Leithner Letter No. 18
26 June 2001

The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.

Ernest Hemingway, “Notes on the Next War”
( Esquire, September 1935)

As markets are cyclical, so is the neighbourhood of Wall Street; and as stocks and bonds shuttle between extremes of optimism and pessimism, so does the real estate of lower Manhattan. The real estate story clarifies and illuminates the financial one.

James Grant
The Trouble With Prosperity (1998)

Stocks partly sell like bonds, based on expectations of future cash streams, and partly like Rembrandts, based on the fact that they’ve gone up in the past and are fashionable. If they trade more like Rembrandts in the future, then stocks will rise, but they will have no anchors. In this case, it’s hard to predict how far, how high, and how long it will last. If stocks compound at 15% going forward, then it will be due to a big ‘Rembrandt effect.’ This is not good. My guess is that we won’t get extreme ‘Rembrandtization’ and the returns will be 6%.

Charles Munger
2001 Wesco Financial Corp. AGM

Mr Munger Speaks

Charles Munger is well-known as the Vice-Chairman of Berkshire Hathaway, Inc. Somewhat less recognised has been his leading role during the past quarter-century at Wesco Financial Corp. Like Benjamin Graham and Warren Buffett, he is a formidable businessman and investor who takes care to disseminate – in his trademark plain and blunt language – the fundamentals of good investment and business practice. Perhaps his most enduring contribution, also like Mssrs Graham and Buffett, is his repeated demonstration that good businesses, investments and ethical principles not only go hand-in-hand: one is always a necessary and often a sufficient condition of the other. For these and other reasons his Letters to Wesco Shareholders repay careful study. 

Similarly, the notes of and report by Whitney Tilson of Tilson Capital Partners LLC, who attended Wesco’s recent 2001 Annual General Meeting, are well worth reading. Like the notes he made at Berkshire’s 2001 AGM, Mr Tilson cautions that the Wesco notes have been reconstructed from 20-odd pages of longhand scribbled rapidly over several hours. They 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. (Tilson’s notes from Wesco’s 2000 AGM are also available on-line).

Mungerisms from Wesco’s 2001 meeting include:

  • Future Returns from Equities “In certain periods, we have a hell of a time finding places to invest our money. We are in such a period.”

  • The Recent Stock Market ‘Decline’ “What you’ve recently seen is just a tea party. If you, like me, lived through 1973-74 or even the early 1990s. there was a waiting list to get OUT of the country club – that’s when you know things are tough. If you live long enough, you’ll see it.”

  • The Scandal of Accounting in American Superannuation Funds “IBM just raised its return expectations for its pension fund to 10%. Most companies are at 9%. We think 6% is more realistic. They may believe it – they’re honest people – but subconsciously they believe it because they WANT to believe it. It makes earnings good so they can promote the stock. The reason accountants don’t say anything is best summed up by the saying, ‘Whose bread I eat, his song I sing.’ I think you’re getting very foolish numbers in American accounting. I don’t think it’s wilful dishonesty, but it might as well be.”

  • University Academics “In modern academia, there’s no shame. People are taught Beowolf, but can’t think their way out of a paper sack.”

  • The Decline of American State Schools “You could argue that [this decline] is one of the major disasters in our lifetimes. We took one of the greatest successes in the history of the earth and turned it into one of the greatest disasters in the history of the earth.”

Some (More) History and a Question

According to Daniel Turov (“Mixed Message,”Barron’s 21 May 2001), “bear markets don’t act like a medicine ball rolling down a smooth hill. Instead, they behave like a basketball bouncing down a rock-strewn mountainside; there’s lots of movement up and sideways before the bottom is reached. Instead, during the Great Bear Market from 1929 to 1942, the Dow Industrials had rallies of 48% (from November 13, 1929, to April 17, 1930), 94% (July 8, 1932, to September 7 of that year), 121% (February 27, 1933, to February 5, 1934), 127% (July 26, 1934, to March 10, 1937), 60% (March 31, 1938, to November 12 of that year), and 28% (April 8, 1939, to September 12 of that year). Yet, on April 28, 1942, the DJIA was still at only 92.92, 76% below its September 3, 1929, high of 381.17.” 

Turov adds that “when the bulls stop asking, ‘is this the bottom?’ and instead are explaining to their friends why ‘this time it’s different, and the market really is a bottomless pit,’ then it will be time for me to pen ‘Buy Signal, Part 2.’ But we’re a long way from that.”

Turov concludes “the Dow first reached the 100 level in January 1906. It traded above and below that level for more than 36 years; it wasn’t until May 1942 that the market left 100 behind for the last time. The Industrial Average first reached 1000 in February 1966. It traded above and below that level for the next 17 years, leaving that figure behind for the last time in February 1983. The Dow first reached the 10,000 level in March 1999. Considering the unprecedented gains of the past several years, would it be that unusual for this benchmark to take a decade or even two before leaving 10,000 in the dust for the last time?”

Another Question: Is ‘Smart’ Money Intelligent?

In the Preface to the more recent editions of Benjamin Graham’s The Intelligent Investor, Mr Buffett stated that “to invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework. ...” An article circulated on the Dow Jones Newswire on 15 May, and published in the June 2001 issue of SmartMoney magazine, corroborates Mr Buffett’s proposition. 

The article, by Eleanor Laise, is entitled If We’re So Smart, Why Aren’t We Rich? The Inside Story of How a Select Group of the Best and the Brightest Managed to Bungle the Easiest Stock. It profiles an investment club whose “recent record has been nothing short of a fiasco, thanks to an overweighting in trendy tech stocks and pitifully bad timing. All told, the club saw the value of its assets fall by more than 40 percent over the past 12 months.” One member confides that “we can screw up faster than anyone else”; another, a member since the mid-1960s, describes its investing strategy as “buy low, sell lower.” During the past 15 years the club has returned an average of 2.5 percent per annum (versus, for example, the S&P 500’s 15.3 percent).

Laise writes that it “sounds as if this group could really use an intelligent investing strategy. And that’s ironic, given who its members are. This is the Mensa investment club. That’s right, Mensa, the organization founded in England in 1946 with the aim of assembling the brightest Britons to advise the government in times of crisis. The cost of admission: an IQ in the 98 th percentile (or better). A half-century later the organization, which Vanity Fair once dubbed ‘a dating service for dorks,’ has 47,000 members in the U.S. (100,000 worldwide) and one of the sorriest investment clubs you will ever see.”

The club’s stock-selection chairman and editor of its newsletter says “it was my hope that a special-interest group within Mensa would have the intellect that would give us some kind of advantage.” What, then, explains the disparity between club members’ formidable IQs and derisory results? Laise provides a strong hint: during the past 15 years its chairman-editor has also been “a committed chartist and incorrigible techie [who] has transformed the club, which has $70,000 in assets, from a small-cap, value-oriented group to a highflying, momentum-buying Nasdaq nightmare. The centerpiece of his strategy is the TC 2000, a technical charting program that seems like a prop from the set of Star Trek. [According to the chairman-editor], ‘this program is the coolest thing. You can show various types of graphs and add indicators, like linear regression, moving average, Bollinger bands. Then there’s volume, stochastics, MACD, time-segmented volume, stuff like that. You can add all kinds of indicators and really confuse yourself.’”

TC 2000 has dictated that the club frequently change its approach to ‘investing.’ Quoth the chairman-editor: “I keep readjusting our strategies every quarter or so. My latest is to watch the 10-day versus 40-day moving average of relative strength compared to the S&P 500.” Laise adds that constant monitoring of technical price indicators has led the club to trade at a dizzying rate. In 2000 it made “88 trades, or roughly one every three trading days. And instead of searching out the solid small caps that were once the heart of the club’s strategy, [it] zeroes in on trendy tech stocks with sky-high valuations.”

Indeed, according to Laise the club’s president-editor “touts his technical indicators on the financial website ClearStation, where he enjoys ruminating on chart patterns. ‘That’s a bullish formation,’ the president explains, tracing the pattern of one large dip followed by a smaller dip. ‘The second dip is people who bought in at the bottom, saying, Oh, gosh, it’s caught back up to where it was. I want to get out here. Then you have everybody out who’s gonna get out based on all this dippy crap, and then you figure for all the rest of the people it’s going to be buying activity.’” 

Laise quotes the high-IQ president-editor’s description of his method of analysis: ‘“I’ll go out and see what these idiots [on ClearStation] have to say about [the chart of a stock’s price], because sometimes they’ll observe something about the chart that I didn’t see.’ He admits he’s taken some of the club’s stock picks straight from Internet message boards.” The president concludes that the club “is philosophical about [my] stock picks. ‘The philosopher Karl Popper had the idea that we learn mainly by making mistakes. That’s been part of [my] approach.’” 

Laise leaves the reader to draw a fundamental inference: that some people, allegedly among the world’s most intelligent, are actually – in the senses that they proceed without a remotely coherent or justifiable framework, and after fifteen years of failure are apparently incapable of learning from their mistakes – astonishingly inefficient and ineffective. 

A New Financial Year

For Australia’s taxpayers and most of its corporations (including Leithner & Co. Pty Ltd), the financial year begins on 1 July and ends on 30 June. The autumn and winter are therefore appropriate times to conduct two exercises. The first is to contemplate the twists and turns, triumphs, trials and tribulations of the financial year just ended; and the second is to subsume these events within broader principles, revisit these principles, learn one’s lessons and adjust one’s sails for the new year.

Regardless of the extent of any rebound of economic activity in Australia, and particularly in light of the record highs they reached in mid-May, the prices of the ‘blue chip’ equities which comprise the bulk of the All Ordinaries and related indexes are prohibitively dear. 

This result is not a prediction that the prices of Australian equities will fall – for all I know – and I clearly don’t – they might increase substantially. Rather, to the extent that it necessitates buying and selling shares of Australia’s largest listed companies, the achievement of results which even remotely approximate those presently expected by most market participants must necessarily rely upon emotional and speculative and not cognitive and investment operations. For these reasons the case for caution remains just as strong in the new financial year as it was in 2000-2001. 

There are some wider and disturbing implications of these results. First and foremost, not many market participants (Mssrs Buffett and Munger are prominent exceptions) seem to recognise the disparity between expected and reasonable results. In sharp contrast, more than a few, apparently including some of Mensa’s high-IQ market participants, are confidently spouting egregious nonsense. Others, including some major institutional investors, are parroting things they want to believe or, like Dr Pangloss, expressing the optimistic hope that all will come good and they will land on their feet. For many, the lessons of the ‘tech wrecks’ of 2000 and 2001 – i.e., that price and value are distinct phenomena, that price may for a time exceed value but that it must eventually regress to it – remain unappreciated and therefore unlearnt. Many continue to obsess about prices and their near-term fluctuations and remain resolutely oblivious about enduring value.

Chris Leithner


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