Leithner Letter No. 43
26 July 2003

“...He learnt on the job, by experience and by increments. His son was sent to Hong Kong to oversee the family’s operations there and was imprisoned in a Japanese prisoner of war camp.”“How terrible,” said my friend. “No,” the old timer replied. “He survived. It was the making of him. He learnt about human nature. He learnt humility.” A pause before he continued. “But we made a big mistake with the grandchildren.”“Oh, what was that?”

“We sent them to Harvard Business School.”

Kate Jennings
Address to The Sydney Institute
29 May 2003

History, Logic and Value Investing

Value investors read voraciously. The introduction to Benjamin Graham: The Memoirs of the Dean of Wall Street (McGraw-Hill, 1996, ISBN: 0070242690) states that “Graham came to his convictions after long, searching and realistic meditations about history, garnered from extensive reading and daily immersion in the intricate values-testing of Wall Street.” His student and colleague, Warren Buffett, spends many hours of many days reading a variety of business and trade publications and “massive quantities of financial statements” (Roger Lowenstein, Buffett: The Making of an American Capitalist, Random House, 1995, ISBN: 0385484917). Mr Buffett’s Vice-Chairman, Charles Munger, told his biographer that “both Warren and I learn more from the great business magazines than we do [from] anywhere else. ... And if you get into the mental habit of relating what you’re reading to the basic structure of the underlying ideas being demonstrated, you gradually accumulate some wisdom about investing. I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.” According to Crédit Suisse First Boston, Lou Simpson, head of investments at GEICO, a subsidiary of Berkshire Hathaway, strives to read at least 5-8 hours per day.

Value investors read in order to achieve two fundamental ends. The first is the accumulation of a wide and reliable base of historical background information. Good decisions require such information. One way to acquire it is for many decades to live, work, observe carefully, conduct one’s affairs by trial and error and learn from one’s inevitable mistakes. Alas, very few if any of today’s businessmen and investors have directly experienced the various economic and financial conditions, ranging from boom to bust and exuberance to despondency, since (say) the 1920s. Most prefer a quicker and less capricious method of attaining justifiable bases, principles and frameworks.

Diligent study of the historical record – and of approaches to business and investment that are justifiable in light of that record – provides the best available indirect substitute for lack of actual direct experience. “As a protection against financial illusion or insanity,” wrote John Kenneth Galbraith in The Great Crash of 1929 (Mariner Books, 1954, repr. ed. 1997, ISBN: 0395859999), “[historical] memory is far better than law. When [in the early 1970s and late 1980s] the memory of the 1929 disaster failed, law and regulation no longer sufficed. For protecting people from the cupidity of others and [themselves], history is highly utilitarian. It sustains memory and memory serves the same purpose as [government regulators] and, on the record, is far more effective.” Richard FitzHerbert (Blueprint for Investment: An Approach for Serious Long-Term Investors, Wrightbooks, 1994, ISBN: 0947351663) adds that wide reading “provide[s] the necessary background and historical depth to facilitate unemotional judgements of the various ideas, advice, opinions and ‘recommendations’ with which investors are bombarded. ... The most important lesson of history is that investors who fail to study history are ill-equipped for their task.”

Secondly, avid and critical reading helps to develop healthy scepticism towards the large amount of information, misinformation and disinformation that one encounters daily (see in particular A Mathematician Reads the Newspaper, Anchor, 1996, ISBN: 038548254X; Innumeracy: Mathematical Illiteracy and Its Consequences, Hill and Wang, 2001, ISBN: 0809058405; and Beyond Numeracy: Ruminations of a Numbers Man, Vintage Books, 1992, ISBN: 067973807X, all by John Allen Paulos). Reasonable and justifiable judgements in the face of uncertainty require caution, disbelief and a basic sense of humility.

To read critically Australian business and trade publications and the business section of the daily newspaper is occasionally to discern a valuable insight or nugget of information. But it is also to recognise that very little of what one reads is worth retaining. Most notably, normative, analytical and empirical statements are routinely confused; key concepts and definitions are typically vague and often equivocate; premises, to the extent that they are introduced, are not infrequently dubious; explicit patterns of argument, to the even more limited extent that they are advanced, are typically weak or invalid (politicians, for example, are addicted to the fallacy of affirming the consequent) and non sequiturs abound; causes and their symptoms, and causes and their consequences, are usually blurred; informal fallacies including false dilemmas, appeals to emotion, force and pity, prejudicial language and straw men, are pervasive; and the improper use of induction is the rule.

Value investors therefore read widely and critically in order to inform themselves of long-term norms and disabuse themselves of unrealistic expectations; to identify economic, business and financial principles that pass the test of logic and historical experience (and to eject those that do not); and generally to inoculate – but, alas, hardly to immunise – themselves against chaff, ephemera and nonsense. An historically-informed, logically-inclined and sceptical investor recognises, as Richard FitzHerbert puts it, that “the investment world is charged with seductive advertising, glossy brochures and persuasive prose. Theories and fallacies are readily assumed as facts. Irrational analysis is reinforced by fads and fashions. Major blunders are committed by senior people and prestigious institutions. As a protection against incompetence and malpractice, government regulation and licensing has proved to be unreliable. ... Armed with valid rules of reasoning and reliable evidence, the sceptical value investor is able to respond in a reasoned (and thus justifiable but hardly foolproof) manner to this deluge of information, part-information and outright falsehood.”

A Skeptic Evaluates a “Management Blurb”

A good example, in the form of a glossy, four-page brochure entitled “Jack Welch on Leadership,” appeared in The Australian on 23 May 2003. “For the first time ever in Australia,” said the brochure, “Jack Welch will address a select audience of directors, executives and senior managers at an exclusive morning forum [during which] he’ll share his views on corporate management, culture and structure, and how to drive change.” The brochure noted that Mr Welch joined General Electric in 1960. He rose steadily through its ranks and became a Vice President in 1972, Vice Chairman in 1979 and CEO in 1981. “A seemingly unlikely contender, Welch’s charisma, tireless efforts, and above all, his strong and consistent ‘get-results’ performance earned him the top spot.” An “investment” of $695 (if undertaken before 31 May) or $895 (from 1 June) bought a seat for the 2.5-hour session at either the Crown Towers in Melbourne (18 June) or the Sydney Convention Centre (20 June).

The brochure also stated in big bold type that Mr Welch is the “CEO of the Century.” This is seemingly because “his twenty-year reign as the head of General Electric brought the company from a bureaucratic behemoth to a dynamic and revered powerhouse. ... During his tenure, Welch has been credited with turning the corporation around ... turning GE into such a powerhouse that it is likely to stay at the top for years to come.”

Some of the points in this brochure are unquestionably true. Mr Welch did, for example, become the chief executive officer of the General Electric Co. in 1981. It is also true that during the past decade he has been lionised. According to Fortune (13 December 1993), for example, he is “widely acknowledged as the leading master of corporate change in our time.” The other points, however, are – at the very least – debateable. Reading the blurb (to say nothing of the many books and articles about him) one might be tempted to conclude that Mr Welch rescued a somnolent and stagnant company that had not changed significantly since Edison and Westinghouse disputed the relative merits of AC and DC.

An excellent book by James Collins and Jerry Porras (Built to Last: Successful Habits of Visionary Companies, HarperBusiness Essentials, 1994, 2002, ISBN: 0060516402), which takes seriously both history and logic, shows otherwise. Mr Welch did not inherit a mismanaged company. Quite the opposite: his immediate predecessor, Reginald Jones, retired as “the most admired business leader in America.” Collins and Porris cite a survey in U.S. News and World Report that in 1979 and again in 1980 found Jones to be “the most influential person in business today.” Similar surveys in The Wall Street Journal and Fortune magazine also placed Jones at the top of the heap; and in 1980 a Gallop poll named him CEO of the Year.

In financial terms, such as growth of profit and return on equity and sales, GE’s results under Jones’s eight-year tenure were at least as impressive as they were during Welch’s first eight years. Under Jones, GE’s pre-tax profits grew at an average annual rate of 14%; under Welch, they expanded at 8.5% per year. GE’s return on equity during Welch’s first eight years averaged 26% percent. This is exceptional but it is not unique; indeed, by GE’s very high standards it is not even particularly impressive. Collins and Porras compiled pre-tax ROE figures for seven “chief executive eras” at GE since 1915 (see below), and found that Mr Welch ranks fifth.

Performance Ranking of “CEO Eras”
General Electric Company

Rank Era Average Annual
Pre-tax ROE (%)
1 Wilson (1940-49) 46.7
2 Cordiner (1950-63) 40.5
3 Jones (1973-80) 29.7
4 Borch (1964-72) 27.5
5 Welch (1981-90) 26.3
6 Coffin (1915-21) 14.5
7 Swope/Young (1922-39) 12.6

Using an updated number that incorporates results from his entire tenure, Mr Welch places third. Note, however, that Mr Welch possessed a huge advantage not available to his predecessors: during most of his time at the helm a very stiff economic and financial wind (i.e., two of the longest economic expansions and the greatest bull market in American history) blew at his back. In sharp contrast, Gerald Swope and John Young enjoyed economic sunshine for only half of their tenure – and during the remainder had to survive the deepest and lengthiest bust in the country’s history. Similarly, but less extremely, the deepest economic and financial funk and greatest price inflation since the Second World War occurred during the Reginald Jones era.

On Evaluating “Management”

In an era when the “performance” of a stock has become the preferred measure of corporate success, it was fortunate, to say the least, that Mr Welch’s tenure coincided with the ignition of America’s longest and greatest bull-market. The bull was spurred to a modest extent by increased corporate earnings and by a very considerable extent by market participants’ greatly increased willingness to pay for those earnings. In 1981 S&P 500 stocks traded, on average, at approximately 9-10 times their earnings. Today, depending upon one’s assumptions and method of measurement, the multiple is at least 25 times and perhaps as high as 40 times – i.e., at nosebleed levels compared to the historic average of roughly 15 times earnings. From an historical perspective, then, if you are Mr Welch’s successor, Jeffrey Immelt, then whatever your undoubted talents and energy it is unlikely that Mr Market will smile as benevolently upon GE’s stock during your reign as he did during Mr Welch’s.

Turning to Fortune 500 rankings, where does GE rate over the past decade in terms of “creation of shareholder value” (a very problematic measure, to be sure, but one universally loved by prominent and charismatic CEOs)? Fifty-fifth. This is outstanding; again, however, just as Mr Welch is not in a class by himself vis-à-vis his forerunners, GE is not sui generis vis-à-vis other major corporations. Fortune, for example, has noted that during the past 17 years Colgate-Palmolive’s shares have decisively “outperformed” GE’s. This 17-year time horizon encompasses the tenure of Colgate-Palmolive’s CEO, Reuben Mark, who avoids the press, is therefore not lionised – and, needless to say, has not been inundated with speaking tours and seven-figure book contracts.

Of the many yardsticks with which to gauge a company’s results, raw stock market gains are hardly the best. As Rob Walker notes in Overvalued: Why Jack Welch Isn’t God, the unprecedented levitation of equities since the early 1980s – the S&P 500 has risen as much as 2,000 percent since 1981 – distorts direct comparisons between stocks’ “performance” before and since the 1980s. Collins and Porras measure the “performance” of selected companies’ stock relative to the overall market. From 1981 to 1995, GE’s shares surpassed the market by a factor of 2.4 to 1. Surely this achievement is unique? Alas, it is not: in another excellent book, Good to Great: Why Some Companies Make the Leap ... and Others Don’t (HarperCollins, 2001, ISBN: 0066620996), Collins profiles eleven major companies that surmount this benchmark. In 2001 he wrote about the former CEO of one, Kimberly-Clark, in the Harvard Business Review. From 1971 to 1991 that company’s stock “outperformed” the market by a ratio of 4.1 to 1. “And yet few people – even ardent students of business history – have heard of Darwin Smith.”

Collins and Porris also show that Welch was by no means the first or even the most important “change agent” in GE’s history. During the tenure of co-CEOs Gerald Swope and John Young, GE established one of the world’s first industrial research laboratories and expanded forcefully and very profitably into the design and manufacture of home appliances. Unprecedented change also occurred under Ralph Cordiner: most notably, during the 1950s the number of market segments GE served exploded twenty-fold. Mr Cordiner also radically restructured and decentralised the company, was one of the first executives in America to embrace “management by objective” principles, created “Crotonville” (GE’s now-famous and much-copied management training centre at Croton-on-Hudson, New York) and wrote the influential book New Frontiers for Professional Managers (New York: McGraw-Hill, 1956). It is easy but mistaken to overlook the relatively low-key Fred Borch, who made massive, very risky but also very profitable investments in such areas as jet aircraft engines and financial services. These two markets, as many GE-watchers know, propelled GE’s progress during Mr Welch’s tenure.

The Myth of the Great and Visionary Leader

The authors of Built to Last rightly emphasise that Jack Welch brought immense energy, skill and a magnetic personality into the CEO’s office at GE’s headquarters. “But obsessing on Welch’s leadership style diverts us from a central point: Welch grew up in GE; he was a product of GE as much as the other way around. Somehow GE the organisation had the ability to attract, retain, develop, groom and select Welch the leader. GE prospered long before Welch and probably will prosper long after Welch. After all, Welch was not the first excellent CEO in GE’s history, and he probably will not be the last. Welch’s role was not insignificant, but it was only a small slice of the entire historical story of the General Electric Company.”

To read the recent blurb in The Australian, as well as a considerable literature about Mr Welch and other Titans of the business world, is to encounter the more general proposition (which is sometimes stated implicitly, other times explicitly but always ubiquitously) that great and “visionary” companies require great and visionary leaders.

The reality, according to Collins and Porras, is diametrically different. They find that a successful company does not require a charismatic and visionary leader. Quite the contrary: such a leader can actually retard a company’s progress. “The evidence from our research punched holes in two widely held and deeply cherished myths that have dominated popular thinking and business school education for years: the myth of the great idea and the myth of the great and charismatic leader. In one of the most fascinating and important conclusions from our research, we found that creating and building a visionary company absolutely does not require either a great idea or a great and charismatic leader. In fact, we found evidence that great ideas brought forth by charismatic leaders might be negatively correlated with building a visionary company. Some of the most significant CEOs in the history of visionary companies did not fit the model of the high-profile, charismatic leader – indeed, some explicitly shied away from that model. ... Like the founders of the United States at the Constitutional Convention, they concentrated more on architecting an enduring institution than on being a great individual leader.”

Collins and Porras note that both sets of companies they studied (i.e., the “treatment” and “control” companies) tended to possess charismatic and visionary leaders at their formative stages and subsequently; similarly, at other times both sets possessed less prominent – but not necessarily less effective – leaders. Hence their conclusion that “great leadership, be it charismatic or otherwise, cannot explain the superior trajectories of the visionary companies over the comparison companies. ... We do not deny that the visionary companies have had superb individuals atop the organisation at crucial stages in their history. They often did. Furthermore, we think it unlikely that a company can remain highly visionary with a continuous string of mediocre people at the top. In fact. ... we found that the visionary companies did a better job than the comparison companies at developing and promoting highly competent managerial talent from inside the company, and they thereby attained greater continuity of excellence at the top through multiple generations. But, as with great products, perhaps the continuity of superb individuals atop visionary companies stems from the companies being outstanding organisations, not the other way around” (italics in the original).

Most observers, in other words, regard GE as the house that Jack built; but Collins and Porras show that it is more accurate to say that GE is the house that built Jack. An excellent way to become and look like a great executive, then, is to work for a great company and to avoid a mediocre one. Mr Buffett concurs: “our conclusion is that, with very few exceptions, when management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact” (Fortune 18 October 1993).

Lessons for Value Investors

The “Jack Welch” phenomenon, as exemplifed in The Australian on 23 May, has nothing to do with Mr Welch per se. Rather, it has everything to do with the people who since the early 1980s have heaped lavish and superlative praise upon prominent and charismatic business leaders. Why is Mr Welch routinely described as the greatest corporate leader of his generation? More generally, why are views about the heads of major corporations so polarised? Why are some idolised and others vilified?

Part of the answer, according to Rob Walker, “is that during Welch’s career America’s relationship with business leaders has changed. For starters, business in general, filtered through coverage of the stock market on networks like CNBC, receives much more public attention than it did in 1980. Add to this the rise of technology companies, from Microsoft to Apple to Dell, that appeared to come from nowhere on the strength of visionary individuals whose entrepreneurial achievements were inspiring in a way few political figures could match. Looking to make business accessible in an age of economic boom and innovation, the press frequently told business stories through the prism of individuals – Iacocca, Bill Gates, Steve Jobs, Welch. In his day, Reg Jones was also lauded by his peers as the nation’s most admired and influential CEO. It’s just that the wider public wasn’t that interested in such things back then.”

Wide reading, a base of reliable historical knowledge and a valid framework through which to sift information enable value investors to evaluate corporate success from a distinctive angle and through a skeptical lens. Undoubtedly vital attributes such as “good management” and “sound leadership” are not things that “analysts” can ascertain during an afternoon visit and a friendly cup of tea. These are not, in other words, things that are best observed face-to-face; rather, they are things whose effects are best inferred from financial statements over long periods of time. The analysis of Collins and Porras in “no way detracts from Welch’s immense achievements. He ranks as one of the most effective chief executive officers in American business history. But – and this is the crucial point – so do his predecessors. Welch changed GE. So did his predecessors. Welch outperformed his counterparts at Westinghouse. So did his predecessors. Welch became widely admired by his peers – a ‘management guru’ of his age. So did his predecessors. Welch laid the groundwork for the future prosperity of GE. So did his predecessors. But we respect GE even more for its remarkable track record of continuity in top management excellence over the course of one hundred years.”

Hence Benjamin Graham actively discouraged the employees of Graham-Newman Corp. from visiting managers and executives and incorporating the impressions gleaned during these encounters into their research. His emphasis was upon principles rather than upon individuals. “It is a mistake,” Graham contended, “to rely on the corporate version of [a] company’s condition without scrutiny. Management can make mistakes or even lie; reported earnings can be manipulated; future earnings are unpredictable, as are market factors such as new products or market share. A skilled analyst picks through the numbers, removes the shine [and] corrects for any spin that has been put on the data” (Janet Lowe, Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street, Pitman, 1995, ISBN: 0273622145).

Alas, American (and Australian) business schools emphasise complex “case studies,” arcane theories and advanced mathematical formulae – and implicitly discount or openly denigrate basic principles of business grounded in common sense, historical experience and contemporary reality. It is very difficult to build and maintain a successful business; but it is invalid and incorrect to infer from this difficulty, as B-schools do, that commerce is innately complex. It is also difficult to lead a good life; but one basis of a good life, the Ten Commandments, is easy to comprehend. According to a draft report compiled in 2001 by their accreditation body, the St. Louis-based Association to Advance Collegiate Schools of Business, the typical curriculum is ivory-tower and out-of-touch. The AACSB’s report stated that “preparation for the rapid pace of business cannot be obtained from textbooks and cases” (see also What’s an MBA Really Worth? and Stuart Crainer and Des Dearlove, Gravy Training: Inside the Business of Business Schools, Jossey-Bass, 1999, ISBN: 0787949310).

Mr Buffett agrees: “business schools reward difficult and complex behaviour more than simple behaviour, but simple behaviour is more effective.” Further, “it has been helpful to me to have tens of thousands [of students] turned out of business schools taught that it didn’t do any good to think.” When asked at Berkshire’s 1996 AGM about modern portfolio theory, part of the financial catechism recited in B-schools, Mr Munger replied that “it is a type of dementia that I can’t even classify.” More generally, “there’s a lot wrong [with American universities]. I’d remove three-quarters of the faculty – everything but the hard sciences. But nobody’s going to do that, so we’ll have to live with the defects. It’s amazing how wrongheaded [the teaching is]. There is fatal disconnectedness. You have these squirrelly people in each department who don’t see the big picture. ... It’s easy to create such a culture, in which you have good people but terrible results. Many areas of government are dysfunctional. Universities are complicit. They don’t feel guilty about the product they’re producing. ... They are strong in the hard sciences, but if you go to business, law, sociology. ...” (see also Steven Yates’ Can Logic Be Taught on Campus?).

In case studies, “case rates” (i.e., fragments of information pertinent to a particular place at a particular point in time) take precedence over “base rates” (i.e., principles that conform to logic and empirical generalisations consistent with the historical record). According to Kate Jennings, in case studies B-students “are given all the facts. Yet life never gives us all the facts; if anything, it continually and spectacularly blindsides us. These days – it’s not always been the case – MBAs graduate with a false sense of omnipotence – everything can be quantified – not to mention a massive dose of entitlement. ... They aren’t encouraged to think for themselves [and] they follow, submissively, the current business fads.” If so, then they will obsess about Jack Welch the individual “CEO of the Century” and discount or ignore the general principles and historical record of the company that recruited, trained and groomed him.

The conclusion, couched in suitably Grahamite terms, belongs to Ron Walker. It applies not only to Mr Welch but, alas, also to a great many things in present-day America. “There’s a difference between being a good CEo – which Welch has been – and being the undisputed all-time champion of corporate leadership. Or, to put it another way, think of Jack Welch as a stock. If the most sensible way to gauge the current value of a stock is the famous price-to-earnings (P/E) ratio – that is, the ratio of a stock’s market cost to the company’s actual or expected profits – then consider Welch’s reputation as ‘price’ and his achievement as ‘earnings.’ A stock can be overvalued, sometimes wildly so, even if its earnings look solid. In bottom-line terms, Welch’s achievements are solid. But his reputation? As a multiple of what he has actually accomplished, it’s ... far too pricey to buy.”

Chris Leithner


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