Leithner Letter No. 42
26 June 2003

As for us, we acknowledge that not one single politician is working to bring about the future that we still vaguely expect. On the other hand, both major parties, both houses of Congress, the White House, the Federal Reserve Board and the Treasury Department are carrying the water of the inflationists. What we have always known is that the government would fight deflation tooth and nail. What we did not expect was that the bond market would be as forgiving of these desperate measures as it has been to date.

The rallying cry of the bulls in recent months has been that nothing would prevent the Federal Reserve from pushing short-term interest rates to zero if that were necessary. ... To restart business activity, the inflationists are depending on the coordinated efforts of bank regulators, central bankers, bond buyers and currency traders. They need confident borrowers, solvent lenders and frightened central bankers. They have the central bankers they need, and we will just have to see about the others.

James Grant
Grant’s Interest Rate Observer
15 March 1991

Such dispiriting dispatches from the front lines of labour and commerce are shrugged off by the sunshine set as evidences of collateral damage. Now that the war is over, the presumption is everything will be hunky-dory. Consumers, their optimism stoked, will buy and buy, borrow and borrow, invest and invest. Business will once again revive and jobs will once again become bountiful. We have only one question for these incorrigibly cheerful souls: how much do you want to bet?

Alan Abelson
Up & Down Wall Street
Barron’s (14 April 2003)

Leithner & Co. Pty Ltd is a private company that adheres strictly to the Graham-and-Buffett “value” approach to investment. Its goal is its method: to undertake investment operations which are based upon thorough research and cautious assumptions; to provide reasonable safety of principal and offer an adequate return; and to inform shareholders regularly, fully and in plain language about these investment operations. Like most Australian corporations, its financial year begins on 1 July and ends on 30 June. The onset of winter is therefore an appropriate time to conduct two exercises. The first is to contemplate the twists and turns, triumphs, trials and tribulations of the financial year coming to a close; 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 next twelve months.

Let’s Cut the Bull

Letter 24-25, dated 26 December 2001-26 January 2002, stated that “in many countries, including Australia, Britain, Canada and (especially) the U.S., the boom of the late 1990s sowed the seeds of bust. Australia’s boom ended in 2000 (see Letters 11-12) and signs of bust gathered pace throughout 2001. ... [Our] plans for 2002 are based on the premise that many of the excesses of the 1990s remain unrecognised and therefore unpurged, and that the bust may be extended and sharp.” Underscoring its dour tone, Letter 24-25 also stated that a “renewed misallocation of resources ... may manifest itself in 2002 through a ‘recovery.’ Whatever the euphoria it incites in financial circles, such a recovery neither causes economic growth nor creates wealth. Rather, it misdirects Australia’s small and eroding pool of funding and thereby weakens the potential for longer term and sustainable prosperity. During 2002, then, Leithner & Co. will be in no hurry to sing ‘Happy Days Are Here Again.’”

In mid-2002 (see Letter 30) this cautious and cheerless assessment remained unrevised, unrepentant and partly vindicated. During the next twelve months financial markets and the results of others’ investment operations seemed to deteriorate more markedly than the pace and structure of commerce. But no matter: far from crimping our fortunes, this severe and disbelieving stance has helped Leithner & Co. to achieve quite reasonable (both relative to others and in an absolute sense) results in 2002-2003.

At the same time, however, and notwithstanding the substantial fall of the prices of many financial assets in Australia in early 2003, during the January-June half it was very difficult to locate additional businesses with requisite good quality and low price. Interestingly – and reassuringly – Mr Buffett finds himself in a similar situation. In Berkshire Hathaway’s most recent Annual Report, released on 8 March 2003, he states that “we [are doing] little in equities. [Vice Chairman] Charlie [Munger] and I are increasingly comfortable with our holdings in Berkshire’s major investees because most of them have increased their earnings while their valuations have decreased. But we are not inclined to add to them. Though these enterprises have good prospects, we don’t yet believe their shares are undervalued.”

Mr Buffett continued: “in our view, the same conclusion fits stocks generally. Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge. The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of [earning] at least 10% pretax returns (which translate to 6% to 7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.” (Whitney Tilson’s summary of and detailed notes taken at Berkshire’s AGM on 3 May 2003 are well worth perusing).

Leithner & Co., then, retains its part-ownership of a swag of businesses; continues to search assiduously (but at the moment unsuccessfully) for additional quality assets at sensible prices; is deeply sceptical about the rosy lenses through which most market participants are presently viewing economic and financial developments in Australia; is cautious about conditions for the 2003-2004 financial year and is therefore hoarding a hefty hoard of cash as a buffer against others’ excesses. “The fact that people will be full of greed, fear or folly is predictable” said Mr Buffett in 1985. “The sequence is not.” Accordingly, “when much of the rest of the investing world, burdened by debt, encounters some crisis forcing a panic, we are standing there with no debt and a loaded gun of cash ready to bag rare and fast-moving elephants.” With a hefty cash weighting and Mr Buffett’s insight, we therefore await with equanimity Mr Market’s next descent, if it occurs, into despondency.

The Condensed Case for Caution

Because they have been detailed and justified in various newsletters, the grounds for scepticism about current conditions and prospects can be summarised briefly. Sean Corrigan writes in Six Myths of the Crash that “two and a half years into one of the most severe bear markets in history, the most striking feature of the typical economic discussion is the persistent state of denial. ... Also notable is the unthinking promulgation of a species of economic fallacies which, though long since discredited, keep springing up like weeds to choke our reasoning about where we might go from here and, therefore, of how we should be preparing to act.” Among the most prominent and damaging fallacies:

  • Myth #1: “the consumer” comprises two-thirds of “the economy”;
  • Myth #2: central banks’ policy of hyper-low interest rates and easy credit creates and maintains prosperity, and promotes recovery from a “slowdown”;
  • Myth #3: spending by individuals and governments also promotes prosperity and recovery;
  • Myth #4: dividends are outré and capital gains are king;
  • Myth #5: nations such as Germany, Japan and the U.S. are facing deflation;
  • Myth #6: in the long run, the prices of stocks always rise. Hence the bull market will resume this quarter – and if it doesn’t then it certainly will in the next quarter or the one after that.

Not Their Finest Hour

“Every decent man,” wrote H.L. Mencken, “is ashamed of the government he lives under.” Several reasons explain this shame. Prominent among them is politicians’ hypocrisy: their ubiquitous “urge to save humanity is almost always a false front for the urge to rule.” Another is politicians’ selective malice: “the most dangerous man, to any government, is the man who is able to think things out for himself. ... Almost inevitably, he comes to the conclusion that the government he lives under is dishonest, insane and intolerable.” A third is the innate fraudulence of politicians’ actions: “the whole aim of practical politics is to keep the populace alarmed (and hence clamorous to be led to safety) by menacing it with an endless series of hobgoblins, all of them imaginary” (see H.L. Mencken, A Mencken Chrestomathy, Random House, 1949, 1982, ISBN: 0394752090).

During the past year, political leaders in Australia, Britain and the U.S. conformed to the abysmal standards that Mencken attributed to them. Most notably, much ink was spilt and economic nonsense (and many outright lies) propagated on the subject of war; and most specifically, the invasion and conquest of Iraq provided the latest in a series of excuses (i.e., the collapse of dot coms and the puncture of The Great Bubble; the trauma of 11 September and its aftermath; corporate scandals and shattered “confidence”) about the economic funk that pervades the “Anglosphere.” For three years or more, politicians and journalists who credulously parrot them have offered one “temporary” excuse after another in order to rationalise the present and to promise brighter days ahead. The spectre of war, it was said by various luminaries including Dr Greenspan, creates much “uncertainty.” This uncertainty causes businesses and individuals to postpone big-ticket expenditures. But once the war is fought and quickly won, we are assured, then the fog of uncertainty will quickly lift and a decisive recovery will follow.

Robert Samuelson (The Washington Post 10 February 2003) detected that “there’s a pattern here. It involves psychology more than economics. We prefer temporary explanations to a grimmer possibility: that the U.S. economy faces prolonged slow growth – or stagnation.” Part of this pattern is the repeated (and wilful?) confusion of correlation and cause and of cause and effect. During an economic bust, non-productive activities are voluntarily halted and non-productive assets are willingly purged or re-allocated towards remunerative ends. In wartime, on the other hand, people and assets are conscripted towards non-productive and destructive activities. These activities erode a country’s capital stock. War, then, does not just extinguish life and liberty: it undermines the accumulation of capital and thereby blunts or eliminates the trajectory of sound economic growth. In this respect war resembles an economic boom: from each, in other words, emanates a stream of at best non-productive and at worst immensely destructive activities. War may spawn an illusion of prosperity; but by creating and encouraging various non-productive activities it sets the stage, both within the belligerent country and at the site of hostilities, for a much harsher economic adjustment than would occur in its absence (see also Letter 38).

Ignorance or bastardisation of history also figures prominently in this pattern (see Letter 28, Letter 33 and Letter 35). Iraq and the Old Country provide an instructive example. In an uncanny forerunner to the events in March 2003, British troops occupied Basra in 1915 and by the end of the Great War had occupied the remainder of Mesopotamia. On 22 August 1920, T. E. Lawrence (better known as Lawrence of Arabia), a full-time adventurer, part-time Middle East correspondent of The Sunday Times and sometime spy, reported to his editors in Fleet Street (whose pay, then as now, was higher than that of His Majesty’s Government) that “the people of England have been led in Mesopotamia into a trap from which it will be hard to escape with dignity and honour. They have been tricked into it by a steady withholding of information. ... Things have been far worse than we have been told [and] our administration more bloody and inefficient than the public knows. It is a disgrace to our imperial record and may soon be too inflamed for any ordinary cure. We are today not far out from disaster.” Lawrence concluded: “we say we are in Mesopotamia to develop it for the benefit of the world. ... [But] how long will we permit millions of pounds, thousands of Imperial troops and tens of thousands of Arabs to be sacrificed on behalf of a colonial administration which can benefit nobody but its administrators?” (see also The Weekend Australian Financial Review 29-30 March 2003).

America’s Banana Republicans

The headlines of the past year have also obscured the emergence of a startling divide that distinguishes the views of the U.S. government held by foreign policy boffins on the one hand and economists on the other. Among the international relations specialists, says John Quiggin (The Australian Financial Review 13 March 2003), “the debate is about the consequences, good and bad, of the U.S. becoming an unchallenged and unchallengeable hyperpower.” In sharp contrast, among a small but growing number of economists “the fiscal position of the U.S. government has now passed the point where terms like ‘unsustainable’ and ‘crisis’ are considered controversial.” The United States, in other words, is presently an historical oddity. In military terms it is the unrivalled Great Power; but in financial terms it is the unsurpassed Foremost Debtor (see also Niall Ferguson, “The True Cost of Hegemony: Huge Debt,” The New York Times 20 April 2003). In its economic and military heyday, Britain was by far the world’s mightiest creditor. Today, however, America consumes ever more than it produces; imports much more than it exports; and owns far fewer foreign assets than foreigners own of American assets. (Don’t smirk: as a group Australians lie in a similar, albeit shallower, hole).

Even more significant, according to Quiggin, “is the adoption by important elements of the U.S. administration of a set of attitudes that might be described as ‘banana republic populism.’” The first element of this strain of populism is the complacent belief that government expenditure should not be limited to the availability of tax revenue: it not only can but should be financed by debt. This belief, which has been proclaimed publicly during the past year, reaffirms the modern Republican Party’s Hoover-FDR (i.e., high-taxing, high-spending, interventionist and militarist) foundations (see also Letter 39). As with Richard Nixon, Ronald Reagan and George H. Bush, so too with George W. Bush: his “conservative” rhetoric and military undertakings distract attention from his embrace of deficits and debt. Immediately upon its assumption of office (i.e., well before 11 September 2001) the Bush administration commenced its biggest spending spree since the 1960s. The domestic welfare budget, for example, has expanded by almost twice as much in the first two years under Mr Bush’s administration ($96 billion) as it did during Mr Clinton’s first six years in office ($51 billion). More generally, discretionary spending has grown by 41% and non-military expenditure by 35% since 1998, thus much heftier expenditures – including the biggest deficits in American history – are promised. And that’s not counting the invasion and occupation of Iraq.

It is interesting to compare mainstream Banana Republicanism to the speeches and press releases of former Congressman Ron Paul, a Republican who takes seriously the Constitution and the ideals of its Founders. To do so is to realise that all but a very honourable few politicians have extended immensely the traditional Keynesian fallacy that a budget deficit is an appropriate measure during a recession whilst a surplus is an appropriate response to a boom. Banana Republican orthodoxy holds that at any time debt-financed deficits are at worst harmless and at most beneficial (see in particular The Wall Street Journal 14 May 2003).

A first defining characteristic of banana republic populism, then, is a smug preparedness to accumulate massive debt. A second is a marked reluctance (also inherited from FDR) to repay it as promised and at 100 cents on the dollar. According to Quiggin, “the second element of banana republic populism is the belief that it is acceptable to repudiate debts to ‘bad’ foreigners. Already supporters of the Bush administration are dusting off the concept of ‘odious debt’ ... as the basis for a post-war repudiation of Iraqi debts to France and Russia.” At home, rather than resort to outright repudiation the government can (in the words of Benjamin Bernanke, a Governor of the Federal Reserve Board, on 21 November 2002) use a high-technology device called a “printing press” to produce “as many U.S. dollars as it wishes at essentially no cost.” Charity begins at home, and so some of the proceeds of this repudiation-by-stealth will be used to compensate the domestic owners of government debt.

Major foreign holders, notably the “unwilling” Chinese, French, Germans and Japanese, will apparently have to fend for themselves. According to Paul Krugman (The New York Times 8 March 2003), only “cognitive dissonance – the fact that foreign investors still can’t believe that the leaders of the United States are acting like the rulers of a banana republic – is preventing an unruly flight from U.S. government debt and currency.” The more ostentatiously Americans live beyond their means, in other words, and the more they confuse debt-financed consumerism and the constitutional right to the pursuit of happiness, the greater the Beltway’s temptation to avoid the pain of higher interest rates, tax rises and budget cuts.

Restating Some Principles of Risk and Return

To be bearish about American politics, finance and economics is hardly to be bullish about their Australian counterparts. Alan Kohler (The Weekend Australian Financial Review 8-9 June 2002) observes that “share prices [in both countries] have been rising and interest rates have been falling for two decades. Capital growth has been the investors’ revered and faithful deity. And as Growth has become entrenched as the investment religion, the old faith of Yield has slipped into the background – a quaint Puritanism from the past, like the Amish of Pennsylvania.” He also notes that “...there are many ways of looking at valuation, and ... one of the classic valuation methods – earnings yield versus bond yield – since 1870 clearly shows that although on this basis the [American] market is much cheaper than it was at its 2000 peak, it is still as expensive, or more expensive, than any valuation peak before the bull market began in 1982.” Kohler therefore puts a fundamental question: given the tendency of Australians to catch cold when Americans sneeze, are the risks that inhere in Australian assets at today’s prices properly recognised?

On the one hand, I disclaim any ability to foretell general business conditions, the overall level and direction of financial markets, the operations of particular companies or the market prices of their securities. I have no crystal ball and ignore the many who claim (implicitly or otherwise) that they do. Yet I continue to believe – as, indeed, I have believed for several years – that the prices of most financial assets in Australia are, relative to their quality, prohibitively high. This negative response to Kohler’s question is derived from first principles, and concludes that since 1999 representative Australian “blue chip” assets have become more attractive relative to “risk free” assets such as Commonwealth Government bonds. But no matter: despite the fact that many blue chips’ prices have received significant haircuts and the yields of government bonds have fallen, at today’s prices equities are no more attractive – and bonds are less attractive – to a value investor than they were during the boom. And the less said about residential real estate the better. In an absolute sense, in other words (i.e., in terms of a sober assessment of the natural rate of interest and these assets’ likely payback periods), during the past several years few Australian assets have become more attractive to Grahamite value investors.

This assessment, whilst not iconoclastic, is nonetheless distinctly contrarian. One seemingly typical financial planner, quoted in The Weekend Australian (22-23 March 2003), implored “whatever you do, don’t rush to cash. The risk is too great that you will miss out on the rebound.” Another, the head of a prominent research firm, says “this is such an unusual situation that it really, really should come good very quickly. ... The optimal portfolio for a medium- to long-term investor today is to put everything in shares” (The Australian 7 May). And a third, employed by one of Queensland’s biggest funds managers, opined “investors have nothing to fear from the stock market except fear itself.” (This planner’s appeal to FDR’s first inauguration does not make the point that she probably intends: the disastrous consequences of his economic policies, which deepened and prolonged the Great Depression, show that Americans actually had much to fear from FDR. See in particular Gene Smiley, Rethinking the Great Depression: A New View of Its Causes and Consequences, Ivan R Dee, 2002, ISBN: 1566634725; Murray N. Rothbard, America’s Great Depression, 1963, 2000, Ludwig von Mises Institute, ISBN: 0945466056 and John T. Flynn, The Roosevelt Myth, Fox & Wilkes, 1948, 1998, ISBN: 0930073282).

Similarly upbeat opinions by prominent market participants were profiled in The Australian Financial Review on 7 and 14 February, 7 March and 4 April 2003. Perhaps the least equivocal and most amusing appeared on 16 May. It stated that “the mood around world stockmarkets is changing for the better. It seems the bulls are starting to take over.” The Chairman of a “growth” fund who is based in America and visiting Australia declared: “we believe the market [in both countries] should move significantly higher in the next few months.” “He says it looks like the Australian market could run to new highs” and “the U.S. market [looks] like a bonfire just waiting to be lit.”

This visitor, remembering his “past bullish comments and the need to maintain humility in the face of the markets, adds that ‘it [the significant rise of prices] may not occur. I’m not saying it will occur; I’m just saying we’re on the verge.’” Indeed, this visiting predictor “readily admits being a little too early with his optimism after the 2001 fall in the markets – and more than one Australian client recently reminded him of the premature calls. He says if anybody followed his advice two years ago, he apologised for the too-early call.” But no refund cheques are in the post: “‘that’s the way it is in markets ... you’ve got to predict often.’ He says it’s no good making one prediction; you have to adjust continuously in the markets for unforeseen events such as the September 11 attacks or the deadly SARS virus outbreak.”

Alas, during the past several years ebullience has not paid handsome dividends. Nor have relentlessly bullish (and, to put it mildly, repeatedly imperfect) predictions impressed retail investors. And for good reason: Robert Gottlibsen (The Australian 7 May 2003) reports that “Australian and U.S. investors who have lost large sums with mutual funds now have statistics that show fund managers rather than the market were responsible for a sizeable chunk of the loss.” Tim Koller and Zane Williams of the consultancy firm McKinsey & Co. have drawn these conclusions in a recent paper entitled Anatomy of a Bear Market. Gottliebsen states “the McKinsey research doesn’t make judgements on the funds managers. But it is clear that many ... were simply caught in a mire of short-term forecasts and index worship. They blew their customers’ money.”

This unpalatable result is no temporary aberration: it applies to most points in time and to most institutional investors (most notably, compare William Sherden, The Fortune Sellers: The Big Business of Buying and Selling Predictions, John Wiley & Sons, 1999, ISBN: 0471358444 with Warren Buffett’s speech entitled “The Superinvestors of Graham-and-Doddsville” and published as an Appendix to Benjamin Graham, The Intelligent Investor: A Book of Practical Counsel, Harper Collins, 1949, 1985, ISBN: 0060155477).

If Mr Buffett is correct, then many institutional investors have generated meagre results – not just since 2000 but also over other and much longer periods – because they misunderstand key concepts such as risk and return. Indeed, assessing their actions and results in recent years, one is tempted to conclude that more than a few simply do not know what they are doing. To cite just one example, consider the article “Why Telstra’s a Real Humdinger” (The Weekend Australian 26-27 June 1999). According to an analyst in Australia’s largest-circulation national newspaper, “the growth premium you are being asked to pay for Telstra now does not take into account any of the goodies in the pipeline that are likely to start appearing over the next couple of years. We have a target price of $20 on the stock by 2003, but all that assumes is above average earnings growth and continual expansion in the ... price-earnings ratio the market is prepared to pay ... The risk/reward profile is better than you will get anywhere else ... and the likelihood of Telstra outperforming the market over a longer period is very, very good.”

Unfortunately for prominent and major investors, vocal investors and great numbers of investors, correspondence with current fads, fashion and the prevailing wisdom – not to mention good intentions, simple hyperbole, crossed fingers, sheer guesswork and the clear blue yonder – are no substitutes for cautious premises, hard evidence and valid reasoning. Many have not just misconceived the nature of risk but have also drastically underestimated its magnitude; and possessing a faulty conception of investment return, their expectations for it have been unrealistically optimistic. A startling and disturbing implication follows from this realisation: the very core of today’s investment mantra, zealously preached in Australian business schools and piously observed by virtually all analysts, brokers, advisers and commentators (as The Australian credulously stated on 7 May “the more risk you take, the more money you make”), is not just false but immensely damaging to investors’ well-being.

The last word belongs to – of all people – John Meynard Keynes and a passage in The General Theory of Employment, Interest and Money (1936) that might just as well have been written in 2002-2003. “Human nature desires quick results, there is particular zest in making money quickly and remoter gains are discounted by the average man at a very high rate.” Further, “the game of professional investment is intolerably boring and overexacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism.” In exchange for cautious assumptions, reasonable safety of principal and an adequate return, during the 2003-2004 financial year Leithner & Co. will happily accept the criticism.

Chris Leithner


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