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Leithner Letter No. 7
26 July, 2000

The Best Value Investor You’ve Never Heard Of

From a modest and nondescript flat at Des Moines Iowa, Joseph Rosenfield, 96 years of age and friend of Warren Buffett for almost 40 years, has made fewer than a half-dozen major investments. For this and other reasons Mr Buffett calls him “a model of unconventional rationality.” Going about his business quietly and modestly (and with assistance from Mr Buffett during the late 1960s and early 1970s), in little more than 30 years Mr Rosenfield has transformed an $11 million endowment into an investment juggernaut with a market value of approximately $1 billion. Grinnell College has 1,300 students, a 108-acre campus, a solid reputation in educational circles and – thanks to Mr Rosenfield – the largest endowment per student of any private liberal arts college in the U.S.

Grinnell’s nest egg not only dwarfs those of top-ranked liberal arts schools such as Amherst and Vassar: it is also bigger than the endowment funds of major universities including Carnegie-Mellon and Georgetown. Yet very few people – including the students who have benefited so much from his actions – would recognise his name or face. Jason Zweig’s article in the June 2000 issue of Money, “The Best Investor You’ve Never Heard Of,” tells a story worth reading, an investment parable worth studying and an approach to ethics and life well worth emulating.

Risk and Risk Control in an Era of Confidence (or Is It Greed?)

It seems to me that many market participants (whether as individuals or employees of investment institutions) are, notwithstanding the severe volatility encountered during April and May, continuing to discount hard evidence, ignore elementary rules of logic and succumb to emotion and unwarranted optimism. Some are doing so by equating hard facts, woolly hype and optimistic predictions; others are doing so by confusing quantitative dexterity with logical rigour. If so, then they under-estimate the risks which inhere in the allocation of investment capital. As Benjamin Graham wrote of Wall Street’s frenzy during the late 1920s, “...there was nothing wrong with these [‘New Economy’] ideas, except that it was almost impossible not to carry them too far. With encouragement from the past and a rosy prospect in the future, the buyers of ‘growth stocks’ were certain to lose their sense of proportion and pay excessive prices. For no clear-cut arithmetic sets a limit to the present value of a constantly increasing earning power. Such issues could become worth any value set upon them by an optimistic market.”

John C. Bogle, founder and former chief executive of The Vanguard Group and currently the president of Vanguard’s Bogle Financial Markets Research Center, stands apart from this crowd. The text of his speech, entitled “Risk and Risk Control in an Era of Confidence (or is it Greed?)” and delivered on 6 April 2000 to the New England Pension Consultants’ Client Conference, Boston, Massachusetts, therefore deserves close study.Bogle’s speech consists in three key premises. First, investing comprises four key elements: reward, risk, time and cost. One element, reward, is beyond the investor’s control. In Bogle’s words, “future stock market returns are completely unpredictable in the short-run and-unless we know more about the world 25-years from now then we do about the world today-may prove even less predictable over the long-run.” Bogle believes that investors can control the other three primary determinants of investing and that they should focus on them.

Bogle’s second premise is that (although we cannot control them) the rewards derived from any given investment is based upon the stream of earnings (if any) which that investment will generate in the future. “The purpose of any stock market, after all, is simply to provide liquidity for stocks in return for the promise of future cash flows, enabling investors to realise the present value of a future stream of income at any time.”

Bogle’s third premise is that “the sheer mathematics of the market – even assuming the continuation of box-car growth rates that are by no means assured – [seems currently] to defy reason. A recent analysis by Professor Jeremy Siegel (author of Stocks for the Long-Run) considered the nine large-cap companies that are currently priced at over 100 times 1999 earnings. Dr. Siegel accepted, for argument’s sake, that the earnings of these companies would grow at their estimated average rate of 33% per year(!) over the coming decade-an even higher rate than I assumed earlier. Even so, for investors to earn a 15% annual return, they would have to sell at an average of 95 times their earnings five years from now, and 46½ times their earnings a decade hence. Based on his analysis of the Nifty-Fifty era of the early 1970s, he reports ’no stock that sold above a 50 p/e was able to match the S&P 500 over the next quarter-century.’ His conclusion: ‘Big-Cap Tech Stocks Are a Sucker Bet.’” In recent weeks, alas, a bet which more and more Australian investors are willingly undertaking.

Australia’s New Financial Year and the Case for Reasoned Scepticism

Like Warren Buffett, John Bogle believes that many of today’s ’investments’ are riskier propositions than their owners realise. He also believes that investors should reduce their expectations about future rewards – which, he hastens to remind us, are beyond the investor’s direct control – to more realistic levels. Messrs Buffett and Bogle thereby echo an admonition uttered by Benjamin Graham during the 1930s: “We [Graham and his co-author, David Dodd] have been trying to point out that this concept of an indefinitely favourable future is dangerous, even if it is true; because even if it is true you can easily overvalue the security, since you make it worth anything you want it to be worth. Beyond this, it is particularly dangerous too, because sometimes your ideas of the future turn out to be wrong. Then you have paid an awful lot for a future that isn’t there. Your position then is pretty bad.” Mr Buffett re-iterated this fundamental point at Berkshire Hathaway’s 1998 Annual Meeting: “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 the price they paid.”

The beginning of Australia’s financial year is an appropriate a time to set out plans and strategies. Leithner & Co.’s policy is one of “reasoned scepticism” (the opposite of Robert Shiller’s evocative phrase “irrational exuberance”).

Chris Leithner


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