REASONED SCEPTICISM
VERSUS
IRRATIONAL EXUBERANCE

Part II

1 September 2000

...continued from Part I

Some More Fundamental Implications About Risk and Return

Several more fundamental implications – each of which is an important point about value investing – also follow from the thumbnail evaluation of X Ltd. These implications reveal more about both our conception of risk and our method of coping with it. They indicate, quite counter-intuitively, that in order to obtain higher investment returns we need not accept higher risk. Quite the opposite: the stringent steps we take to reduce risk can increase rather than decrease the eventual returns on our investment. (Recall that we regard the ‘riskiness’ of an asset as the likelihood that its purchase will lead to a substantial and permanent loss of capital).

Table 2: Risk Derives from Companies’ Operations
and Assessments About Their Future Operations –
Not the Volatility of Asset Prices

As Table 2 indicates, to assume that a company with a mediocre track record of operations will continue on a mediocre path is riskier – perhaps mismanagement, industry-specific or industry- or economy-wide factors (to which mediocre companies may be particularly prone) will at some point in the next five years turn a mediocre track record into a poor one. To assume that a company with a sound track record will continue on such a path is also riskier. Perhaps lower quality management, bad decisions, unforeseen or unforeseeable difficulties or other factors will turn a sound track record into a mediocre one. Riskiest of all is the assumption that a company with a mediocre track record – or, as is usually the case in the tech and dot com areas, no track record of any description – will henceforth produce stellar results. Rarely if ever, it seems to me, is one’s crystal ball clear enough to make this heroic assumption with any degree of confidence.

It is for this reason that (unless there exist very exceptional and compelling reasons to do otherwise) Leithner & Co. restricts its attention to companies which have established (i.e., 5-10 year) track records with respect to three criteria. First, they generate growing ‘real’ (as opposed to ‘accounting’) profits. Second, their earnings are high relative to the capital required to generate those earnings (in our example, X Ltd’s projected earnings are 11-13% of its book value). Third, the earnings which they retain are not squandered or destroyed but rather are used to generate higher earnings in subsequent years. One way we cope with investment risk, in other words, is to minimise or eliminate the purchase of risky assets.

Very Low Initial (Acquisition) Price

Another fundamental implication of our evaluation is that, for value investors, an asset’s purchase price is as important a consideration as its soundness. Bargain price and sound business operations, like Siamese twins, are inextricably linked. It is axiomatic that investors should attempt to pay as little as possible for the income stream which they (cautiously) assume a given asset will generate. For each penny of X Ltd’s earnings in 2001, for example, we strive in 2000 to pay $0.05 but assume cautiously that we will actually pay 50% more, i.e., $0.075. We therefore refuse to pay high prices, endeavour to pay a bargain price but are prepared to settle (if our cautious assumptions do not, alas, come to fruition) for a reasonable price.

In this respect our attitude as investors towards an asset is identical to our attitude as consumers towards virtually any good or service. Other things equal, the lower the price the greater the quantity demanded. If, for example, the price of a certain grade of beef mince decreases from $4.99 to $3.99 per kilo and becomes cheaper relative to its substitutes (mutton, pork, chicken, etc.) then consumers will tend to demand fewer of these substitutes and more beef mince. Many if not most participants in financial markets, however, seem to turn this axiom of human action – the ‘law of diminishing marginal utility’ – on its head. They act as if financial assets were ‘Giffen Goods’ – the higher their price the greater the quantity demanded. (A nineteenth-century economist, Sir Francis Giffen, reputedly observed that an increase in the price of potatoes during an Irish famine led to an increase in the consumption of potatoes. See the digression below).

Given the generous assumptions set out in ‘Irrational Exuberance’ in Australia, at the close of business on 1 June market participants revealed their willingness to pay $0.21 per penny of BHP’s estimated 2001 earnings, $0.22 per penny for Telstra’s, $0.29 for Solution 6’s and no less than $0.46 for News Corp.’s estimated 2001 earnings. In so doing they reveal that they are prepared to pay between three and six times more for the earnings of these relatively-risky (by our conception and Table 1) assets than we are prepared to pay for the earnings of the less-risky X Ltd. Perhaps market participants in effect regard these companies’ common stock as Giffen Goods. Perhaps demand curves slope upwards in the Southern Hemisphere. Perhaps emus can fly.

As Table 1 implied, the rationale for buying a quality asset at a low price is simple: the lower the purchase price the higher the earnings yield; the higher the earnings yield, in turn, the larger the pile of earnings (dividends plus retained earnings) accumulated per dollar of capital invested; and the bigger the stash of earnings accumulated relative to the initial investment the higher the investment’s long-run compound return. And as Table 2 showed, to make cautious assumptions about a sound security is simultaneously to reduce the risks in any decision to allocate investment capital. Leithner & Co. therefore follows a rather stringent variant of Benjamin Graham’s rule – it purchases quality assets whose current earnings yield is more than twice that of a ‘risk free’ (i.e., Commonwealth government) bond. We also cope with risk, in other words, by minimising the chance that we pay too much for less-risky assets.

A Digression About Giffen Goods

I cannot resist the somewhat-mischievous temptation, given the implications of our analysis, to point to some striking similarities between the purchase of ‘traditional’ Giffen Goods and modern speculative financial assets. Let us assume that a household’s satisfaction depends not only upon the quantities of goods and services that it consumes, but also upon the prices that it prefers to pay for particular goods or services. The household may, for example, buy expensive and exclusive items such as diamonds, a Lambourghini or a portfilio of dot com, convergent media, B2B and biotech stocks – not because its members particularly like these things, but because they wish to display their ability to buy them in an ostentatious-yet-socially-acceptable way.

In the words of Thorstein Veblen, author of The Theory of the Leisure Class, “they indulge in conspicuous consumption, and when their neighbours copy them they are indulging in pecuniary emulation.” The household values the diamonds, luxury motor car and trendy stocks, in other words, precisely because they are expensive and/or their price has recently increased dramatically (and preferably both). The ability to purchase expensive, exclusive and fashionable goods and services vastly increases one’s ability to impress one’s impressionable friends and to talk fashionable talk at dinner parties. If so, then a fall in their price will prompt the household to stop buying them; and a dramatic decrease will prompt it to dump its holdings and switch to other objects of ostentatious display (such as objets d’art and luxury apartments at Noosa).

The Irrelevance of ‘Intermediate’ Market Quotations

Implicit in Table 1 is a tenet of value investing which will surprise and perhaps shock many market participants. The ‘performance’ of an asset is measured primarily in terms of the size of the long-term stream of earnings it generates – and not at all in terms of short-term fluctuations in its market price. If all goes to plan and X Ltd earns $0.14 per share in 2002, for example, then the yield of those earnings, given our purchase price of $1.00, is 14.0%. Volatility in the price of X Ltd stock during that year does not affect this result. Accordingly, except to the extent that they allow us to buy more of a quality asset at an even cheaper price, short-term fluctuations in market quotations are irrelevant for our purposes and we are indifferent to them. Indeed, from our perspective the best possible outcome in 2002 is that X Ltd’s business operations exceed our conservative assumptions and that the price of its shares decreases. As long as our cautious expectations about X Ltd come to fruition, then at some point its price will recover strongly.

On what basis do I say this? As a range of scholars have observed since the late-nineteenth century, on a day-to-day, week-to- week and even month-to-month basis the prices of stocks fluctuate largely randomly. And as Timothy Vick noted in Wall Street on Sale, they are like a broken clock – on occasion perfectly accurate but at other times inaccurate (sometimes wildly so). Yet unlike market quotations, which are a will o’the wisp, a company’s earnings are tangible and fixed in time. And of critical importance, over much longer periods (5-10 years and longer) a reasonably strong correlation exists between growth in earnings, shareholders’ equity and market price. If all goes to our cautious plans, and given X Ltd’s sound track record, there are both logical and empirical grounds to believe that over the years the price of its shares will reflect the earnings which it has generated and retained on our behalf.

Value investors therefore strive to filter out short-term (market price) noise and concentrate upon longer-term (company operations) music. They devote considerable time to the study of an asset’s financial statements, put forward cautious assumptions about its capacity to generate a stream of earnings and wait patiently until it or a similarly-attractive asset becomes available at a sensible price. In so doing they liberate themselves from an obsession which is as pointless and distracting as it is ubiquitous: they do not presently have, never have had and never will have an opinion (to say nothing of a forecast) about macro phenomena such as the future level or direction of ‘the market,’ interest rates, inflation or business activity. Value investors neither need nor utilise macroeconomic predictions. They waste no time fretting about gloomy forecasts and their purchases of quality assets at bargain prices are not deterred by such prophesies. Quite the contrary: because these forecasts can spook some market participants and make excellent businesses available at excellent prices, value investors tend to buy excellent securities which others dismiss as unfashionable, old-fashioned or otherwise out-of-favour. Finally, because they make no attempt to predict ‘the market’ they are able to ignore the mindless, short-term and self-defeating rat-race of attempting to ‘beat the market.’

Moderate Diversification and Buying-and-Holding

It is clear that relatively few companies are ‘sound’ in the particular sense of that term used in this circular. Equally clearly, still fewer become available at multiples as low as 5-7.5 times their earnings and 1.0 times (or a discount to) their book value. Another two implications thereby follow from this reality. First, because attractive investment opportunities occur infrequently value investors can investigate each opportunity thoroughly and act only on those in which all the facts at hand seem to work in their favour. As a result, value investors’ portfolios will tend to consist in modest numbers (in practice, approximately 10-20) of quality assets and a relatively large allocation of cash.

Statistical simulations corroborate this stance. They indicate that the benefits of diversification are real – but that an increase in the number of assets beyond 20 or so provides little added benefit. Common sense tells us that it is better to possess 20 excellent assets than a grab-bag of 20 excellent and 80 mediocre ones. The greater the number of assets, the less thorough the research which precedes their purchase; and after their purchase, the more cursory the ongoing examination of the operations of the business which underlies each asset. In Warren Buffett’s estimation (as well as that of Lord Keynes, one of the twentieth century’s most influential economists), if it forces investors to conduct more thorough and rigorous research then this concentration of effort actually reduces the overall risk which inheres in investment operations. Value investors thus tend to cope with investment risk by placing their eggs in a select and manageable number of baskets – and then watching those baskets very carefully.

Second, since ‘value’ investments are so difficult to find, the value investor should retain them as long as their operations meet stringent assumptions and their earnings yields are significantly greater than those offered by ‘risk-free’ government bonds. Unless they have compelling reasons to do otherwise, in other words, value investors buy and hold – they buy quality assets at bargain prices and often hold them indefinitely, thus obtaining returns commensurate with the results of the underlying business’s operations. The focus, then, is upon the asset and its ability to generate a stream of income – not upon ‘the market’ and the cacophony of opinions, predictions and actions of other market participants.

Conclusion: A Policy of Reasoned Scepticism

Most people are reasonably optimistic about the future and confident about their knowledge and abilities. In most respects this is a Good Thing: people with a positive mental attitude tend to be happier and are more focussed, determined, virile and successful than those with negative outlook.

When making financial and investment decisions, however, optimism about the future and overconfidence about one’s abilities seem to be distinct disadvantages. Time after time they lure investors into over-estimating assets’ future streams of earnings and paying too much for them – i.e., into becoming speculators. They also tempt market participants to buy and sell rather than buy and hold, and to trade on the basis of rumours, late-breaking news, tips and other spurious prompts. Speculators typically think that they ‘know’ more than can reasonably be known and often act on the basis of this ‘knowledge.’ As a result, on any given day a substantial proportion – one study estimates one-half – of the turnover on a financial market consists in churning based upon over-optimism and over-confidence. Unfortunately, however, and as more and more research in the field of behavioural finance is demonstrating, the higher the market participant’s level of optimism, degree of self-confidence and frequency of trading, the less rigorous and thorough his research – and the lower the return (net of tax, brokerage, etc) on his investments.

Leithner & Co.’s response to this general human bias towards hubris and the pretence to knowledge is a policy of ‘reasoned scepticism.’ This means that the reasoning which underlies its investment operations be made explicit (and therefore that its errors and omissions be more easily detectable) and that its assumptions incorporate a stringent ‘discount for overconfidence.’ As this circular and its two predecessors suggest – and as the circular entitled Why Speculation Necessarily Ends in Tears and Aesop’s Fable of the Tortoise and Hare confirms – there are reasonable grounds to believe that the returns from ‘reasoned scepticism’ – modest as they may well be in the future – will over time surpass those generated by ‘irrational exuberance.’

The objective, then, is to not allocate capital in order to obtain the gratification of immediate ‘market out-performance’; rather, it is to avoid risk whilst capturing the prospect of reasonable long-term reward. It makes no sense and I do not attempt, in other words, to jump over the imposing two-metre bars which everybody else is trying to surmount. Both the height and the competition bode badly for my chances. Far better to search assiduously for – and, when found, step over – the 200mm bars which others are ignoring. The likelihood of consistent success is far greater and the risk of permanent injury much lower.

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