Leithner & Co Pty Ltd - A New Financial Year and a Renewed Case for Caution

A NEW FINANCIAL YEAR
AND A RENEWED CASE FOR CAUTION

Part IV

15 August 2001

...continued from Part III

HB: Do you think that Wall Street or the typical analyst or portfolio managers have learned their lessons of the “Go-Go” funds, the growth cult, the one-decision stocks, the two-tier market, and all?

BG: No. They used to say about the Bourbons that they forgot nothing and they learned nothing, and I’ll say about Wall Street people, typically, is that they learn nothing and they forget everything. I have no confidence whatever in the future behavior of the Wall Street people. I think this business of greed – the excessive hopes and fears and so on – will be with us as long as there will be people. I am very cynical about Wall Street.

HB: But there are independent thinkers on Wall Street and throughout the country who do well, aren’t there?

BG: Yes. There are two requirements for success in Wall Street. One, you have to think correctly; and secondly, you have to think independently.

Harman Butler,
An Hour With Mr Graham
Financial Analysts Journal (1976)

An Expensive Market and a Meagre Margin of Safety

Under the least demanding and most plausible assumptions of Scenario No. 1 in Part III, the owner of a share of All Ordinaries Ltd, a proxy for the weighted average price and characteristics of Australian ‘blue chip’ equities on 15 May, can over the next five years expect to earn an annualised compound return of 6.8%. The corresponding return from a ‘risk free’ Commonwealth Government bond is 5.1%. One’s choice of the share or the bond thus depends upon the margin of safety that one requires from the share. On the one hand, the share’s return is one-third greater than the bond’s (i.e., 6.8 ÷ 5.1 = 1.33); on the other hand, its return is less than two percentage points greater than the bond’s.

Interestingly, this 6.8% exceeds the return earned by the average Australian institutional investor during the 2000-2001 financial year. Despite its very different underlying assumptions, it also closely approximates the long-run return which Warren Buffett (in a series of speeches published in Fortune magazine in November 1999) and Charles Munger (at Wesco Financial Corp.’s 2001 AGM) have braced American market participants to expect. In one speech, Mr Buffett stated that “I think it’s very hard to come up with a persuasive case that equities will over the next 17 years perform anything like – anything like – they’ve performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate – repeat, aggregate – would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that’s 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.”

Implicit Speculation

In sharp contrast, on 30 April The Wall Street Journal published the results of a survey, financed by the Institute of Psychology and Markets, of American investors’ short- and long-term expectations. With respect to the next 12 months, it found that 5% of the survey’s respondents expected no return; 10% of respondents expected returns of 1-5%; 23% expected returns of 5-10%; 33% expected returns of 10-20% and 6% expected returns of 20% or more. With respect to the next ten years, the ISM survey found that 1% of respondents expected no return; 3% of respondents expected returns of 1-5%; 12% expected returns of 5-10%; 41% expected returns of 10-20% and 20% expected returns of 20% or more (the percentages do not sum to 100% because some respondents did not answer these questions are were unsure of their response). Over both short and long periods, then, a plurality expects that their investments will return approximately 15%.

These expectations notwithstanding, it should be added that the assumptions underlying Scenario No. 1, whilst the least demanding of the three, are nonetheless rather stiff: return on equity and hence growth of earnings must unfold exactly as envisaged; retained earnings must not be squandered; and the multiple of price to earnings and price to book value must not fall below their present levels (which are higher than, although not dramatically disengaged from, historical averages). The fortunes of All Ords Ltd, in other words, must unfold exactly according to these projections for five years in order to provide a compound return which after five years modestly but hardly dramatically exceeds that guaranteed today from a five-year Commonwealth Government bond.

What are the chances that these projections will transpire? Should one accept the assumption (perhaps faith is a better term) that the operations of All Ords Ltd will proceed without glitches and that its operations will unfold and its earnings grow at the required rate or better for the next five years? Can one rely upon market participants to maintain AO’s ratio of market price to earnings at the required multiple or higher for these five years? Whether they were aware of it or not (most probably weren’t), the purchasers of equities with these characteristics are responding affirmatively to each of these questions.

If Australian blue chips’ return is to exceed that of a Commonwealth Government bond by a significant margin, one must have grounds to believe either that our assumptions are unduly cautious or that the market prices of major Australian companies will increase more quickly than their earnings. Over the long term, however, the value of an asset cannot grow faster than the stream of earnings it generates; further, and more generally, the valuation of the Australian market as a whole cannot grow more quickly than Australia’s economy. In an American context, and in Mr Buffett’s words, “maybe you’d like to argue a different case. Fair enough. But give me your assumptions. If you think the American public is going to make 12% a year in stocks, I think you have to say, for example, ‘Well, that’s because I expect GDP to grow at 10% a year, dividends to add two percentage points to returns, and interest rates to stay at a constant level.’ Or you’ve got to rearrange these key variables in some other manner. [But] the Tinker Bell approach – clap if you believe – just won’t cut it.”

A Renewed Case for Caution

For this reason I do not believe that it makes sense to purchase a representative selection of Australian equities, i.e., the ‘blue chips’ which comprise the vast majority of the All Ordinaries Index, at anything approaching their current market prices. To do so is not to invest on the basis of the outcomes of these companies’ fundamental operations: rather, it is to gamble that their market prices will continue to increase and thereby become detached from their operations. To gamble in this manner, in turn, is to assert that the (further) ‘Rembrandtisation’ of major Australian equities will proceed apace.

Because Leithner & Co.’s investment philosophy precludes speculation, it prohibits the purchase of such companies at current prices. (The purchase of companies earning superior returns on equity at far lower price multiples is a different matter.) The case for caution, outlined in circulars entitled ‘Irrational Exuberance’ in Australia and Reasoned Scepticism Vs. Irrational Exuberance, thus remains as strong in the new financial year as it was in 2000-2001.