Leithner Letter No. 9
26 September 2000

Telstra and Mr Market

Telstra Corp. Ltd, Australia’s second-largest listed company, is clearly a formidable enterprise. Despite a ratings downgrade earlier this year and the possibility of a further downgrade in the months ahead, it nonetheless retains one of corporate Australia’s highest credit ratings. And at the end of August it reported the largest 12-month profit ($A3,700 million) in Australian corporate history.

Value investors in the Graham-and-Buffett mould seek to purchase sound assets – on the critical condition that they are available at a bargain price. In their search for value at a sensible price they bear in mind Benjamin Graham’s motto that “you are neither right nor wrong because the crowd disagrees with you, [but] because your data and reasoning are right. ... The right kind of investor [takes] added satisfaction from the thought that his operations are exactly opposite to those of the crowd.”

With that attitude in mind, in November 1999 I set out assumptions and reasoning which yielded the (at the time contrary) conclusion that the market price of Telstra’s securities exceeded their value. I wrote that “if this contrarian case holds water then the conventional wisdom has recently encouraged 1.6 million Australians to undertake what will turn out to be a mediocre long-term investment.” Since then the prices of Telstra’s securities – like those of many of their American, British and other counterparts – have fallen significantly. Telstra presently hovers at an 18-month low (common stock) and an all-time low (IRs).

In response to this development, the attention and energy of Telstra’s senior management, its major shareholder (the Commonwealth Parliament) and market participants seem presently to be focussed at least as much upon day-to-day fluctuations in the company’s share price as they are upon its present and future operations. The 8 September cover story of Business Review Weekly fret about Telstra’s share price. On 7 September The Australian Financial Review reported that management was considering the unusual step of releasing details about its first-quarter operations “to try to shore up its collapsing share price.” AFR also reported that the “lacklustre share price is causing nervousness among government ministers, who are worried the small army of Telstra shareholders might react adversely to potentially large paper losses.” One of its editorialists reported that both its Chairman and CEO met secretly in Parliament House on 6 September with the Finance Minister and Communications Minister. “And it’s a sure bet that the meeting discussed the vexed issue of the company’s share price and the looming date for shareholders to convert their instalment receipts into full shares.” (Non-institutional investors paid $4.50 per IR in November 1999 and must pay a further $2.90 in November 2000 in order to convert it into a fully-paid common share).

The fall from grace of Telstra’s share price also seems to be causing nervousness among minority shareholders. Robert Gottliebsen has written unequivocally of “the panic to get out of Telstra.” According to Gottliebsen, “there is a crisis. if Telstra shares remain at their current level, then we will be looking at a huge public share loss spread around an unprecedented number of people. The political consequences will be massive.” (The Weekend Australian 9-10 September).

Seemingly as a by-product of their obsession with the decrease of its share price, Mr Market and his hangers-on have become gloomy with respect to Telstra’s current operations and outlook for the future. Recent headlines are unequivocal: ‘Telstra Adrift in Sea of Doubt’ (The Australian 29 August), ‘Telstra Under Pressure’ (The Australian 31 August), ‘Investors Turn Torch on Telstra’ (The Australian 7 September), ‘Telstra Facing a Loss of Faith’ (The AFR 6 September) and ‘Telstra Alarm Bells Ringing’ (The AFR 7 September). And for good measure, in an article entitled ‘Telstra Is Bringing Us All Down’, Alan Kohler stated that senior management’s “strategic failure to deal with the digital revolution” has caused not just the fall of the prices of Telstra’s securities: it has much to do with the recent decline to record lows of the $A vis-à-vis the Yen and $US (The AFR Weekend Edition 9-10 September). The implicit rule: Anything That Is The Matter Down Under is henceforth to be blamed upon the perceived shortcomings in Telstra’s management.

Graham Has Been Forgotten ...

Two points – each of which is simple, fundamental and therefore publicly unutterable in finance and investment circles – emerge from the Telstra Share Price Saga. The first is that ‘regression to the mean’ or something akin to it occurs on financial markets.

Benjamin Graham premised his investment research and practice upon three axioms: a security’s price and value can and often do diverge; they may sometimes diverge for uncomfortably long periods of time; but eventually they will converge towards one another. The considerable success of Graham-Newman Corp. owed much to the increase of the prices of sound-but-unfashionable securities, bought at depressed market prices, towards their intrinsic value. Conversely, if the price of a company’s securities is bid aboveits value by euphoric buyers, then – even when the company’s basic operations and prospects remain unchanged – it is likely that, like Icarus, it will eventually fall from its rarified level. It is possible that 1.6m or more Australians are unwittingly experiencing this unpleasant reality.

“Analysts” cited in the Australian press (The Courier-Mail 2 September, The Weekend Australian 2-3 September) have tended to “advise” readers not to be swayed by day-to-day price movements and to retain their Telstra Instalment Receipts for the “long-term.” Similarly, the Prime Minister, Mr Howard, told Melbourne Radio 3AW on 1 September that “I don’t give a day-to-day commentary and I would simply make the observation that people should take the long view.”

Taken at face value (and thus possibly unfairly), these analysts and advisors appear to be oblivious both to the basic distinction between price and value and to their tendency eventually to converge. Warren Buffett has described one consequence of this omission: “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 what they paid.” Perhaps that is what the Prime Minister, together with many stockbrokers, funds managers, financial advisors and media commentators, mean when they continue to say – as they said at the time of the T2 float – that Telstra is a long-term investment. If they have paid a price which exceeds its value, then the owners of Telstra IRs may have to wait a long time – and in the process incur a significant opportunity cost – for their investment to generate its expected return.

... and Kahneman and Tversky Have Never Been Learnt

On the other hand they might decide to cut their losses and sell. In this respect a second elementary, fundamental and (with one partial exception) unuttered point emerges from the Telstra saga: the “advice” tendered by these “analysts” appears to be oblivious to key findings – such as the aversion to loss, ‘sunk cost fallacy,’ ‘endowment effect’ and ‘framing’ – of behavioural finance. This fascinating field of study, also known as behavioural economics or the psychology of economic misjudgement, draws insights in approximately equal measure from both economics and psychology. As shown by its founders Daniel Kahneman, Richard Thaler and the late Amos Tversky, money, finance and investing figure prominently among those things which render individuals uncertain, anxious and confused. Indeed, research in this field helps to explain why many otherwise-sensible people repeatedly make retrospectively-foolish financial choices. This very point inspires Why Smart People Make Big Money Mistakes and How to Correct Them: Lessons from the New Science of Behavioral Economics (Simon & Schuster, 1999), an excellent book written for a general audience by Gary Belsky and Thomas Gilovich.

Some Good Introductions to Behavioural Economics

Behavioural finance, it seems to me, is hardly a be-all-and-end-all. It is, however, an important tool with which to uncover and confront the biases which can impair one’s financial decisions. Everyone knows that optical illusions distort the way we ‘see.’ Now scholars are discovering that cognitive illusions – sets of biases imbedded within the human mind – distort the way we think. Charles Munger, Vice-Chairman of Berkshire Hathaway, has stated that “I came to the psychology of human misjudgement almost against my will; I rejected it until I realised that my attitude was costing me a lot of money.”

A short article by Scott Medintz entitled Reading Between the Lines provides an entrée to this field. Medintz writes that “the new science of behavioral finance can help investors understand why they make mistakes – and how to prevent the next one. Investing mistakes, like most things we do, have both immediate causes and more fundamental ones. Didn’t do your homework on a stock that tanked soon after you bought it? Your more fundamental error may have been crediting previous lucky moves to skill, and thereby grossly over estimating your investing abilities. In fact, psychological factors lurk behind many, if not all, common investor slip-ups – so much so that a whole academic discipline called behavioral finance has developed to study them.”

Whitney Tilson’s article entitled The Danger of Investor Overconfidence on The Motley Fool’s website provides a concise (3pp) introductory overview of some of the field’s major insights. The end of the article also contains useful links. Tilson notes correctly that investment decisions and performance can be affected more by emotions than intellect. Warren Buffett agrees: “success in investing doesn’t correlate with IQ once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

Undiscovered Managers, a money management firm based at Dallas, Texas, has put together a simple and concise Introduction to Behavioral Finance. Their Behavioural Finance Research Library contains academic research from leading scholars in the field. Of particular relevance are Terrence Odean’s Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment and Are Investors Reluctant to Realize Their Losses?

Finally, if you can spare 40 minutes, then the time spent listening to the audio interview conducted on 8 October 1999 (that’s 10-8-99 on Wall Street Uncut’s website) between Gary Belsky and Dave Allman will be time well-spent.

Graham Has the Last Word

It seems to me that we have a psychological error and a cognitive misconception to thank for the angst presently being experienced by Telstra’s owners. The psychological error derives from the overconfidence of investors, both institutional and individual; and the cognitive misconception stems ultimately from the conventional but mistaken conflation of investment risk and short-term price volatility.

In Graham’s words “... the risk of paying too high a price for good quality stocks – which is a real one – is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of lower than expected quality at times of favourable business conditions. thus it follows that most of the fair-weather investments, acquired at fair-weather prices, are destined to suffer disturbing price declines when the horizon clouds over – and often sooner than that.” The owners of Telstra Instalment Receipts are hardly the only ones who might ponder those words.

Chris Leithner


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