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Leithner Letter No. 21
26 September 2001

If the reason people invest is to make money, then in seeking advice they are asking others to tell them how to make money. That idea has some element of naïveté ... [and] it is when the investor demands more than an average return on his money, or when his adviser undertakes to do better for him, that the question arises whether more is being asked or promised than is likely to be delivered.

Benjamin Graham, The Intelligent Investor

Things Brokers Say

Benjamin Graham’s major works were first published during the early 1930s and late 1940s. Yet as more and more market participants are coming more and more painfully to realise, and The Wall Street Journal recently recognised (“Investment Books Turn More Bearish Following the Stock Market’s Tone,” 30 August 2001), these works’ themes are as relevant today as they were fifty or more years ago. To cite just one example, in The Intelligent Investor Mr Graham criticised the fact that “aside from forecasting the movement of the general market, much effort and ability are directed in Wall Street toward selecting stocks or industrial groups that in matter of price will ‘do better’ than the rest over a fairly short period in the future.” Graham did so because this endeavour “is [not] suited to the needs and temperament of the true investor. As in all other activities that emphasize price movements first and underlying values second, the work of many intelligent minds constantly engaged in this field tends to be self-neutralizing and self-defeating over the years.” Alas, many Australian market participants are presently in a position to confirm the destructive results of such behaviour.

As a contemporary example of this ubiquitous phenomenon, consider a circular dated 13 August 2001 signed by a Senior Client Advisor (let us call him Fred) who claims more than 20 years experience and is employed by a major multi-national broker with branches across Australia. Half of the circular’s contents appears under the heading Fred’s Specials – Stocks I Expect Could/Should Double (or More) Over the Next Twelve Months. Fred’s statements with respect to the items on his list can be grouped into three categories:

  1. Reassurances: “shares in the following companies are relatively small market capitalisation stocks that I follow very closely. ... Every recommendation on my ‘specials’ list is value-based on current and potential future fundamentals.”

  2. Incitements of Clients’ Greed: “the common thread linking [these companies] is that I believe they all have the potential to provide investors with exceptional capital growth over the next twelve months (without high risk).”

  3. A Virtual Declaration of Prescience: “each and every one of the following stocks has multiple drivers and/or features which have the potential for generating significant market interest in the company’s stock – both initially and ongoing. ... When these certain events occur, [their] share prices will escalate accordingly.”

With respect to the first entry on the list (its name is not relevant; hence let us, with apologies to Pierpont, The Australian Financial Review’s most insightful correspondent, call it Blue Sky Mines NL), Fred makes a series of specific statements. These statements, closely mirroring the general statements about the list as a whole, also fall into three categories:

  1. Technical Gobbledeegook: Blue Sky Mines “has the fully patented EARS and ERMS processes for converting ilmenite in mineral sands into titanium dioxide pigment. ...”

  2. Momentous Events Which Will Occur Shortly: “in July 2000 the company signed a major joint venture agreement with X Ltd ... [and] future significant developments are in the pipeline. ... Recognition of BSM’s key strategic value ... is rapidly increasing [and] the Y Joint Venture is very close to announcing [that] plant construction is about to commence. ...”

  3. A Virtual Assurance That This One’s Gonna Be a Gusher: “various stockbroker reports have given BSM shares a valuation of between $0.40-$0.50 [versus its current price of $0.11]. ... I believe BSM’s share price has a very high probability of more than doubling over the next twelve months.”

Six Things This Broker Didn’t Say

Fred’s words about BSM paint an alluring picture. Indeed, the depiction is so enticing that his clients, anticipating a stampede into the company, might be tempted to request that Fred immediately add parcels of its shares to their portfolios. Before doing so, however, it is instructive to note that no description of a company, however detailed and well-intentioned as this one undoubtedly is, can include all relevant particulars. Granting this limitation, it is nonetheless intriguing that Fred’s enthusiastic description of BSM’s future omits any analysis – indeed, any mention – of its past. Equally intriguing, whilst there is much detail about BSM’s potential, mention (to say nothing of a summary) of its actual operating results, past or present, is nowhere to be seen. It is therefore interesting that, in sharp contrast to Fred’s soft words, the hard numbers from BSM’s financial statements tell a grim tale.

BSM’s financials for the financial years 1991-1992 to 1999-2000 (as of 31 August it had not yet reported its results for 2000-2001) are summarised in the table below. Rows 1 and 2 indicate that its operations have not (to put it mildly) produced rivers of gold. Quite the contrary: in only one year has its operating cash flow been positive; and its earnings have never been positive. Having no history of earnings, it comes as no surprise (Row 3) that BSM has no history of paying dividends. BSM, to adopt the phrase of which many brokers are fond, is clearly a very consistent performer. The catch is that its operations have consistently lost rather than made money.

The Operating Results of Blue Sky Mines:
Not A Beautiful Set of Numbers

Row Criterion 1992-1993-1994-1995-1996-1997-1998-1999 2000
1 Cash Flow
(Cents per Share)
-0.71.5-2.3-0.7-0.6-0.5-0.4-0.2 -0.4
2 Earnings
(Cents per Share)
-0.8-0.6-1.6-1.9-1.8-0.6-0.9-0.3 -0.4
3 Dividend
(Cents per Share)
---------------- --
4 No. of Shares
(Millions)
115.6-129.2-154.2-168.8-188.6-217.2-245.8-275.1 305.2
5 Return on Assets (%) -15.5-10.9-23.2-36.1-47.8-16.0-34.3-8.7 -10.4
6 Return on Equity (%) -16.5-11.2-23.8-37.6-49.7-16.3-35.0-9.0 -10.7

The question thus arises: how on earth can a company that has lost money for a decade remain in business? Row 4 provides a clue: each year BSM has issued shares (presumably, although I have not confirmed it, in exchange for cash). It has done so at a ferocious pace: its annual rate of issuance has been at least 9.5% of its share capital (1994-95), has been as high as 19.3% (1992-93) and has averaged 13.0% per annum. From these figures one is tempted to surmise that BSM derives its working capital not from its own operations but rather from an annual drip-feed provided by existing and new shareholders.

Without this form of outpatient care BSM would be hard pressed to sustain itself. How has BSM managed the fixed capital provided by its owners? Its uninterrupted history of losses (Rows 1-2) tells us much of what we require to answer this question, and Rows 5-6 tell us the rest. To divide a company’s earnings for a financial year by its average total assets during that year is to compute its return on assets (ROA); to divide its after-tax earnings by shareholder’s equity (i.e., assets minus liabilities) is to compute its return on equity (ROE). The more a company uses creditors to finance its operations the greater the extent to which ROE will tend to exceed ROA. The larger a company’s assets relative to its liabilities, on the other hand, the more ROA will approximate ROE. BSM’s average ROA for the period 1992-2000 is minus 22.5% and its average ROE is minus 23.3%. BSM, then, has relied little or not at all upon creditors to finance its steady and hefty losses. Why should it? Its uninterrupted history of losses is likely to deter them; and besides, shareholders have year after year been prepared to keep the company on life support – despite receiving not a penny of return and in the process significantly depleting their capital.

Driver’s Licenses Versus Fishing Licenses

Assuming that Fred is diligent and his statements are sincere (we have no reason to think otherwise), it is nonetheless difficult to say whether his glowing description of Blue Sky Mines, as we have dubbed it, tells us anything significant about its future operations. The Great Things that Fred confidently prophesies might indeed occur; yet nowhere in his circular are the premises, reasoning and evidence which yield grounds to believe that these Great Things will subsequently generate a sustainable stream of earnings.

Conversely, Fred’s description, despite its undoubtedly good intentions, omits much that is significant about BSM’s past operations: bluntly, whatever has occurred in the past has not produced profits. Fred’s focus of attention on future events and prices, and his seeming lack of interest in past events and their inability to generate earnings, thus speaks (implicitly, inadvertently but nonetheless loudly) volumes about Fred – and, as Internet, biotech and other New Economy stocks have returned to earth, not a few other Australian brokers. In this crucial respect the Cult of Capital Gain is unbroken and a key lesson of the past eighteen months remains unlearnt.

It is therefore tempting to conclude, as Richard FitzHerbert suggests in his excellent book Blueprint for Investment: An Approach for Serious Long-Term Investors (Melbourne, Wrightbooks, ISBN 0 947351 66 3), that advisers like Fred in effect hold fishing licenses rather than driver’s licenses. To obtain and retain a driver’s license one must do more than merely pay a prescribed fee: one must also demonstrate some minimal ability safely to operate a specified category of vehicle. In contrast, to hold a fishing license does not presuppose any ability to catch fish. Indeed, from the point of view of the licensor it is preferable that no such ability exists; for, given some number of fish, more licenses can be issued and revenue raised. Rather, the possession of a fishing license establishes that the licensee has paid a fee and that, if its holder remains within the rules, he will not be fined if he is caught fishing.

This, from the point of view of the licensee, is very fortunate. According to The Wall Street Journal (15 August 2001), “Wall Street analysts – those professional stock-pickers who should know all about the subject – appear to have played hooky the day it was taught in business school. A study of analysts’ picks over the past three years shows that the stocks they rated ‘buy’ or ‘strong buy’ had far more risk than the average stock in the market and only marginally higher returns. Not only should investors have avoided the stocks that Wall Street was touting, the study said, but also they should have actually bought the stocks on which the analysts were lukewarm. ... The study helps to explain why Wall Street analysts looked so prescient as stock markets soared in the late 1990s. And it shows why so many of them have been so wrong since then.”

Things to Say to Brokers

It follows that at least some advisers, analysts and brokers, their confident assertions about future developments, prices, etc. notwithstanding, actually have feet of clay. Clearly, then, in order to separate alleged experts’ wheat from chaff individual investors must inform and educate themselves. In Graham’s words, “the investor will gear his expectations and the character of his security operations to the development of his own knowledge and experience in the field. .... [and] the intelligent investor will not do his buying and selling on the basis of recommendations received from a financial service [i.e., bulletins, newsletters and the like]. Once this point is established, the role of the financial service then becomes the useful one of supplying information and offering suggestions.”

It is not inconceivable that advisers, analysts and brokers can provide a salutary educational service. Most notably, in response to a claim that a particular recommendation is value-based on current and potential future fundamentals, the investor might ask “can you please justify that claim? Give me the premises, reasoning and evidence (based upon an analysis of operating results over the past 5-10 years) which yields grounds that corroborate what you so confidently assert.”

Individual investors must also recognise advisers,’ analysts’ and brokers’ incentives – and the reality that these incentives and investors’ material self-interest need not co-incide. In Graham’s view, expressed in The Intelligent Investor, “in the past Wall Street has thrived mainly on speculation, and stock-market speculators as a class were almost certain to lose money. Hence it has been logically impossible for brokerage houses to operate on a thoroughly professional basis. To do that would have required them to direct their efforts toward reducing rather than increasing their business.”

Further, “most stock-exchange houses ... still adhere to the old-time slogans that they are in business to make commissions and that the way to succeed in business is to give the customers what they want. Since the most profitable customers want speculative advice and suggestions, the thinking and activities of the typical firm are pretty closely geared to day-to-day trading in the market. Thus it tries hard to help its customers make money in a field where they are condemned almost by mathematical law to lose in the end.” Accordingly, in response to a claim such as “I believe BSM’s share price has a very high probability of more than doubling over the next twelve months” the investor might well ask: “so you’re willing personally to guarantee in writing that my outlay of capital will be refunded in full if this ‘sure thing’ does not eventuate?”

Above all, individual investors must exercise caution and caveat emptor (“let the buyer beware”). The intelligent investor, says Graham, “should be wary of all persons, whether customers’ brokers or security salesmen, who promise spectacular income or profits. This applies both to the selection of securities and to guidance in the elusive-and perhaps illusive-art of trading in the market. ... Thus the security buyer who wants to avoid being influenced by speculative considerations will ordinarily have to be careful and explicit in his dealings with his customer’s broker; and he will have to show clearly, by word and deed, that he is not interested in anything faintly resembling a stock-market ‘tip.’”

Accordingly, in response to a claim such as “each and every one of the following stocks has multiple drivers and/or features which have the potential for generating significant market interest in the company’s stock – both initially and ongoing. ... When these certain events occur, [their] share prices will escalate accordingly,” the intelligent investor might well laugh and reply: “I’m an investor, not a speculator. I’m interested in tangible businesses and hard numbers about their results – not in trading pieces of paper and soft words about stock prices. And speaking of short-term price fluctuations, on what basis do you presume to predict them? Your breezy confidence implies that you’ve read neither William Sherden’s The Fortune Sellers: The Big Business of Buying and Selling Predictions (John Wiley & Sons, 1999, ISBN: 0471358444) nor Burton Malkiel’s A Random Walk Down Wall Street (7th ed., 2000, W.W. Norton & Company, ISBN: 0393320405), both of which dispute – and probably refute – claims that any individual can predict these things. Besides, if you were able consistently to foresee price movements, you’d be famous, retired and living in the lap of luxury!”

In Graham’s perhaps-optimistic words, “Once the customer’s broker understands clearly that he has a real investor on his hands, he will respect this point of view and cooperate with it.”

Chris Leithner


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