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Leithner Letter No. 29
26 May 2002

...We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, [Vice Chairman Charles Munger] and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.

Warren E. Buffett
1992 Letter to Shareholders

A lot of what passes for financial journalism is little more than titillating investment pornography. Hot stocks? Superstar stock funds? Short-term market predictions? You won’t find that garbage here. ... If you are looking for stock tips, look elsewhere.

Jonathan Clements
The Wall Street Journal (21 April 2002)

Journalists, Analysts and Reigns of Error

In ancient times, seers “read” the entrails of sheep. Today, in neither a literal nor a figurative sense does it take much guts in order to make forecasts; but given their ubiquity and the credulity with which many people receive them, it takes great fortitude to ignore forecasts.

Benjamin Graham and Warren Buffett, outstanding investors whom many celebrate but few emulate, pay (or, in Graham’s case, paid) no attention to “experts” and their predictions. Why? Because the ability of economists to foretell inflation, interest rates and the like – and of brokers and analysts to foresee financial markets’ general direction, companies’ earnings and the prices of individual securities – is at best very limited and often non-existent. As The Economist (16 March) observed, “the secret of successful forecasting is to give a number or a date but never both. ... How well did our panel [of private-sector economists] do? Embarrassingly: their forecasts missed by a mile” (see also William Sherden, The Fortune Sellers: The Big Business of Buying and Selling Predictions, John Wiley & Sons, 1999, ISBN: 0471358444; and Scott Schuh of the Federal Reserve Bank of Boston.

For this reason, and unlike most other market participants, investors in the Graham-Buffett mould particularly distrust effusions of warm and woolly words. Instead, they embrace hard logic, cold figures and dour assumptions concerning the long term compounding of capital and streams of income. Buffett’s Berkshire Sees Lower Returns Than Most Pension Funds by Miles Weiss, published by Bloomberg on 20 April, is a good example. They therefore think for themselves, conduct their own analyses and keep their own counsel. Accordingly, and for many of the reasons described by journalist Bernard Goldberg (Bias: A CBS Insider Exposes How the Media Distort the News, Regnery, 2001, ISBN: 0895261901) and cognitive psychologist Massimo Piattelli-Palmarini (Inevitable Illusions: How Mistakes of Reason Rule Our Minds, John Wiley & Sons; 1996, ISBN: 047115962), they take at face value little of what they read in newspapers and magazines; accept without careful consideration and corroboration even less of what they hear on radio and television; and run as fast as their legs can carry them from “tips” in newsletters and chat sites on the Internet.

Journalists tend to pitch an undifferentiated message to a conformist audience. The economic and other structural characteristics of the mass media predispose journalists (however punctilious their personal predilections and unshakable their ethical standards) and the experts whom they cite towards two particular tendencies. The first is a short-term focus that manifests itself in an obsession about assets’ prices (as opposed to values); and the second is a dramatic and sensationalist imperative that is reflected in a fixation upon recent developments – and opinions, conjectures and rumours about these developments.

If investing can render people uncertain and therefore prone to an erratic herd mentality, then the economic characteristics and structural biases of the mass media can unwittingly increase the size, accelerate the charge and accentuate the impulsiveness of this herd. And although single lemmings are seldom either criticised or ostracised (psychological safety seems to reside in large numbers, no matter how crazy the behaviour of the group), lemming-like behaviour often ends in tears. Prompted to a significant extent by what its audience wants to hear, the mass media’s conformist message both reflects and is prone to what Mr Sherden has called a “reign of error.” This point underlies Why Smart People Make Big Money Mistakes and How to Correct Them: Lessons from the New Science of Behavioral Economics by Gary Belsky and Thomas Gilovich (Fireside, 2000, ISBN: 0684859386).

Journalists, Analysts and Mr Market

A specific example of this general phenomenon, in the form of three reports by two prominent and reputable financial journalists, appeared in The Australian, this country’s largest national-circulation broadsheet, between 18 and 29 April. The report dated 18 April began with the sentence “Telstra’s share price kick yesterday on higher than average volume of 27.4 million shares can’t be interpreted yet as the anxiously awaited recovery for the [telecommunications company or ‘telco’], but there is growing awareness among investors that the stock is fundamentally undervalued. ...” also stated that a telecommunications industry analyst at a prominent multinational brokerage firm “was brave enough to tip a share price of $5.60 to $5.70 by the end of the year. He’ll probably be found to have been conservative.” (Leithner & Co. has never owned, nor presently intends to own, shares of Telstra Corp. Ltd).

These contentions resemble (but, thank heavens for small mercies, are not nearly as egregious as) the virtual declarations of omniscience by the Senior Client Advisor whose crystal ball was scrutinised in Letter 21. They therefore invite the same riposte: “I’m an investor and not a speculator. I’m interested in tangible businesses, hard numbers about their operations and cautious assumptions about their prospects. Because they usually end in tears, I’m not interested in trading pieces of paper, soft words about stock prices and idle speculations about the future. And speaking of prices and prospects, on what basis do you presume to predict them? Your breezy confidence implies that you’ve read neither Sherden nor a host of other studies that, considered as a whole, refute the claim that one can accurately forecast these things. Besides, if you were able consistently to foresee short-term movements of prices, you wouldn’t need a day job and would instead repose in the lap of luxury!”What reasoning underlay this journalist’s bullish contention about Australia’s largest telecommunications company? Although it was not presented explicitly, the argument justifying this conclusion about Telstra seemed to consist in three premises:

  1. If a company’s past and present operations and future prospects are demonstrably better than those of certain other companies, and if the price of its shares does not reflect this superiority, then the company is “undervalued” vis-à-vis the comparison companies.

  2. If a particular security is “undervalued” relative to comparable securities, then its price will subsequently increase such that the undervaluation disappears.

  3. Telstra’s operations and future prospects are demonstrably better than those of certain other telecommunications companies and large Australian companies

Relative Versus Intrinsic Value

The Australian (18 April) described Telstra not in absolute but in relative terms; and it extolled not just its operations but also its earnings and the market price of those earnings. “Telstra looks good compared with other large and medium-sized telcos globally. ... Its rivals are gradually weakening as the competition intensifies – the latest being Telecom New Zealand, which will have to take a writedown of at least $1 billion on its ill-fated and highly-overpriced AAPT acquisition. ... In the meantime, those Australian telcos ready to have a go at the tough and slow business and data market are cutting their throats vying for business. Telstra is hurting in this market, too, but it will still be standing well after its smaller rivals quit this particular game. When IT managers are given the go-ahead by their chief financial officers to start spending again in a year or two, those left standing will do very nicely. [In Europe] ... telcos still trade at a premium of up to 50 per cent to the overall market. Dutch telco Telia is on a prospective price-earnings multiple of 41 times, Deutsche Telekom is on 38 times, France Telecom is 24 times and poor old [British Telecom] is on 18 times. [In contrast], Telstra trades at a discount to the Australian market. At yesterday’s 10¢ higher closing price of $5.29, it’s on 16.6 times 2002 estimated net earnings of $4 billion, while the ASX (minus the banks) is 21 times.”

Stated explicitly and in this form (and hence running the risk that we have inadvertently misconstrued his intended meaning), the journalist’s second implicit premise is susceptible to two objections. First, accepting for the moment that Telstra is “undervalued” relative to certain other companies, and assuming that market prices eventually adjust such that the mispricing of one security relative to another disappears, two possibilities present themselves. The first is indeed that the price of Telstra increases relative to those of its comparison securities; but the second is that the prices of the comparison securities decrease vis-à-vis that of Telstra. To say that Telstra is undervalued with respect to certain other companies is necessarily to say that those companies are overvalued with respect to Telstra; and if one grants that prices adjust in a manner that removes this disparity, then a priori it is as likely that the other companies’ market capitalisations fall as it is that Telstra’s rises.

Indeed, just such a development has occurred in recent years. At the height of the mania in 2000, North American and Western European telecommunications companies strode the globe like a Colossus – and their executives and analysts developed correspondingly colossal hubris. Today, however, their combined market capitalisation has been trimmed by roughly $US2 trillion; and many, struggling to survive, have not yet come completely to terms with the developments and decisions that underlie their present chastened circumstances. The demand for telecommunications was drastically overestimated and therefore infrastructure was vastly overbuilt; moreover, debt and equity rather than retained earnings financed these “malinvestments.” In America alone since 1996, telecommunications companies borrowed more than $US1.5 trillion. The result is that state-of-the-art networks sit unused, financial statements bleed profusely and owners of equity and debt feel acute (and in some instances terminal) pain.

As The Australian Financial Review reported on 24 April, “the deterioration of the global telecommunications sector is deepening rather than easing, sending the industry on a downward spiral eerily reminiscent of the bursting of the technology bubble. Telecommunications companies around the world are going bankrupt, posting losses, slashing financial forecasts, cutting tens of thousands of jobs and offering little encouragement that the situation is turning around.” According to one source cited by the AFR, “the root cause of the problem in the sector appears to be a simple case of collision between reality and gigantically overoptimistic forecasts of demand. ... These forecasts drove what has turned out to be excessive capital spending, which is now manifested in overcapacity and falling prices.”

Given this sombre background, even if Telstra is “undervalued” relative to certain other securities it does not follow that its market capitalisation will subsequently rise. Indeed, a second objection (which criticises both the first and the second implicit premises) raises the possibility that it will fall – and, by extension, that overseas telecommunications companies will fall much further. According to this objection, it is not appropriate to value one security in relative terms, and thereby to regard one security as undervalued (or overvalued) relative to another. Rather, it makes sense to value a security in absolute or intrinsic terms. On this basis, and noting as a simple example that during the past century Australian equities have on average been priced at approximately 12-14 times their earnings, Telstra’s price is presently at least 20% dearer (and the average ASX stock minus the banks is at the moment roughly 40% dearer) than this long-term benchmark implies. If Telstra’s market capitalisation regresses towards some mean, in other words, it is plausible that it will fall towards this historical mean.

Two Caveats But No Margin of Error

That Telstra’s equity is not as glaringly expensive as that of the average company on the ASX does not change the fact that by historical standards (and despite its extended retreat since its heyday in early 2000) it remains dear. In short, and as Samuel Johnson noted more than two centuries ago, “a horse that can count to ten is a remarkable horse, not a remarkable mathematician.” That is to say, a telecommunications company such as Telstra, which has maintained its earnings and dividends and accumulated debt at a restrained pace, is by today’s standards a remarkable telecommunications company. It is a sound business, to be sure, but stable earnings and moderate debt do not make it a remarkable business; and still less do they necessarily make it an “undervalued” business.

This is the gist of a second report, written by a different journalist, which appeared in The Australian on 24 April. That report began with the sentence “Telstra has ridden out 24 hours of carnage for telecommunications companies ’round the world as the outlook for the industry implodes. ... Analysts predict [its] shares could be headed for $5, in what is becoming a second leg of the telco downturn.” Quoth one analyst: “this is a reality check that the growth that everyone was anticipating is just not there.”

The Australian (18 April) did, it is important to acknowledge, contain two important caveats. First, “weighing on Telstra’s share price is concern that it may be tempted to pay too much for a media asset, particularly likely target Nine Network. ... [Second], Telstra is prey to ... the whims of Canberra politics so long as it’s 50.1 per cent government owned.”

Alas, the extent of this second risk became clearer to Telstra’s hundreds of thousands of shareholders on 23 April. On that day, according to The Australian (24 April), “Telstra shares crashed heavily on news the Commonwealth Government plans to dramatically curb [sic] the company’s dominance in the Australian telecommunications market. Executives at smaller telco carriers were ecstatic at the news whilst Telstra executives were shellshocked at the extent of the reforms, [which constitute] a policy that turns four years of telecommunications deregulation on its head.”

In a third report, The Australian (29 April) added that “Telstra shares are facing further steep falls this week as [its Board of Directors] discuss radical changes for Telstra’s business canvassed by the Government. A scheduled Telstra board meeting has taken on a crisis tone with Telstra management caught unawares by the political moves against it last week. [According to a telecoms analyst at, you guessed it, a major multinational brokerage firm], ‘the potential impact could mean a Telstra share price of $4, compared with a $5 closing price on Friday. ... Share price falls of a further 10 to 20 per cent could be on the cards this week.’ [This same telecoms analyst] ‘said that life was going to get even tougher’ for the three incumbents, Telstra, SingTel/Optus and Vodaphone, as Hutchison continued to ratchet up to $3 billion capital spending spree to roll-out a third-generation mobile phone network.”

An addendum to this report appeared on 30 April: the analyst cited on 29 April “said that, although the news last week could knock $1 off Telstra’s share price in a worst-case scenario, he wasn’t predicting a 10 per cent to 20 per cent sell-down. ... He said the likelihood was a 10¢ to 20¢ sell-down from last week’s price of $5.21 ... which means the share price falls had already been overdone“. Also on 30 April, yet another broker at yet another major multinational brokerage firm, cited in Brisbane’s Courier-Mail, “predicted the stock would stay at less than $5 in the short term, but could be bolstered by bargain hunters because the stock was ‘fundamentally undervalued.’”

Croupiers, Prices and Values

We are thus presented with a disconcerting state of affairs: the valuation imputed to one of Australia’s largest publicly-traded companies and cited by experts in this country’s largest national-circulation newspaper ranged within seven business days by more than 40%, i.e., from $4.00 to $5.65 per share. This episode shows that journalists’ prognostications and the predictions of the analysts whom they cite, like prophesies by people in many fields not usually likened to astrology, are prone to relentless overconfidence, egregious error and rapid revision (hence forecasters’ necessity to forecast early and forecast often). Further, the relentless focus upon prices, day-to-day volatility of prices, late-breaking events and factoids distract attention from what is most important to investors: the hard numbers, dour assumptions and valid patterns of reasoning which yield cautious and justifiable estimates of intrinsic value.

These numbers are widely and freely available, and the intelligence to analyse them is possessed by almost anyone who has the aptitude to rear children, hold a steady job, repay a mortgage, drive a car safely and be a good spouse, friend and neighbour. The vast majority of Australian (and British, New Zealand, Singaporean and other) adults, in other words, possess the brains – but perhaps not the spare time – required in order to allocate capital intelligently; and investing, whilst hardly easy (indeed, it is very difficult) is nonetheless not as complex as truly challenging activities such as rearing well-adjusted children and conducting harmonious friendships and marriages. That is the enduring theme of Benjamin Graham’s two books written for a general audience (The Intelligent Investor: A Book of Practical Counsel, HarperCollins, 4th rev. ed., 1985, ISBN: 0060155477; and The Interpretation of Financial Statements: The Classic 1937 Edition, Harper Business, 1998, ISBN: 0887309135). In Mr Buffett’s words (Fortune 1990 Investor’s Guide), “you don’t need a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.”

Alas, Australian adults’ intelligence is ever more distracted and their time wasted by a vast and well-remunerated phalanx of brokers, financial advisors and journalists. The incentives of these croupiers (as Mr Munger has dubbed them and as present investigations in America and a recent decision in a Melbourne courtroom have demonstrated afresh) do not seem to co-incide with the interests of the investing public. No wonder Mr Buffett reportedly stated at Berkshire’s AGM in 2000 (see Letter 5) that financial advice “is basically not worth anything.” Further, and as Letter 21 implies, although it might mitigate its worst manifestations no amount of well-intentioned regulation or reform will eliminate this unpalatable fact.

Quite the contrary: more regulation produces more protection of incumbents, and protection of incumbents produces yet more problems. One unintended result, according to Austin Donnelly (The Courier-Mail 4 May), is that the present “ownership of most advisers by fund managers can mean a double conflict of interest. In addition to the conflict of interest of advisers who work on a commission basis, a second potential conflict of interest arises because most advisers are now owned by fund managers including life offices [who do not necessarily publicise this important fact]. This means that there can be two conflicts of interest preventing the adviser from being fair and objective.” The Weekend Australian (4-5 May), in an article entitled “Independent Advice Gets Harder To Find,” made the same point.

Croupier #1

For politicians, too, authoritative talk is cheap because its potentially adverse consequences are borne by others. Australians who bought T2 instalment receipts in 1999, paid the second instalment and retained the converted Telstra shares have incurred unrealised capital losses equivalent to approximately 36% of their initial outlay. It is true that most brokers, advisors, funds managers and media commentators cautioned at its launch that T2 would be unlikely to repeat the rapid and spectacular capital gains achieved by T1. Less commendably, however, few concluded that at the prices prevailing in 1999 and 2000 Telstra was anything other than a good long-term investment; and, perhaps disturbingly, very few if any specified what they meant when they uttered the phrase “long-term investment.”

The Prime Minister and the Liberal-National coalition in Canberra disavow responsibility for T2’s paper losses. Mr Howard said on Melbourne radio 3AW on 3 May (quoted in The Weekend Financial Review 4-5 May) that “we didn’t say anything about Telstra that was untrue and nobody in our situation associated with the privatisation of that kind can be held to account for subsequent fluctuations in the share price. ... I mean, that is the nature of the beast, you buy shares, you make a decision based on investment advice, you either make a profit or incur a loss.”

Nonetheless, as with some financial journalists and the “experts” whom they cite so too for the Prime Minister: Telstra’s shares presently represent “a very good investment in the long term.” Seemingly lost upon them is the systematic tendency, summarised by Benjamin Graham almost seventy years ago, towards a “reign of error” that is aided by advisers and abetted by journalists. In Graham’s words, “with a rosy prospect for the future, the buyers of ‘growth stocks’ [are] certain to lose their sense of proportion and pay excessive prices.” Mr Buffett has described its invidious consequences: “investors making purchases in an overheated market need to recognise that it may often take an extended period for the value of even an outstanding company to catch up with what they paid.” Perhaps this is what journalists, market experts and Prime Ministers really mean – or others should infer – when they say that something-or-other is a “long-term investment.”

Hence yet another appeal to caveat emptor. Journalists’ reports and citations tell us at least as much about their attitudes, patterns of thought and propensity towards Groupthink (see Irving Janis, Groupthink: Psychological Studies of Policy Decisions and Fiascoes, Houghton Mifflin College, 2d. ed. 1982, ISBN: 0395317045) as they do about the world that journalists purport to describe and explain. It is not just the stock market but also the business pages of Australian newspapers and the myriad sources cited therein which, to use the words of Philip Fisher (Common Stocks and Uncommon Profits, John Wiley & Sons, repr. 1996, ISBN: 047111927X), are “filled with individuals who know the price of everything but the value of nothing.” Wesco Financial Corp.’s Letter to Shareholders, written by Charles Munger, was posted on the Internet on 29 April.

Leave It to Prof Beaver

Professor Graham Beaver of the Nottingham Business School is delivering a seminar (co-sponsored by the Institute of Public Administration Australia, Qld Division, and the Queensland University of Technology) entitled Developments and Directions in Strategic Management Research on 21 May at 17.00 in the IPAA Seminar Room (Ground Floor, 240 Margaret Street, Brisbane). Its abstract reads like a breath of fresh air: “These days no self-respecting MBA degree would be without a compulsory core program on strategic management. Indeed, there appears to be almost universal agreement that it is a fundamental management activity that is inextricably linked to corporate performance, enterprise success, and management independence. ... However, much of the recent work is verbose in composition, self-indulgent, scientifically pretentious, replete with contradictory findings and managerially sterile. ...”

RSVP to c.waterson@qut.edu.au, tel. 07 3864 5094 or fax 07 3864 1766.

The trouble with gilded prosperity, such as that which has occurred in Australia in recent years, is that to a significant extent it takes the form of a boom induced by a central bank’s inflation. Such a boom period is not a period of good business: to a significant extent, and as has become painfully apparent to speculators-who-thought-they-were-investors in telecommunications, Internet/IT and media companies, it constitutes an incipient waste of resources on bad investments. Perhaps in several years this sobering point will also become apparent to today’s speculators-who-think-they-are-investors in certain “blue chip” equities and residential real estate in Sydney, Melbourne and Queensland’s Gold and Sunshine Coasts.

Chris Leithner


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