Leithner Letter No. 2
26 February 2000

Is Australia Really a Low-Inflation Country?

On 2 February the Reserve Bank of Australia increased the official cash rate, the rate of interest applied to funds lent between banks and other institutions, from 5.0% to 5.5%. It did so, according to the statement which accompanied its decision, partly because it detected incipient signs of inflation in the Australian economy. A vociferous band of critics, however, has discounted both actual and incipient inflation and contended that higher interest rates will harm businesses and consumers. Despite their differences, three key assumptions (which, it seems to me, have been completely overlooked coverage and discussion of interest rates) unite these disputants: first, Australia is a low-inflation country; second, disinflation and low interest rates underpin the robust growth which has been achieved in recent years; and third, the lower the rates of inflation and interest, the longer the current prosperity will prevail. Similar debates, conducted by similar coalitions of support and opposition, are being conducted in Britain, Canada and the U.S.

I dissent from both groups and these shared assumptions.

Value Investing During the Internet Mania

The Internet is one of the greatest paradoxes of our times. It was originally conceived and built on a non-profit basis, and (thus far at least) few “Internet companies” have reported sustained profits from their operations. Yet hundreds of billions of dollars – and billions more with every passing week – are resting upon the conviction that the Internet will generate enormous returns to those entrepreneurs and their shareholders who can unleash its apparently limitless commercial potential. The resolution of this paradox clearly has tremendous implications for investors. Is the Internet an unprecedented bonanza? Has it been hyped into a bubble of speculative excess which must at some point burst? Should investors change their principles in response of its development?

Partially as a consequence of the intense focus upon the Internet and technology companies (and the associated spotlight upon telecommunications and media companies), value investing – the practice of buying established and profitable companies at prices less than their intrinsic value – has become distinctly unfashionable. Indeed, Warren Buffett, CEO of Berkshire Hathaway, Inc., self-made billionaire and the most prominent and successful value investor, has during the past several months been the subject of considerable adverse comment (a subject to which I will return in a subsequent newsletter).

I have thought long and hard about these issues over the past several months, and set out the results of my thinking in a six-part circular to shareholders. (An abridged version appeared in the Australian Financial Review on 13 January.)

Underlying e-infrastructure, e-business and e-commerce are economic principles which, starting from first principles and reasoning deductively, a startling conclusion becomes apparent: the economic fundamentals of e-business and e-commerce are far less favourable than e-entrepreneurs and their shareholders seem to believe.

Reasoning again from first principles, the consequences of these economic fundaments for Internet Service Providers (ISPs) shows how the conviction that the Internet will inevitably yield huge profits is attracting fierce competition; and this competition, in turn, is necessitating network diversification, joint ventures, mergers and “bundling” of network infrastructure and media content. Hence the AOL-Time Warner merger and the recent meteoric rise of News Limited shares.

The same holds true for e-business and e-commerce ventures. Despite their generally problematic fundamentals, the prospects of e-commerce and e-business firms need not necessarily be unfavourable. Indeed, of the new approaches to business made possible by the Internet, e-business “Infomediaries” have the potential to produce sustainable profits. They might also improve significantly the efficiency of “Old Economy” industries such as chemicals, transport and steel.

It was thought initially that the Internet would mainly be an e-commerce phenomenon, and that it would make money from its rapid dissemination of explicit information and sale of physical goods. It has long been fashionable to disparage the relevance of the knowledge of the particular circumstances of person, time and place. But it now appears that e-business, thanks to the recognition and use of implicit knowledge, may reorganise entire industries. The description of the (market) mechanism by which implicit knowledge can be disseminated is, according to Austrian School economists such as Friedrich von Hayek and Ludwig von Mises, the central task to which economics should be devoted. It is therefore apt that the Internet, a largely unintended consequence of advances in computing and telecommunications technology, is providing one such mechanism.

Most investors appear to be either oblivious to or dismissive of the economic fundamentals of e-business, e-commerce and e-infrastructure. Nor has the great difficulty of assessing the intrinsic value of e-business and e-commerce firms deterred them. Quite the contrary: if anything, ignorance of these particulars has only increased and emboldened speculators’ convictions about the Internet and the “New Economy.” Today’s market participants are thus treating the Internet and technology companies much like their forebears treated the communications innovations of yesteryear. Therein lie great dangers.

Even a casual perusal of economic history demonstrates that technology affects businesses and their customers in significant ways. Equally clearly, improvements in communications, of which the Internet is the latest major innovation, have been occurring steadily since the mid-nineteenth century. It is therefore possible that the Internet’s undoubted benefits will eventually diffuse so widely that, much like the telephone and fax machine, the ‘Net becomes part of the basic commercial infrastructure which all enterprises must use in one way or another in order to remain in business. If so, then established companies which harness the opportunities provided by Internet and other technologies (as opposed to the developers of those technologies) may benefit most therefrom.

Two points should be emphasised in regard to the approach that I am taking towards the Internet and ‘Net-related phenomena.’ First, I have no idea (nor, I believe, has anybody else any credible idea) how long Internet- and technology-inspired excesses will last. Nor do I know what will change the behaviour of the governments, lenders and speculators which are fuelling them. The fact that they are motivated by greed, fear and sheer folly is predictable; but the timing and sequence of these emotions are not. Hence the less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct ours.

Second, the key to successful investing ultimately has nothing whatever to do with predicting the growth of a particular technology (Internet, biotech, pharmaceutical or whatever) or which company will emerge as its principal or most profitable provider. Still less has it anything to do with predicting how a particular technology is going to affect the economy or society at large. The keys to successful investing – as Benjamin Graham outlined them during the 1930s and as Warren Buffett, Walter Schloss and other value investors have practised them successfully since the 1950s – remain the estimation (using cautious and conservative assumptions) of individual companies’ intrinsic value and the purchase of their securities when they are available at a discount to that value. The advent of Internet and other technologies do not affect – and still less do they upset – these principles.

Chris Leithner


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