Leithner Letter No. 6
26 June, 2000

“Self-love, my liege, is not so vile a sin as self-neglecting.”

Shakespeare’s Henry V

This month’s Newsletter emphasises the negative consequences which can occur – and, I believe, continue to occur – when participants in markets discount hard evidence, ignore elementary rules of logic and succumb to emotion and unwarranted optimism. In so doing, they neglect the very self-interest which their emotional and optimistic impulses sought to promote.

A Modern ESOPs Fable

Share options provide perverse incentives which they present to managers and the damage which they often do to companies’ owners. Other things equal, Leithner & Co. therefore avoids businesses which issue options over shares to their managers or employees. Many businesses which use cash properly and systematically to recompense their staff – from the greying executive in the board room to the pimply teenager in the mail room – are nonetheless able to reward their shareholders commensurately for the risks which inhere in the investment of capital. Conversely, the more arbitrarily and lavishly companies remunerate their executives and other selected staff, i.e., the more they use options over shares, the more poorly they tend to reward their shareholders.

On 16 May 2000, a series of articles and an editorial in The Australian Financial Review discussed Employee Share Option Plans (ESOPs). One of the articles, a front-page lead, began with the sentence “the retreat in the share prices of technology stocks has hit many employee share schemes, leaving participants sitting on sizeable paper losses.”

Warner reports that “some dot-com employees are learning the hard way that their stock options are not only worthless, but can wind up costing them money. it’s the new-economy dream gone horribly awry. What’s happened is that some dot-com option-holders have had to pay more money in taxes than they could hope to make selling shares of their deflated stock in the public markets. This is the ugly fine print of the options culture. It’s horribly arcane and it depends on what kind of stock options you have, but few people who signed up for an exciting job at a startup worried about such things.”Australian and U.S. tax law, and the fine print of

Australian and American options contracts, clearly differ in a number of important respects. The concluding sentence of Warner’s article, however, applies not just to its intended audience but also to Australian employees who participate in employee share option schemes and Australian investors who subsidise them. Hence a modern “ESOPs Fable” which is a by-product of the dot-com, IT and startups mania, which in turn derives from loose credit, blind optimism and naked greed: “when the market’s going up, everyone thinks that they’ll get options and be the next dot-com millionaire but I think there are going to be more [horror] stories like this.”

A New Book for Value Investors

Henry David Thoreau, a resident of Walden Pond, near Concord, New Hampshire, wrote in his diary “how many a man has dated a new era in his life from the reading of a book? The book exists for us perchance which will explain our miracles and reveal new ones.” Two pessimistic books, each published in April, are probably not changing people’s lives. Arguably, however, they describe and analyse something which is a matter of wonder and amazement; and judging from their sales and reviews, they seem to be catching people’s attention.

The first book is Valuing Wall Street: Protecting Wealth in Turbulent Markets (McGraw-Hill Professional Publishing, ISBN 0071354611) by Andrew Smithers and Stephen Wright of the London financial consulting firm Smithers & Co. At the book’s heart is the Q Ratio, devised by Nobel Laureate James Tobin in 1969, which tracks the ratio between the market value and net worth (i.e., physical and financial assets minus liabilities) of publicly-traded securities. Tobin designed Q as a measure of the cost of capital: the higher its value the lower the cost. Smithers & Co. use it differently, i.e., as a measure of the value of both an individual security and the overall market. To their (and Benjamin Graham’s) thinking, if a company’s stock is priced very high relative to its tangible net assets then it is probably overvalued; and the higher the average stock’s ratio of price to book value, the dearer the market as a whole. On the basis of the value of Q, Smithers and Wright warn that overall equity prices in the U.S. are currently dearer than at any time in the twentieth century. Indeed, “since Q shows the stock market to be overvalued by more than twice, a fall of 50% to 60%, or more, is likely [and] could easily bring the Dow Jones Index to under 4,000.”

Gene Epstein, writing in Barron’s Online on 15 May 2000, made three important points with respect to this prediction. First, he noted that Smithers & Co. has been sounding this warning since 1996. Second, Q measures tangible assets but excludes intangible assets. Examples of intangible assets include the patent on Viagra, the copyright on Windows98, brand names like Coca-Cola, the masthead of The Wall Street Journal and trade secrets like Colonel Sanders’ recipe for Kentucky Fried Chicken. Third, if these intangibles (whose value, alas, defies anything other than crude measurement) were included in the denominator of Q then its value would be lower and the inference about the valuation of individual stocks and the overall market “less drastic.” The critical and unanswered question – how much less drastic?

Another New Book for Value Investors

The second new book is Irrational Exuberance (Princeton University Press, ISBN 0691050627). Its author, Yale University economist Robert J. Shiller, is one of the leading scholars of behavioural finance (a field of study which combines psychology and economics). His book, the subject of a review in the 3 April edition of Business Week and the lead article of the 22 May 2000 edition of Barron’s Online, attacks mantras ranging from the efficient market hypothesis to the stocks-beat-bonds-over-the-long-term hypothesis. It also suggests that no explanation – including the technology-driven New Economy and Baby Boomers’ scramble to accumulate assets for retirement – accounts adequately for the high valuations prevailing today on Wall Street.

Shiller concludes that the behaviour of an “irrationally exuberant” (a phrase he used early in 1996 in a briefing note to Federal Reserve Chairman Alan Greenspan) herd has driven American financial markets to unsustainable heights. For each month between 1880 and early 2000, he calculated the stock market’s price-earnings ratio. The figure has varied from 5.0 during the 1920-21 depression and the nadir of the Great Depression to 44.3 in January 2000. This latter figure dwarfs the previous record (32.6 set in September 1929) and in Shiller’s view makes a “correction” inevitable. It is noteworthy that, stripped of their econometric embellishments, Shiller’s logic and evidence parallel those of Charles Kindleberger, the University of Chicago’s historically-inclined scholar of financial speculation and author of the classic Manias, Panics and Crashes: A History of Financial Crises.

Shiller notes that the correction which he is predicting need not be short and sharp, but rather can unfold over years or even decades. During the period 1901-21, for example, American equity markets gradually lost two-thirds of their real value and earned an average annual return of minus 0.2% per year. The years which followed the Great Crash were little better: from peak in 1929 to trough in 1932 the S&P 500 lost 80% of its value and from 1929 to 1949 returned an average of 0.4% per year. Finally, between 1966 and 1986 its return net of inflation averaged 1.9% per annum. If history is any guide (Shiller reckons that it is) then American investors should not expect more than modest real returns from their investments during the next ten or more years. (Warren Buffett, in a series of outstanding speeches edited by Fortune writer Carol Loomis in 1999, draws the same conclusion).

Gene Esptein has also criticised Shiller’s methods and questions his conclusions. In the 8 May 2000 issue of Barron’s Online he stated they discount the “big earnings surge of recent years,” attenuate the denominator of the price-earnings ratio and thereby greatly exaggerate the level of the market’s earnings multiple since the mid-1990s. Further, the 430-odd non-technology companies in the S&P 500 are selling for approximately 16 times earnings – a figure which only modestly exceeds their long-run historical average. (A rough parallel, it seems to me, currently exists in Australia: the same market which overvalues most high-profile ‘blue chip’ and ‘tech’ companies also undervalues a select number of low-profile medium and small firms).

Australian Blue Chip and Tech ‘Cover Stories’

I follow closely and take seriously the writings of James Grant, publisher of Grant’s Interest Rate Observer and author of several outstanding books. In the preface to The Trouble With Prosperity: A Contrarian’s Tale of Boom, Bust and Speculation Grant asked and answered (to my satisfaction, at least) what has probably been the key question posed by participants in financial markets during the past five-or-so years: “...have we, then, reached a new Garden of Eden? Categorically, no. I base this assertion on the tendency of people in markets to miscalculate – to invest too much and then too little – and to rationalise these errors with a macroeconomic cover story” (italics added).

Borrowing Grant’s phrase, since the beginning of May a “cover story” about Telstra Corp. Ltd has been clearly discernible. This story, in the form of a spate of negative articles and media commentary, seemingly rationalises what in retrospect appears to be the error of participating in the Telstra 2 float (or, equivalently, of buying Telstra at prices prevailing during the past couple of years). A “Solution 6 cover story,” which excuses speculators for paying up to $18.00 in January for a security which was quoted at less than $3.00 in May, has also been prominent during the past few weeks. And on 27-28 May The Australian Financial Review published what may the first instalment of a “News Corp. cover story” which will absolve many funds managers and investment institutions for paying up to $26.00 in April for the NCP scrip which they sold for $12.00 in December.

Why the cover stories? Experts have preferred and continue to prefer implausibly optimistic to conservative assumptions, anecdotes rather than explicit reasoning and woolly words to hard numbers. In so doing they have miscalculated: the use of very generous (to the companies concerned) assumptions, simple-yet-rigorous reasoning and information readily and continually available to the general public to yields the conclusion that the purchase at current prices of the shares of many of Australia’s largest companies and seemingly safest ‘blue-chip’ securities does not provide what Benjamin Graham called a “margin of safety.” Nor, even at their much-reduced prices, do the fallen market darlings of the tech sector.

The prevalence of cover stories may be a symptom that experts have neglected plausible assumptions, explicit reasoning and hard numbers, and that they now seek to distract attention from that neglect. (In President Harry Truman’s words: “an expert is someone who doesn’t want to learn anything new, because then he wouldn’t be an expert.”) Accordingly, it seems to me that brokers, financial analysts, planners, journalists and commentators should be studying not only Smithers’ and Wright’s Valuing Wall Street and Schiller’s Irrational Exuberance: equally importantly, they should be pondering the implications of Shakespeare’s Henry V.

The Year Ahead

Leithner & Co. has avoided and continues to steer clear of ‘blue chips’ (which in most cases are overpriced) and tech companies (which in many cases are doomed to extinction). Its cash weighting is also high. At the same time, however, a small number of quality Australian financial assets have been and remain available at prices attractive to value investors. This stance, unconventional to many people, is particularly out-of-step with the distemper of the times. It seems to me, however, that it is both prudent and conservative. A circular to shareholders, to be dated 15 August 2000 and released early in the new financial year, will justify this position and thereby outline the gist of the Company’s intended operations during the next twelve months.

Chris Leithner


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