Leithner Letter No. 52
26 April, 2004

Money, then, acting as a measure, makes goods commensurate and equates them; for neither would there have been association if there were not exchange, nor exchange if there were not equality, nor equality if there were not commensurability.

Nicomachean Ethics (350 BC)

Value is. nothing inherent in goods, no property of them, but merely the importance that we first attribute to the satisfaction of our needs. The value of all goods is merely an imputation of this importance to economic goods. [Hence] value does not exist outside the consciousness of men [and] the value of goods is entirely subjective in nature.

Carl Menger
Principles of Economics (1871)

What is “Value” Anyway?

Stock brokers, financial advisers and planners, analysts and strategists and commentators and speculators regularly express the opinion that this security (or market sector or market as a whole) is “undervalued” or that that one is “overvalued.” But the prominence of value in their view of the world is much more apparent than real: virtually without exception, as a careful reading of their reports and quotes in the media makes plain, their preoccupation – indeed, their obsession – is “the market” and short-term “performance” (see also Letter 21).

Mainstream market participants almost invariably think about the market in terms of a price index, i.e., a weighted average of the current prices of the securities comprising the index. Analogously, they regard a stock not as a title to part-ownership of an underlying business but as a piece of paper whose price fluctuates over time. Performance, whether of an individual security, segment of a market or market as a whole, is defined as the change of price (usually expressed in percentage terms) from one point in time to another. Accordingly, the more an index increases (or the greater the rise of a particular asset’s price) the better its performance. Conversely, the smaller the rise (or the greater the decrease) the more negative the interpretation. And if Index A (say, Jack’s portfolio) increases relative to Index B (Jill’s portfolio or some market index), then A has “outperformed” B.

Like most human beings, brokers, advisers, planners and journalists are creatures of habit; as such, they seldom subject their habits to searching scrutiny from first principles. Perhaps for this reason, they cannot recognise that three fundamental assumptions underlie their neglect of value and glorification of price, index, short-term performance and unrealised capital gain. The first assumption is that there exists a one-to-one correspondence between the price and the value of a good, service or security. Value, in other words, is simply an unobserved carbon copy of an observable and objective price. If the price of a steak or a haircut or a stock is $10.00, then its value is also $10.00 – nothing more, nothing less and no doubt about it; and if a price changes by some amount then value changes by an identical amount.

Secondly, goods and services possess an intrinsic and objective property (classical economists from Adam Smith to David Ricardo and Karl Marx nominated their inputs of land and labour) such that their prices (and hence values) can be determined by their cost of production. According to Adam Smith, for example, “labour is the real measure of the exchangeable value of all commodities.” Thirdly, equality of value is a necessary condition of the proper exchange of some amount of one given good or service for some amount of another. If their value were not equal, in other words, then they should not change hands.

It follows from the first and second assumptions that the values of different quantities of certain goods can be declared equal to one other. If the price of good X is 0.4286 times the price of service Y, for example, then the value of seven units of X equals three of Y. And it follows from the second and third assumptions that the price of a good or service should approximate what it costs to produce – and if it does not then the exchange is “unfair” because one of the parties is “exploiting” the other. Further, if “proper” trade occurs only when the values being exchanged are equal, then any exchange in which one party is deemed to receive much more value than he gives must be dishonest or otherwise illegitimate – and therefore deplorable and best resolved by legal sanction and (because these days the state must intervene whenever anything is the matter) government regulation.

From these assumptions spring various harmful absurdities. Prominent among them are not just the syllabus and catechism of contemporary finance, but also antitrust laws and government organisations such as the Australian Competition and Consumer Commission (see in particular Pierre Lemieux’s Smash the State, Not Microsoft and Domenick Armentano’s articles such as Antitrust and Microsoft, The Immorality of Antitrust Law and Antitrust Policy: Reform or Repeal?). The notion that price should approximate cost plus some permissible margin has been used to justify the “cost-plus” pricing mechanisms used to fix contracts, utility rates, insurance premiums, tolls on roads, bridges and tarmacs, wages and terms of employment and myriad other things regulated by governments. Among its invidious consequences, “cost plus” invites producers to use resources less efficiently than they otherwise might (i.e., to increase their costs in order to “justify” higher rates to the government regulator) and to conflate their higher costs with perks for managers and workers.

These three assumptions, as Gene Callaghan notes in his excellent article, Carl Menger: The Nature of Value boast a lineage that extends back to Aristotle (see also Hans Sennolz’s preface to Eugen von Böhm-Bawerk, Value and Price: An Extract from Capital and Interest, Libertarian Press, 1960, 1973, ISBN: 0910884013). Above and beyond their troubling consequences, Callaghan also notes that they are circular. If, for example, the value of a PC depends upon the labour and materials required to construct it, and if the value of these materials depends upon the labour and other materials required to produce them, then how does one determine the value of that labour? If the value of a kilo of apples depends upon the value of the labour and land that produced it, then how does one ascertain the value of farm labour and land? Classical economists implicitly recognised but ultimately failed to resolve this difficulty.

Karl Marx, for example, acknowledged that someone who smashed chairs could not expect the same pay as someone who built chairs. According to Marx, only “socially valuable” labour determines the value of goods and services. By what criterion do Marxists characterise labour as “socially valuable”? The “social value” of the goods it produces! Hence the vicious circle the classical economists could not resolve (and which continues to bedevil parts of contemporary mainstream economics and finance): the value of goods and services derives from the value of the capital, labour and land required to produce them; and the value of that capital, labour and land depends upon the value of the goods and services they produce. Given this circularity, it is no wonder that the typical broker or financial planner is more than happy to talk interminably about the price of a security – but suddenly turns mute when asked to define and justify its value.

The founder of the Austrian School, Carl Menger, demonstrated that the conceptions of value and price adopted by Aristotle, the British Classicists, Marx and their contemporary mainstream progeny are muddled and mistaken. So too, in important ways, are contemporary mainstream views about the market and exchange in the market. To regard value and price as synonyms is to introduce a circularity into one’s reasoning that leaves these concepts unexplained – and may render estimates of value and negotiations of price prone to error. Menger hardly intended to overthrow classical economics. He applauded its emphasis upon universal and immutable economic law and the laissez-faire policy conclusions derived from these laws. Menger sought to reconstruct classical economics by grounding laws of supply and demand and the theory of monetary calculation in the choices and actions of consumers. It is interesting that Menger, William Stanley Jevons and Léon Walras uncovered very similar principles (such as subjectivism and the law of diminishing marginal utility) separately but almost simultaneously.

Neoclassical economics builds upon the stones laid by these three founders; yet the efficient markets hypothesis, modern portfolio theory and the like, which are close relatives of modern neoclassicism, utterly ignore Menger and the Austrian School. It is also interesting to note that Grahamite value investors, reprobate dissenters from the contemporary mainstream, pay much more attention to value than does the mainstream (see also The Meaning of “Over-Valued” by Christopher Mayer). Value investors think about value in terms that are not Austrian but are nonetheless much closer to Menger than Aristotle. Anticipating the assessment of John Burr Williams (A Theory of Investment Value, Fraser Publishing Co., 1938, repr. ed. 1997, ISBN: 087034126X) that “separate and distinct things not to be confused, as every thoughtful investor knows, are real worth and market price,” Benjamin Graham (Security Analysis: The Classic 1934 Edition, McGraw-Hill, 1996, ISBN: 0070244960) held that price is what is paid and that value is what is received; observed that over time price and value tend to gravitate towards one another but that at any given point in time they may diverge (sometimes by a wide margin); and lamented that very few people recognise the fundamental difference between value and price. It is this vaguely Austrian conception of value and price that ultimately distinguish Graham and his successors from the contemporary mainstream. Value investors, as practitioners of Graham’s principles are often called, thus reject today’s dogma that the price and value of a security necessarily coincide at all times.

Subjective Value and Marginal Utility

Carl Menger (1840-1921) was an Austrian finance journalist, academic, civil servant and for two years one of the tutors of Crown Prince Rudolf. During the 1870s he climbed the academic ranks at the University of Vienna, and in 1879 was appointed by Emperor Franz Joseph, Rudolph’s father, to the Chair of Political Economy in its Law Faculty. His appointment was to a significant extent the result of the impact of his book Principles of Economics (1871, 1994, Libertarian Press, ISBN: 0910884277). It revolutionised economists’ thinking about value and their comprehension of the formation of prices. Perhaps most importantly, Menger showed that the value of any particular good or service does not inhere in the good itself; rather, it resides in each individual’s perceptions, judgments and calculations about the good and the various ends it might serve. These perceptions vary from one person to another; and for any given person they also vary from one time and place to another. Value, then, is an attitude or disposition that a person adopts towards a good, service or security. He chooses whether to value it; and if so, he chooses what value to place upon it. Value, in short, is subjective; accordingly, there is no such thing as “intrinsic value.”

John Burr Williams approached this view (but did not shake himself completely from the notion that value is an innate characteristic) when he noted that “concerning [a stock’s] true worth, every man will cherish his own opinion.” To say that value is subjective is not to say that it is arbitrary or that any value is as plausible as another. Quite the contrary: rigorous statements can be derived from first principles about the process individuals use to ascribe value to goods, services and securities. Most notably, an individual’s valuation of a given amount of a particular good derives from his assessment of its marginal utility. The greater an individual’s assessment of the utility an extra unit of the good provides, in other words, the greater his valuation of that unit. The value of any single unit of a stock of identical goods in an individual’s possession is his perception of the least important (marginal) alternate use to which the unit can be put. Individuals strive to place the limited resources at their disposal to the most highly valued uses. Once those most highly-valued uses are met, each additional unit of a stock of identical goods will be allocated to a lesser-valued use than was previously possible; and the value attached to each additional (marginal) unit will be lower than that assigned to previously-held units.

Consider, for example, a Robinson Crusoe who discovers three fertile fields on his island. Imagine that each is identical to and interchangeable with the others. One will be assigned to the fulfillment of what Crusoe regards as its most urgent uses (say, the cultivation of foodstuffs essential to his survival). The second will be put to work satisfying his assessment of the most urgent wants that have not yet been satisfied (say, the cultivation of crops not essential to survival but of which Crusoe is very fond). The wants which field #2 satisfies are clearly ranked lower by Crusoe than the wants that field #1 has satisfied. Similarly, field #3 might be capable of performing the same service as the others, but it will be put to work satisfying the highest of the remaining wants satisfied by neither #1 nor #2 (say, the cultivation of colourful and aromatic flowers). Under these conditions the value to Crusoe of any one of his three equivalent fields is equal to his assessment of the value of the least-urgent (“marginal”) wants which they are able to serve, i.e., the cultivation of colourful and aromatic flowers.

As the number of units of an identical good in one’s possession decreases, on the other hand, they can be put to fewer uses; and the value to the individual of the least important (marginal) use to which this decreased available stock can still be applied will increase. If a landslide destroys field #2, for example, then Crusoe will be able to satisfy fewer of his wants. Given his ranking of wants and the two remaining fields’ ability to satisfy them, he will therefore cease the cultivation of flowers and shift field #3 to the cultivation of crops not essential to survival but of whose taste he is very fond. Under these conditions the value to Crusoe of any one of his two remaining fields is his assessment of the value of the least-urgent wants which they are able to serve, i.e., non-essential foodstuffs. Crusoe has fewer fields, they can fulfil fewer of his wants and their value to him has therefore increased.

A necessary condition for exchange is that the two goods being exchanged have reverse valuations on the respective value scales of the two parties to the exchange. If Jones possesses a certain amount of good X and Smith possesses a certain amount of good Y, and if each is to exchange some of his good for some of the other, then two conditions must obtain. To Jones, the marginal utility of an added unit of Y received from Smith must be greater than the marginal utility of the unit of X traded to Smith; and to Smith, the marginal utility of an added unit of X received from Jones must be greater than the marginal utility of the unit of Y traded to Jones. As long as these conditions continue to hold Smith and Jones will exchange additional units of X and Y. In Menger’s words, “this limit [to exchange] is reached when one of the two bargainers has no further quantity of goods which is of less value to him than a quantity of another good at the disposal of the second bargainer who, at the same time, evaluates the two quantities of goods inversely.”

In any exchange, therefore, the price of one commodity is simply its expression in terms of the other. The price of a unit of X, for example, is the amount of Y that Smith is willing to exchange for it; and the price of a unit of Y is the amount of X that Jones is willing to exchange for it. Subjective utilities (i.e., the value scales of particular individuals in certain places with respect to marginal amounts of particular goods at a given point in time) determine the prices and quantities of goods exchanged. Clearly, these utilities change constantly as individuals’ assessments of their circumstances change; accordingly, so too do prices. Prices, then, do not depend upon costs of production (which, as Menger showed, are also subjective).

Equally clearly, prices neither measure utility nor equal value. Menger established a causal link between the subjective values underlying the choices of consumers and the objective market prices used in the economic calculations of businessmen. A price is objective in the sense that it is inter-personal (i.e., agreed by two people); but its purpose is to facilitate exchange resulting from the disparity of individual subjective valuations rather than the equality of labour costs. Menger’s elucidation of value and price explained things that his classical forebears could not. Why, to cite an important example, is the value of a diamond typically so high relative to the value of water – despite the fact that the utility of water is arguably much greater than the utility of a diamond (i.e., the water rather than the diamond is essential to life)? Menger resolved this paradox a century after Adam Smith raised it. He showed that an individual’s valuation of a good is determined by its marginal rather than its total utility. For most people, in other words, a diamond is typically much dearer than a cup of water because (with the likely exception of a jeweller dying of thirst in the middle of a desert) an extra diamond generally has much greater utility than an extra cup of water. Water is generally cheap because it is relatively plentiful; and diamonds are expensive because the opportunity cost of their extraction and processing is high and therefore their supply is limited.

Time and Value Imputation

To Menger, the starting point both of the character and the value of goods is subjective. The very conception of a good, in other words, begins in the minds of thinking and acting human beings and radiates outwards to their physical surroundings. In this context it is important to emphasise another of Menger’s principles: human action is purposeful and thus tends to concentrate upon the establishment of the “goods-character” and value of things that most directly satisfy consumers’ wants. Menger categorises these things, such as food, clothing, shelter, domestic appliances, leisure and entertainment, as “consumers’ goods” (which are also known as “lower order” goods and “goods of the first order”). More generally, lower-order goods are goods that are consumed by their final users.

Clearly, however, consumer goods must be produced and it takes time to produce them. Menger dubbed the intermediate and capital goods required to make consumer goods as “producers’ goods” (also known as “higher order goods” or “goods of the second and higher orders”). Steel provides a vastly simplified example. Consumers neither desire nor consume – and therefore do not value – steel per se; instead, they desire, consume and value certain goods of which steel is a component. Consider a consumer good, such as a motor car, which contains much steel. The machines required to assemble a car’s steel components, as well as the components themselves, can be regarded as second-order producers’ goods. Taking the process of manufacturing back one stage, the machines, machine tools and materials required to produce the components (such as moulds, blast furnaces, pre-fabricated steel, etc.) can be conceived as third-order producers’ goods; and the materials required to produce these goods, such as processed iron ore and coal, are fourth-order producers’ goods, and so on.

Menger’s insight is that the “goods-characters” of consumers’ goods radiate outwards from human beings and their subjective wants towards external things more remote from the direct satisfaction of those wants. Given a particular supply of (say) iron ore, for example, the more valued by consumers are the goods whose manufacture requires iron then the more valuable the ore. Further, the greater the value imputed to iron ore the greater the incentive to transform a given “thing” (such as a newly-discovered deposit of ore) into higher-level producers’ goods (mined ore, processed ore, pig iron and steel) and ultimately into lower-level consumers’ goods (motor cars, refrigerators and washing machines). By means of this process of value imputation, then, the prices of producers’ goods are derived from the prices of consumers’ goods; and the prices of consumers’ goods are derived from their ability to satisfy consumers’ wants.

In the view of Menger (which modern Austrians have inherited), the technical process of production proceeds forwards, i.e., from goods of higher order to goods of lower order; and at each stage there occurs a transformation of the good into another good which more directly satisfies consumers’ wants. For this reason, and to use a much-bastardised phrase, the creation of value is envisaged at each stage. Production thus proceeds from goods relatively remote from the direct satisfaction of human wants and towards goods relatively close to the satisfaction of those wants. The economic process of valuation, on the other hand, proceeds backwards, i.e., from goods of lower order to goods of higher order. The imputation of value, in other words, proceeds from more refined goods back to the less refined goods required to produce them.

Individuals, then, demand neither iron ore and petroleum nor smelters and refineries; nor do they value iron and crude oil per se. Rather, they value things like motor cars, petrol and the convenience of personal transport; and the prices of the motor car and its associated higher-order goods is derived from consumers’ valuation of the convenience of personal transport. Similarly, individuals do not demand heating oil, natural gas or electricity directly: instead, they value the comfort and convenience which oil-, gas- and electrical-powered consumers’ goods (such as heaters and air conditioners) furnish. It is in this manner that the prices and values of these lower-order producers’ goods are derived from and depend upon the satisfaction consumers derive from their associated consumers’ goods. Prices in unfettered markets transmit signals among producers and consumers which cannot be transmitted by other means. A higher (lower) price signals that, for the moment and whatever reason, consumers are prepared to exchange more (less) money for the good, service or asset.

Producers compare this objective price with its subjective opportunity cost (i.e., their perception of the most profitable alternate use to which they can put their leisure, labour and capital). If producers are prepared to forego this alternative, then they may have an incentive to commence, maintain or increase production; conversely, if opportunity cost is greater than price, then producers may have an incentive either to reduce or to cease production. On the other side of the transaction, consumers also compare price and opportunity cost (i.e., the best alternate use of what they must forego in order to make the transaction). If the former is greater than their perception of the latter, then they may have an incentive to reduce or cease consumption of the good; conversely, if they are prepared to forego this best alternative, then consumers have an incentive either to commence, maintain or increase consumption. Market prices thus provide an objective means whereby buyers and sellers can make calculations about their subjective wants.

Carl Menger and the Intelligent Investor

Prices Are Set “At the Margin”

A price is a ratio at which the “most eager” buyer(s) and “most eager” seller(s) voluntarily exchange some specified good, service or commodity. A buyer is “most eager” in the sense that (s)he is willing to exchange it for the greatest amount of some other commodity such as money. A seller is “most eager” in the sense that (s)he is prepared to accept less money for it than is any other seller. Hence a security’s least optimistic present owner and most optimistic non-owner determine its price. In John Burr Williams’ words, “the margin will fall between owners and non-owners, the in and outs, the ayes and nays; and at this margin, opinion, mere opinion, will determine actual price.” The price of a stock, bond or other security at any point in time is determined by marginal opinion at that time. It follows that a particular price is unique to a given buyer(s) and seller(s), the security being exchanged, their attitude towards it and their information about it. All of these determinants of a security’s price are subject to sudden and unexpected change; accordingly, so too is its price.

A stock’s price may, in other words, tell us something about the value imputed to it by an eager buyer and eager seller at 11.00 on Monday 15 March; but it tells us nothing about the value attributed to it by other owners and by non-owners. Still less does it tell me the value I should impute to it. A stock’s price and its value, then, are very distinct things; in any given exchange the one will not equal the other; and current price may differ greatly from my estimate of its value. Only if the current price differs considerably from my own assessment of its value and no better investment opportunity presents itself does this price give me an incentive to act. According to Warren Buffett (Forbes 4 January 1988), “the market is there only as a reference point to see if anybody is offering to do anything foolish.” Mr Buffett added (The New York Times Magazine 1 April 1990) “for some reason, people take their cues from price action rather than from values. What doesn’t work is when you start doing things that you don’t understand or because they worked last week for somebody else. The dumbest reason in the world to buy a stock is because it’s going up.”

Prices Are Neither Omniscient Nor Prescient

The price of a stock or bond, then, is determined by marginal opinion. But opinions are not facts, and the opinions of marginal buyers and sellers are not necessarily informed opinions. Market participants, in other words, are neither omniscient nor prescient. James Grant puts it tartly in Minding Mr Market: Ten Years on Wall Street With Grant’s Interest Rate Observer (Farrar, Straus & Giroux, 1993, ISBN: 0812924843): “to suppose that the value of a common stock is determined purely by a corporation’s earnings discounted by the relevant interest rates and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen to the defence of Joseph Stalin and believed Orson Welles when he told them over the radio that the Martians had landed” (see also William Sherden, The Fortune Sellers: The Big Business of Buying and Selling Predictions, John Wiley & Sons, 1997, ISBN: 0471181781).

Like human beings more generally, brokers, advisers, investors and speculators are a very varied lot. They are occasionally prone to extremes of emotion; accordingly, the prices they pay stocks and bonds are as fallible as they are variable. Indeed, the market’s function as a mechanism by which value is (re)discovered assumes that miscalculations and changes-of-mind will be commonplace. A buyer, for example, may (without any intention by the seller to deceive) realise retrospectively that he received less value than he paid. Many buyers of tech stocks learnt in 2000-2001 that they had made such miscalculations. Conversely, the buyer makes a more fortunate error when (without any obvious ignorance on the seller’s part) he discovers after the transaction that he has received far more value than he paid.

In this respect both the buyers and sellers of Berkshire Hathaway during the 1960s, 1970s and 1980s miscalculated. Assume that the economics and operations of a business (call it X Ltd) change little from day to day. If so, then the short-term price volatility of its stock tells us nothing about these economics and operations, and plenty about marginal buyers’ and sellers’ perceptions of these things. More generally, some price changes stem directly from the appearance of genuinely new information about the business, its operations and financial results. Equally clearly, however, most fluctuations bear little or no direct relation to these things. If so, then the absurdity of defining the “performance” of a security or bundle of assets in terms of short-term price changes becomes readily apparent. For the same reason, an increase of price per se does not signify the creation of wealth and a decrease of price need not imply its destruction. As Menger showed, a change of price necessarily reveals only that a change in marginal market participants’ subjective preferences for one commodity vis-à-vis another has occurred. According to Graham, “you are neither right nor wrong because the crowd disagrees with you.” Rather, “you are right because your data and reasoning are right.” Indeed, and as he also emphasised, “the right kind of investor [takes] added satisfaction from the thought that his operations are exactly opposite to those of the crowd.”

As a Rule, Disbelieve the Media

Using Menger’s insights into value and price, it becomes clear that the standard boiler-plate of media reports about the stock market are misleading– and that several of the claims commonly reported are patently false. When tumult is observed on the stock exchange, for example, reporters typically draw erroneous conclusions. Approximately 1.157 billion shares, bonds, options and other instruments on the Australian Stock Exchange were traded for $2.281 billion on 12 March. By my (admittedly crude) calculations there are approximately 385 billion securities registered on the ASX. The Australian and Radio 4BC described the trading that day as a “selloff” – even though considerably fewer than one-half of one percent of those securities changed hands.

From one day to the next, and from week to week and month to month, most investments stay invested. It is also false to talk, as journalists and others typically do when prices fall suddenly and precipitously, about “a rush to get out of the market.” Under these circumstances, reporters imply that trades are conducted solely by one party – sellers. But every transaction requires a buyer as well as a seller; and every stock that is sold must also be bought. For every person who wishes to exchange a share of X Ltd for some amount of cash, there exists another person who is prepared to exchange that amount of cash for the share. And for every person who wishes to “exit the market” at some price there must also exist another who wishes to “enter the market” at that price. At the end of a day’s trading “the market” contains the same number of shares (ignoring IPOs, rights and companies’ repurchase of their own shares) that it did at the opening bell. At the close of trade, then, it has neither shrunk nor grown and the “exits” are perfectly matched by the “entries.” This point also dispels the old chestnut that “the market” is some sort of “collective mind” or “social intelligence” that exists apart from the actions of individual market participants.

The Bizarre Cult of Unrealised Capital Gain

It is also false to assert, as journalists and others regularly do, that on a particular date market participants “made” or “lost” money. This assertion, like so many others in the mainstream media, misconceives the nature of prices. As Menger demonstrated, a price is the ratio at which one good (say money) is exchanged for another (say a share of X Ltd). It is not an indicator of intrinsic value. To believe otherwise is to conflate “paper” gains and losses, adjustments of sentiment and changes in wealth. Finally, this assertion claims knowledge that one cannot easily possess, i.e., the prices at which those who sold their shares in X Ltd on a particular day originally bought those shares. As a closely related point, a moment’s reflection shows that dividends and interest payments on the one hand and unrealised capital gains on the other are fundamentally incommensurate things.

Dividends are “endogenous” in the sense that they are generated within a company. They are tangible outcomes of its operations and earnings. Because they are usually paid in cash, and because the value of cash cannot be manipulated (by a company, as opposed to a central bank), once they are declared their worth cannot be questioned. Dividends are also “permanent” in the sense that once they are paid they cannot be revoked. Unrealised capital gains, in sharp contrast, are neither endogenous nor objective nor permanent. They are “exogenous” – they do not derive directly from the company or its operations; rather, they arise indirectly from outsiders’ perceptions of the company and its assets, earnings, prospects, etc. The extent of an unrealised capital gain depends upon the price that marginal buyers and sellers at a given point in time are prepared to pay for a company’s stock. Because this willingness changes from day to day, until they are realised their dollar value is usually volatile and can often be ephemeral.

Dividends and unrealised capital gains, then, are measured in terms of a common metric: dollars and cents. But in many respects they are incommensurate. Like wallabies and road trains, it may make sense in a particular situation to count each separately. But it makes no sense to combine these counts. Thornton Parker has noted (What If Boomers Can’t Retire? How to Build Real Security, Not Phantom Wealth, Berrett-Koehler, 2001, ISBN: 1576751120) that an unrealised capital gain – which he dubs “phantom wealth” – is created or destroyed when a market transaction establishes a new price for a given company’s shares. Yet on the basis of that marginal transaction, all of the company’s shares are treated as if they are “worth” the new price. For example, if a company has 100 million shares outstanding, and if in a transaction involving 100 shares the per-share price rises by $1, then the value of each of the 100 million shares is deemed to rise by $1. Although only a miniscule fraction (1 out of every million) of the shares has been traded, each of the 100 million shares is now valued at the new market price. In so doing, an unrealised capital gain of $100 million has been created out of thin air.

In Parker’s words, “nobody knows where all that money came from and it is many times greater than the price increase times the number of shares traded. If, on a subsequent day, the price slips by a dollar, the $100 million vanishes – it was just a phantom.” Parker worries that unrealised capital gains comprise a major component of most private wealth – especially retirement plans and particularly in the U.S. Given that few American stocks pay significant dividends, the major (and often the only) only reason to buy them is the expectation of capital gain at some point in the future. To a greater and greater extent, then, today’s portfolios (whether private or institutional) are perceived as inventories of things that are bought and held in the expectation that they will later be sold at higher prices. Significantly, however, “standard accounting practice requires virtually all other inventories of things that are bought for resale to be valued at cost or market price – whichever is lower. They may be marked down, but never up, and profits are not recorded until the items have been sold. Portfolios of stocks are the glaring exception to that practice. When they are marked up, profits are recorded, even though they haven’t been – and may never be – made.”

Can It Really Be Realised?

It is in this context that another fundamental difficulty attaches to unrealised capital gains: the alleged ease with which they can be realised. Selling shares whose market price has increased above their purchase price is usually assumed to be trivial, automatic, and frictionless. But it need not be so and at critical historical junctures has not been so. Consider as an example a seminal analysis (published in the Journal of Financial Economics) of changes, measured annually between 1926 and 1979, in the share prices of companies listed on the New York Stock Exchange. For each five-year period during these years, companies were placed into five equally sized groups (quintiles) on the basis of their market capitalisation (i.e., their number of shares times the market price per share). For the entire period, the average annual total return for companies in the smallest quintile was 11.6%; and the average for companies in the largest quintile was 8.8%. The analysis also concluded that the owners of “small cap” companies reaped stunning capital gains from the nadir of the Great Depression to the late 1930s, and that outsized capital gains can be reaped by purchasing “small cap” stocks at the troughs of recessions. Most notably, between 1930 and 1935 owners of small-cap stocks reaped average capital gains of up to 120%.

This path-breaking study, and others inspired by it, has provided a basis for the investment of billions of dollars by hundreds of thousands of investors in “small cap” funds. As David Dreman (Contrarian Investment Strategies: The Next Generation, Simon & Schuster, 1998, ISBN: 0684813505) shows, among their other shortcomings these studies overlook the inherent illiquidity of small companies, the frequently very low prices of their shares and the illiquidity of the NYSE during the Depression. During the 1930s, most of the small cap shares in question sold at a fraction of a dollar (many sold for as little as $0.25 or even $0.06 per share). Further, many of these companies’ shares were so thinly traded that appreciable numbers could be neither bought nor sold. Any hypothetical purchaser in 1930 would have been unable to buy more than a handful of shares (the average daily volume of companies in the smallest quintile was 240 shares per day during the entire 1930-1935 period, and the median volume in 1930 was 95 shares). Similarly, the hypothetical seller who sought in 1935 to sell the shares purchased in 1930 would have encountered considerable difficulty selling even a handful. Given the very small number of shares involved, any unrealised capital gain incurred would have been very modest; and the gain would have been very difficult if not impossible to realise.


The next time somebody tells you with a straight face that all investors have the same information, expectations and time horizon; that markets are very liquid, making transaction costs so small that they can be ignored; and that value and price are synonyms, the sane response is to laugh. The core of value investing, in the words of Benjamin Graham (widely regarded as the founder of modern financial analysis) is the contention that “investment is most successful when it is most businesslike.” This focus upon businesses, their economics, operations and results – and not “the market” – permeates value investors’ assumptions, reasoning and behaviour. It also forms the basis by which they measure the results of their investment decisions. Value investors think first about value and then about price, and they do so in terms that are not Austrian but are nonetheless much closer to Menger than Aristotle. The volatility of a company’s stock has nothing to do with its operations and financial results. For this reason it plays no part in any rational assessment of its value.

Yet for the vast majority of brokers, advisors and speculators-who-think-they-are-investors, prices and short-term fluctuations are the be-all-and-end-all. The greater the short-term increase of a security’s price, the more favourable their evaluation of its “performance”; conversely, the smaller the rise or the greater the decrease the more negative the interpretation. And if Asset A or Index A increases relative to Asset B or Index B, then A has “outperformed” B. From the point of view of a value investor, this pervasive “double-barrelled foolishness,” as Robert Hagstrom called it in The Warren Buffett Portfolio (John Wiley & Sons, 2000, ISBN: 0471247669), is not only counter-productive – at times it is also dangerous. It encourages people to check stock quotes every day, to rejoice when prices rise and worry when they fall. It also prompts institutions with responsibility for billions of others’ savings constantly to buy and sell, churn assets at dizzying rates and generate appreciable transactions costs – i.e., to do everything except act as businessmen and make justifiable estimates of value. The mainstream’s genetic disposition to neglect value and glorify price, index, short-term performance and unrealised capital gain, which stems from Aristotle and culminates in the “twaddle” and “dementia” (as Charles Munger has denounced it) of contemporary mainstream finance, is the principal reason why speculation is typically far more prevalent than investment on financial markets. This genetic predisposition and the behaviour it spawns is a big reason, as many briefly learnt during 2000 and may have to relearn, Why Speculation Inevitably Ends in Tears.

Chris Leithner


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