Leithner Letter No. 8
26 August 2000

Three Pointless Obsessions

Most market participants, including institutions, brokers, advisors and private investors, obsess about ‘the economy,’ its growth and the statistics such as Gross Domestic Product devised to measure its size and growth. Most agree that contraction and slow growth are bad, that rapid growth is also bad – lest it generate inflation and prompt the central bank to increase interest rates – and that moderate growth is good. Hence the attention paid and discussion devoted around the world to central banks’ attempts to engineer ‘soft landings’ (reductions of GDP’s rate of growth from the rapid to the moderate range) and ‘recoveries’ (increases of growth from the slow to the moderate range). And consequently the prominence accorded to attempts – much like those of the gizzard squeezers’ endeavours to tell Roman Emperors when the Huns would attack – to forecast levels of and rates of change in GDP.

Yet ‘the economy’ is a virtually meaningless figure of speech; and a fixation upon GDP and other aggregate-level statistics distracts rather than informs investors. A recent article entitled Does the Concept of an Economy Make Sense? by Dr Frank Shostak, Chief Economist at Ord Minnett Jardine Fleming Futures, provides a salutary reminder of these key points.

‘The economy’ is a virtually meaningless phrase because economic transactions cannot be distinguished from the individuals and firms which undertake them. In Dr Shostak’s words, “in the real world there is no such thing as national output. All wealth is produced by somebody and belongs to somebody. Goods and services are not produced in totality and supervised by one supremo.” Because individuals have different preferences and their goals change over time, governments’ ability to manipulate their transactions will be clumsy, their capacity to predict transactions’ course will be crude – and their attempt to summarise the transactions of large numbers of entrepreneurs, producers and consumers, buyers and sellers and importers and exporters in terms of a single number, GDP, will obscure much that is important and illuminate surprisingly little that is relevant.

Accordingly, for value investors the relevant figures on which analyses are based are not the aggregate-level statistics such as GDP, employment, balance of payments, etc. which are assembled by the Australian Bureau of Statistics. Rather, the appropriate data are the company-level profit-and-loss statements (which, under new accounting standards, become statements of financial performance), balance sheets and statements of cash flow produced by companies’ accountants and auditors.

Plus Ça Change

Investment institutions, brokers, advisors and private investors – not to mention many business people and homeowners – also tend to obsess about interest rates. This obsession takes the form of extensive discussion, prediction and speculation about their direction and level. On 2 August, in an announcement whose timing surprised some pundits, the Reserve Bank of Australia increased its official cash rate (i.e., the rate of interest charged to funds lent between banks and other institutions) by one-quarter of a percentage point.

This second obsession is also pointless. (Warren Buffett once famously remarked: “if Fed Chairman Alan Greenspan were to whisper to me what his monetary policy was going to be over the next two years, it wouldn’t change one thing I do”). Obsession about interest rates is futile because the key question to ask about the price of credit relates not to its level and short-term direction but rather to its integrity. Artificially-low and stable terms of credit – ‘easy money’ – can introduce distortions into and mask deformations in the chains of transactions from the production of raw materials to the final consumption of particular goods and services. Hence value investors ignore the chatter and ask themselves whether today’s prices of credit reasonably reflect people’s valuation of time. Do these prices, in other words, convey plausible signals about the extent to which people are willing to forego consumption today and direct their savings into investments? Do they communicate reasonable expectations about these investments’ ability to generate greater consumption tomorrow? Acting on these signals, would entrepreneurs and investors make remunerative and sustainable choices? Or would they be tempted to undertake ‘malinvestments’ which must eventually be liquidated?

The defining feature of credit-induced booms, it seems to me, is not that they are periods of when the pace of business activity is brisk. Rather, they are times when the artificially-low price of credit tempts entrepreneurs to squander precious capital on dud investments.

Woolly Words, Hard Numbers and Tacit Speculation

On 27 July The Broken Hill Proprietary Co. Ltd released its preliminary financial statements for the 13-month period ended 30 June 2000. Befitting its position as one of Australia’s largest listed companies, BHP’s results have been the subject of extensive discussion and comment.

Two aspects of this discussion are noteworthy. The first is the profusion of soft words, the paucity of firm figures and historical perspective – and the virtual absence of hard logic. Obscured within the fog of words, for example, are the company’s Earnings Per Share (E.P.S.) of approximately – depending upon one’s assessment of ‘abnormal’ items – $1.05. On the one hand, E.P.S. have rebounded smartly from the record loss of $1.34 recorded in 1998-1999. Yet E.P.S. for the financial year just ended – which were derived from the largest profit (measured in absolute terms) in BHP’s history – are virtually identical to those recorded in 1994-1995. BHP currently boasts a high (20%) return on shareholders’ equity. But this impressive figure owes much to the fact that more than half of the company’s per-share book value has been destroyed since 1997 (the smaller the number x by which one divides another number y, the bigger the resulting number z). Finally, BHP’s unfranked dividend, $0.47 per share, is the lowest since 1994; and since 1991 dividends have increased at a compound rate of just 3% per annum.

The coverage of BHP’s results did not emphasise these points. Nor did it underscore the laudable attempt of BHP’s Chief Financial Officer to note the undoubted strengths but to downplay the blue-sky potential of its present operations. Hence the second aspect of journalists’ coverage – its accentuation of possible upsides and attenuation of possible downsides. One commentator in The Australian crowed on 28 July: “if [Chief Executive Officer Paul] Anderson can keep it up – and there is every indication that he will – then BHP’s share price will be re-rated to recognise the strength of its management.” One journalist stated that “during the next five years, Mr Anderson aims to double BHP’s share price to $40, and market capitalisation to around $60b, giving it the size and liquidity needed to win the backing of the world’s largest institutional investors.” Another of The Australian’s journalists quoted Mr Anderson: “if we can’t get to $40 in the next few years, then we aren’t doing our jobs.”

Brave Assumptions and Hard Facts stand in the way of this objective. First, if the price of BHP shares is to double during the next five years, then either its E.P.S. must double, or the multiple which market participants attach to earnings must double, or some combination of the two must occur. Second, to assume that its earnings multiple will double is to assume that it will increase from approximately 20 (not far from the All Ordinaries’ current average) to 40 (nose-bleed territory). Third, to assume that E.P.S. will double during the next five years is to believe that they will grow at a compound rate of 15% per annum during that interim. Fourth, to make that third assumption is to take for granted something which has not occurred in living memory (as The Australian’s otherwise-crowing commentator confided on 28 July: “apart from brief periods, BHP management has not had the confidence of [investment] institutions for two decades”). Fifth, it is worth recalling that upon his accession to the helm of Boral Ltd, its then-CEO, Mr Tony Berg, also prophesised (in response to baiting by journalists) that its share price would double. Five years later the price of its shares had not doubled – quite the contrary: it had decreased – and Mr Berg was no longer at the helm.

An increase of 100% in the price of BHP’s shares during the next five years thus implies either that these already-ambitious (judging from the historical record) expectations about its operations will turn out to be conservative or that its share price will increase more quickly than its earnings. Over the long term (which is admittedly longer than five years), however, the intrinsic value of an asset cannot grow faster than the earnings which it generates. Accordingly, the juxtaposition by market participants of modest past results and exuberant expectations about the future is fraught with risk. (Another oft-quoted Buffettism: “Our conclusion is that, with few exceptions, when management with a reputation for brilliance tackles a business with a reputation for poor economics, it is the reputation of the business that remains intact.”) If so, then a startling possibility stares us in the face: during the next five years Mr Anderson and a significant number of other ‘blue chip’ CEOs will innocently but nonetheless to a significant extent rely upon speculators – and the market price fluctuations on which they thrive – to do their jobs. (Perhaps that’s one reason why Australian CEOs and speculators are beginning to exhibit American-style appetites for options over shares).

‘Risk Management’ Leads Back to Graham and Dodd

This sobering point begs questions about the conventional definition of risk and the practice of ‘risk management.’ Most market participants have a third obsession: they define investment risk in terms of the short-term ups-and-downs of a security’s market price. As a result, the practice of investment risk management is conventionally understood as an attempt to reduce within acceptable bounds the short-term variability – particularly in a downwards direction – of an investment portfolio’s current market worth.

A small and reprobate minority, value investors in the Graham-and-Dodd mould, disregard both the conventional definition of investment risk and the standard practice of investment risk management. In Benjamin Graham’s words, “basically price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies” (italics added).

Chris Leithner


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