Capital (Munger) “Obviously, consideration of costs is key, including opportunity costs. Of course capital isn’t free. It’s easy to figure out your cost of borrowing, but theorists went bonkers on the cost of equity capital. They say that if you’re generating a 100% return on capital, then you shouldn’t invest in something that generates an 80% return on capital. It’s crazy.” (Buffett) “A corporation’s cost of capital is 1/4 of 1% below the return on capital of any deal the CEO wants to do. I’ve listened to many cost of capital discussions and they’ve never made much sense. It’s taught in business school and consultants use it, so Board members nod their heads without any idea of what’s going on.”

  • Asset Allocation “Asset allocation recommendations put out by Wall Street – 65% in stocks, a certain percentage in bonds and cash – [are] total nonsense.”

  • Derivatives (Buffett) “I don’t think managers of derivatives know what’s going on, much less outsiders reading the annual report.” (Munger) “The derivatives business suffers from the accounting profession selling out yet again. It’s an irresponsible system. The whole system of accounting [for derivatives] is wrong.”

Where One ‘Expert’ Went Wrong

In light of these comments, The Australian Financial Review’s (30 April) assessment is worth repeating: Berkshire’s “emphasis on business morality, transparency and long-term investing” has during the past year been vindicated and thereby “constitut[es] a victory of old-fashioned American capitalism over the excesses of the late 1990s technology boom.” In sharp contrast, and according to Peter Elkind’s article Where Mary Meeker Went Wrong (Fortune, 14 May), “Meeker has become. the single most powerful symbol of how Wall Street can lead investors astray. For the past year, as Internet stocks have crumbled and entire companies have vaporized, Meeker has maintained the same upbeat ratings on her companies that characterized her research reports in the glory days. For instance, of the 15 stocks Meeker currently covers, she has a strong buy or an outperform rating on all but two. Among the stocks she has never downgraded are Priceline, Amazon, Yahoo, and FreeMarkets – all of which have declined between 85% and 97% from their peak. For this she has been duly pummelled in the press, accused of cheerleading for Morgan Stanley’s investment banking clients.”

Elkind continues: “in responding now to criticism that she let investors down, Meeker refuses to admit – or even see – how compromised she is. She [has stated that] ‘if you take a company public and you are really aggressive on the downside, it can be devastating.’ Of course, if you’re not aggressive on the downside, it can be devastating for investors. But that was never a Meeker priority.”

Fortune’s 14 May edition contains three other sobering articles. According to its website, Betrayal on Wall Street explains how the IPO market became a racket in which banks consistently short-change the startup clients they’re advising in order to create quick profits for institutional traders. In Hear No Risk, See No Risk, Speak No Risk we learn how a chorus of telecom analysts overlooked warning signs at a company called Winstar and kept croaking ‘buy’ right up until this broadband wannabe choked on its own debt. And in his confessional essay Diary of a Financial Pornographer, Nelson Schwartz takes a hit for all of us at Fortune and in the media who got caught up in the bubble madness.”

To the list of incidents of madness and mass hysteria nominated by James Grant in the opening quote we can therefore add a much more recent entry: people who believe that all journalists report dispassionately, that all brokers and ‘analysts’ act in investors’ interests – and trust them when they counsel that tech and IT stocks are worth buying at any price.

Chris Leithner


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