But for some time few quality assets such as these have been available at what value investors would regard as reasonable or bargain prices. In a circular to shareholders dated 1 November 1999, for example, I set out assumptions, reasoning and evidence which yielded the conclusion that Teltra’s common stock and Instalment Receipts had been bid to levels significantly higher than their intrinsic value. Their purchase at prices which have prevailed during the past couple of years thus lacks what Benjamin Graham called a “margin of safety.” To buy them at these prices is unwittingly to speculate rather than consciously to invest.

Telstra’s Alleged Funk

That assessment was very much a minority and contrarian assessment. Indeed, until very recently anything other than highly optimistic assessments of Telstra’s operations and the future trajectory of its share price have been very difficult to find. Since mid-April or so, however, many of the same analysts, journalists and commentators who previously praised it have become rather harsh critics. An article in The Australian Financial Review on 11 May, for example, babbled that “many fund managers expressed frustration at [Telstra’s] ‘lack of a clearly articulated direction.’ One, who declined to be named, said there was ‘huge antipathy’ in the investment community. [Another] criticised Telstra’s response to investor concerns. ‘Investors want a clearer articulation of strategy and reassurance of management capability. Ever since Frank Blount left Telstra its direction has been unclear,’ [And a third stated that] ‘twelve months ago everybody was euphoric about the Telstra story. Now that situation has reversed and you’re hard pressed to hear a good word from anyone.’ In response, on 8 June its CEO decried the “ferocious commentary” to which it has recently been subjected.

Not long ago a juggernaut, today Telstra is supposedly plagued by a range of unresolved difficulties and insuperable uncertainties. Once there existed harmonious relations within its board and between its management and majority shareholder; today, however, disagreements between and among them are so deep that (according to the 6-7 May edition of The Australian Financial Review) unless his lieutenants “deliver fast” Telstra’s CEO “will be gone within months.” Hitherto Australia’s flagship in the New Economy, critical elements of its strategy have, according to its new critics, either misfired or been overtaken by events.

Three components of this changed assessment received extensive press coverage during the week of 1-5 May (several others were added later in May and during the first half of June):

1. ‘uncertainty’ about its e-commerce strategy: Telstra’s alliance with Pacific Century Cyber Works, announced on 12 April, is “a high-risk $6.5b punt on Asian mobile telephony” (AFR 6-7 May). On 5 May Telstra’s CEO attributed the decrease during recent months in the price of its shares and IRs to “uncertainty” about the details of this agreement.



2. the Commonwealth Parliament’s majority ownership: according to the Prime Minister, the decrease in the price of Telstra’s shares and IRs can be attributed to the fact that the company is shackled by state-ownership. Parliament refuses to relinquish or even permit the dilution of its stake; in consequence, Telstra finds it difficult to issue new equity and use it to purchase ‘New Economy’ assets. It thereby “[places] Canberra in the absurd and deeply conflicting position of giving a leg-up to Telstra’s competitors” (The Weekend Australian 6-7 May). On 5 May The Australian editorialised bluntly that Telstra’s ownership structure is a “disaster” and that “without [a] full sale, Telstra stock [is] doomed.”



3. downgrading of Telstra’s debt rating: on 2 May Standard & Poor’s decreased the rating of Telstra’s debt from AA+ to AA and placed the company on a negative credit watch. Moody’s Investors Service decreased its rating from AA2 to AA3. Telstra’s credit remains among the strongest of any Australian corporation. Nonetheless, these downgradings are “a [manifestation] of deep problems that are showing no clear signs of being solved” (AFR, 6-7 May).

Covering Their Tracks

This change of perception (and similar ones involving other prominent Australian companies such as Solution 6 and News Corp.) conforms to a more general and long-established sequence of events:

• Step #1: analysts, financial journalists and commentators accept a company’s PR statements at face value and repeat them virtually without question. (News Corp.’s plans to float its satellite assets provide an excellent example. Not only have its statements, projections, etc. been repeated enthusiastically by a phalanx of brokers, financial analysts, planners, journalists and commentators: in some instances they have bolstered them with words and numbers which are more emphatic and superlative than those used by the company itself).



• Step #2: a herd mentality pushes the price of the company’s securities above their intrinsic value. The result is that people in markets, ‘experts’ as well as ‘amateurs,’ not only invest too much money – but also too much of their own faith, status and credibility – in this company.



• Step #3: because its market price greatly exceeds its intrinsic value, the purchase of this company’s securities is a speculation rather than an investment. Accordingly, at some point the security’s price begins to regress towards its intrinsic value. Speculators-who-thought-that-they-were-investors and who bought these securities at an inflated price subsequently realise that they have miscalculated; and any sudden and sharp fall in price makes these miscalculations even more painfully apparent.



• Step #4: whatever their background, occupation and so on, humans in general and experts in particular do not like to admit, either to themselves or to others, that they have miscalculated. (I, by the way, am by no stretch of the imagination exempt from this characterisation). Instead, the temptation is great to rationalise one’s miscalculation with what James Grant calls a “macroeconomic cover story.”

The term “cover story” implies no impropriety by Telstra, Solution 6, News Corp. or any other company. Rather, it implies miscalculation by analysts, journalists and other experts, and attracts attention to the very thing from which these experts seek to distract attention. At first glance each cover story seems to indicate that new information, an unexpected event or a series of startling developments about a particular company have come to light. This information, it is suggested, is so new, unexpected and startling that it not only overturns the rationale which underlay the purchase of the company’s securities: it also excuses the miscalculation which this new information has uncovered. At first glance, then, the cover story concludes implicitly that you shouldn’t berate your broker because the Solution 6 which he touted as a “strong buy” in January collapsed in April and May. Nor should hundreds of thousands of Australians blame their financial advisors or the Commonwealth Government for the glaring fact that their TLS Instalment Receipts are under water. Not even the experts could know that it would come to this.

The ‘Real Story’: Experts’ Over-Optimism and Regression to the Mean

Upon reflection, however, there is no compelling reason to claim that the ‘new developments’ set out in cover stories are causes of any subsequent decreases in the prices of the relevant companies’ securities. Rather, it is equally plausible to claim that cover stories are consequences of these securities’ excessive valuations. Indeed, the very purpose of cover stories is to distract attention from this central and disturbing conclusion. They do so partly by containing many woolly words but few if any hard figures. They typically consist in idle and isolated assertions rather than sets of inter-related premises (i.e., arguments); and to the extent that one can charitably reconstitute them as arguments, one finds that they violate the most elementary rules of logic. (Parliament’s majority stake in Telstra, to give just one example, has existed since the company was first listed on the ASX. The company’s structure of ownership is thus a constant rather than a variable; as such, it cannot logically account for the change in the price of its common stock).

The phrase “regression to the mean” refers to a particular pattern among observations which are made repeatedly over time. Consider as an example a student’s test scores. If it is reasonable to assume that the student’s scholastic aptitude remains constant over some (say, six-month) period of time, then an extreme result observed at one point will probably be followed (“regress”) by a result which is much closer to the student’s true capabilities. An abnormally high test score, for example, is likely to be followed at the next test by a lower score; and an abnormally low score is likely to be followed next time by a higher score.

Investors such as David Dreman and behavioural economists such as Richard Thaler and Werner De Bondt have uncovered strong evidence that regression to the mean, or something akin to it, occurs on financial markets. Using data extending back over several decades, they studied the securities of companies whose prices over a given interval either increased or decreased more than the market average. Thaler and De Bondt found that “extreme returns of stocks listed on the New York Stock Exchange were found to be subsequently followed by significant price movement in the opposite direction.” If at a given point in time investors are either unduly optimistic or pessimistic about a particular company’s securities, and if that company’s fundamentals remain unchanged, then at some point in the future their stance is likely to reverse.

Very fashionable stocks and market segments thus become less exalted, and highly unfashionable companies and sectors return to average favour. If the price of an excellent company’s stock is savaged to the point where it is considerably below its intrinsic value, then – as long as the company’s operations and prospects remain sound – the price of its securities will eventually recover. Conversely, if a company’s shares are inflated above their intrinsic value, then – even when its operations and prospects remain unchanged – it is likely that it will subsequently fall from its exalted status. This simple but profound notion was recognised at least 2,000 years ago. (Horace, the Latin lyric poet and satirist, wrote in his Ars Poetica that “Many shall be restored that now are fallen; and many shall fall that now are in honour”). Today, however, it appears either that market participants have forgotten it or that their methods obscure it. And that, it seems to me – and not some cover story – is the real story.