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1. A Private Company and Not a Managed Fund Leithner & Co. Pty. Ltd. is a private company, limited by shares and based in Brisbane, which specialises in the purchase of quality and underpriced securities (Australian and New Zealand stocks and bonds). Like many private companies, Leithner & Co. has more than one class of share. These are Class C (which Dr Chris Leithner owns in his capacity as Custodian of shareholders' capital) and Class E (which others own in their capacity as Equity investors). Point 4 below shows how the Company’s profits, if they materialise, are allocated among these two classes of shares.As a first distinguishing feature, Leithner & Co. is a private company and not a managed fund (unit trust). This structure has critically important implications for its operations. Unlike a managed fund or unit trust structure, organisation as a company facilitates “businesslike” investment operations. The focus of attention is not, to give one example, upon shares or bonds; and still less is it upon fluctuations of their prices from week to week, month to month, etc. Rather, businesslike investment operations emphasise the businesses to whose earnings our part-ownership entitles us. It also directs attention to the progress and development of those businesses over the longer term. Leithner & Co.’s principal activity, then, is not the management of businesses; rather, it is the part-ownership (i.e., selection and monitoring) of businesses. After they are purchased and until they are sold, the current market prices of the assets owned by Leithner & Co. (as opposed to the operations and results of the businesses underlying those assets) are irrelevant. These prices and their day-to-day, week-to-week and month-to-month fluctuations affect neither Leithner’s Profit & Loss statement nor its Balance Sheet; accordingly, they do not affect the measurement of Leithner & Co.’s results (for details see point 2). Hence the incentive of Leithner & Co.’s shareholders to consider their company as a business whose progress is gauged through its financial statements; their motivation to focus upon the operations of the companies of which they are part-owners; and (except to the extent that it provides an opportunity to buy quality assets more cheaply or to sell them at an inflated price) their rationale to ignore the fluctuations of those assets’ market prices. Conversely, 99% of market participants obsess about market prices and their day-to-day changes. They do so in no small part because the unit trust structure of the vast majority of investment vehicles encourages them – explicitly as well as implicitly – to do so. Unit holders are legal owners, on a pro-rata basis, of the trust’s assets. As such (depending upon the trust deed) they have a pro rata claim to those assets and can exercise that claim at any time. And when they wish to “cash out” the trust must redeem their pro-rata ownership within some specific (1 week, 2 week, etc.) period. Thinking charitably, despite their better instincts trust managers must always be prepared to redeem assets. And the basis on which they do so is the weighted average of those assets’ market price on the day the redemption is requested. Hence the relentless and obsessive focus upon market prices, short-term “performance” and the association of prices with performance. In sharp contrast, shareholders of a corporation like Leithner & Co. have no pro rata claim to the company’s assets; rather, they have a pro-rata claim to its earnings – if they eventuate. An owner of Coles Myer Ltd shares, for example, is not an owner of Coles’ assets and thus cannot present himself at a Liquorland outlet and proceed to help himself gratis to bottles of Bundaberg rum. Unlike unit-holders, in other words, shareholders don’t “cash out.” It is true that companies occasionally buy back their own shares; normally, however, shareholders exit by selling to a third party their title to the company’s earnings. The phrase “title to the company’s earnings” is used in order to emphasise the absolutely critical importance of the Statement of Profit-and-Loss and its relationship to the Balance Sheet. In sharp contrast, unit trusts seldom emphasise and sometimes do not even mention them. Hence the very counterintuitive point that it is in the short-term interest of Leithner shareholders that the market prices of the assets that Leithner & Co. has purchased fall. As long as their ability to generate earnings remains intact, more of a good thing can be bought at a lower price, increasing the earnings on Leithner’s P&L relative to the amount spent in order to generate them.
2. Businesslike Measurement of Results Leithner & Co.’s structure as a private company also has fundamental implications for the measurement of its results. Here, too, the key term is “businesslike.” Unlike a managed fund, its results have everything to do with the earnings generated by the businesses of which it is a part-owner and nothing to do with either the price volatility of their shares or their level at a given point in time. As a business, its results are gauged like that of any other business: in terms of its earnings, return on equity, etc. To understand this point fully, consider Leithner & Co.’s shares. Each share has been and will continue to be issued to existing and new shareholders in exchange for $1.00. The initial choice of $1.00 was arbitrary; but its maintenance at a constant level over time keeps everybody (i.e., existing and new shareholders) on an equivalent accounting (and, since we are sharing risk, moral) footing. As a simple example, let us say that on 1 July (i.e., the beginning of the financial year) Leithner & Co.’s capital structure consists in $1,000 and 1,000 shares. Its balance sheet thus consists in $1,000 of assets (let us assume cash), no liabilities and therefore $1,000 of shareholders’ equity (i.e., assets minus liabilities). It also follows that Leithner has a book value of $1.00 per share (i.e., shareholders’ equity divided by the number of shares). Let us now say that during the financial year Leithner buys 1,000 shares of X Ltd at $1.00 per share. Leithner’s balance sheet still comprises $1,000 of assets. The form of these assets, however, has changed: what was $1,000 of current assets (i.e., cash) has now become $1,000 of non-current assets (i.e., investments). As before, there are no liabilities, $1,000 of shareholders’ equity and book value is $1.00 per share. To extend this example, let us say that during the financial year Leithner & Co. receives a dividend of $100 from X Ltd. For simplicity, let us also ignore taxes, expenses, etc. If no other income is received before the end of the financial year, then Leithner’s return on its equity for the financial year is thus 10% (i.e., $100 of earnings ÷ $1,000 of assets). At the end of the financial year its assets have increased by $100 and its balance sheet consists of $100 of cash and $1,000 of investments, making a total of $1,100; it has incurred no liabilities and issued no other shares and thus has $1,100 of shareholders’ equity; and its book value is $1.10 per share (i.e., $1,100 of assets ÷ 1,000 shares). In the Leithner (and, more generally, company) lexicon, then, “return” has nothing to do with assets’ market prices and price fluctuations; rather, results have everything to do with the cash generated by those assets and hence the earnings appearing on Leithner’s P&L. The return to Leithner shareholders is thus the cash (net of costs, taxes, etc.) generated by their equity – not the changes in the quoted market price of Leithner’s assets. It is no accident that Mr Buffett normally begins Berkshire Hathaway’s Annual Letter by stating that year’s return on shareholders’ equity; equally significantly, his most celebrated purchases such as See’s Candies, Buffalo News, etc., remain on Berkshire Hathaway’s balance sheet at their initial purchase price. Let us now assume that Leithner & Co. pays the entire $100 to its shareholders in the form of a dividend. That creates a current liability on Leithner’s balance sheet. Note that the form of the dividend – i.e., whether it is paid to shareholders as cash or additional Leithner shares – does not affect this point. After the declaration of but before the payment of the dividend, Leithner’s balance sheet looks like this:
Given in this example that Leithner & Co. has 1,000 shares on issue, its book value is ([$1,100-$100]/1,000) or $1.00 per share. After the payment of a (say) cash dividend, Leithner’s balance sheet looks like this:
If the dividend were paid in the form of additional shares, which is Leithner’s normal practice, then its balance sheet looks like this:
In each case, the share’s book value remains at $1.00. It is in this way that, repeating this process over time, a Leithner shareholder’s per share dividend may well remain static but (because her holding of Leithner shares increases over time) the absolute size of the shareholder’s dividend stream may increase. Similarly, new shareholders can join on the same moral and accounting basis (i.e., $1.00 of per share book value) as existing shareholders.
3. Graham-and-Buffett “Value” Investment Philosophy The purpose of Leithner & Co. is to invest its assets in bonds, other businesses and cash deposits (“securities”) for its shareholders’ benefit.The Company adheres strictly to a businesslike, long-term, “value” approach to investing (see Investment Philosophy for a detailed description of this approach and a discussion of its comparative rarity in Australia). Leithner & Co. is a value investor in the manner practised by Benjamin Graham (widely recognised as the founder of modern securities analysis) and his colleagues Warren Buffett, Thomas Knapp and Walter Schloss.Graham-style value investors have several identifying characteristics:
4. Sharing of Risks and Rewards Graham-Newman Corporation and Buffett Partnership Ltd (Buffett’s investment vehicle between 1955 and 1969) shared risks and rewards in a unique way. Their approach harmonised their interests as custodians of capital with those of other investors. As a consequence of this harmony, and Graham’s “value” approach to investment, over time they achieved outstanding results for both their investors and themselves. Leithner & Co. Pty. Ltd. adopts the essence of their logic to Australian legal and taxation conditions.
Because I seek to benefit from my actions, I invest the Company’s assets not just as if they were mine, but precisely because (as a Class C shareholder) to a significant extent they are mine. I therefore seek to invest conservatively and for the long term. Each year’s investment returns (if any) will be allocated among shareholders in the following manner: the first five percentage points of any return will accrue to Class E shareholders (dividends in the form of either cash or additional shares); and any return above this threshold will accrue equally (again, either in the form of dividends or bonus shares) to Class E shareholders and me as the sole Class C shareholder. As a simple example, let us say that the Company earns a return of 10% on its investments (see point 2 above). The first five percentage points of this return will accrue to Class E shareholders; and of the remaining five percentage points, one half (2.5 percentage points) accrues to Class E shareholders and the other half (again 2.5 percentage points) to the Class C shareholder. If the Company earns a return of 10% on its investments, then Class E shareholders will receive three quarters of it on a pro-rata basis and the Class C shareholder will receive the remaining quarter.
As Class C shareholder, I am seated last at the dining table, and receive a helping only after Class E shareholders. If I wish to earn a return from the Company’s activities, which I most assuredly do), then I must ensure that Class E shareholders first do so. Further, the better the returns I earn for Class E shareholders the better the return which I earn for myself. My self-interest as Director and Class C shareholder thus harmonises with the self-interest of Class E shareholders.
The contrast of this arrangement with institutional investment managers and unit-trust structures is stark. With very few exceptions, it appears that investment managers typically shoulder relatively little investment risk and yet obtain much of the reward from the management of other people’s money. Moreover, they seldom seem to invest substantial amounts of their own capital in the funds that they manage, and virtually always charge management fees regardless of the results which they obtain for their investors. Because, in effect, they do not eat their own cooking, other investment managers have surprisingly little incentive to cook well. That, I believe, is one reason why surprisingly few of them do well for their investors. In contrast, Leithner & Co.’s incentive structure provides strong reasons to invest conservatively and for the long term. Unlike most other investment managers, Leithner & Co. sticks resolutely to basics. It does not use instalment or other warrants, call and put options, futures contracts and other esoteric – and, as Graham, Buffett, Knapp and Schloss believe, speculative and dangerous – derivative financial instruments. Nor does Leithner & Co. borrow money. These constraints will cause the Company to forego what others might regard as exciting opportunities. They might also penalise its long-term results. At the same time, however, they reduce the risk to shareholders’ capital.
Twice each year, after the conclusion of the financial year and also at its halfway point, the Company’s results are reported to its shareholders. And at regular intervals between the Annual and Half-Year reports, Newsletters and Circulars to Shareholders describe developments directly or indirectly affecting the Company. I write Annual Reports and Half-Year reports with a view towards what I would want to know if my position and that of my shareholders were reversed. Absent, therefore, are costly irrelevancies and distractions such as glossy paper (too expensive), colour photos (I’m too ugly) and catchy graphics (often incomplete or misleading). Instead, present are extended descriptions and explanations of my actions – which are requisites to an understanding of our current and future operations and the results they might produce.
7. Frugality of Operations and Avoidance of Hidden Costs Very closely related to the transparency of an investment vehicle’s operations is the frugality or otherwise of its operations. Older Australians will recall the adage that fat dividends tend to be associated with thin corporate carpets; similarly, Charles Munger, Berkshire Hathaway’s Vice-Chairman, has emphasised that the rationality of a business is inversely related to the opulence of its quarters. Leithner & Co.’s approach to investment enables its operations to be conducted frugally. Graham-style value investing consists in dispassionate analysis of financial statements (a painstaking but low-cost activity): it does not result from attending overseas conferences and major sporting events, hosting extravagant entertainment, lobbying politicians in Canberra and undertaking “fact-finding” missions. Accordingly, because no “management fee” is levied upon shareholders and overhead expenses are pruned wherever possible, its Directors cannot indulge themselves in the manner to which most other investment managers are accustomed. Leithner & Co.’s structure as a private company (as opposed to a unit trust) also enables it to avoid a host of what have been described as “hidden” costs. Norman Sinclair, in a paper entitled “The Hidden Costs of Managed Investments” prepared in July 1998 for the Australian Shareholders’ Association, analyses the charges levied by many large-scale investment vehicles structured as unit trusts. Sinclair concludes that “the current state of play [in these large-scale unit trusts] leaves the average investor in a very disadvantaged position. Whilst managed investments are theoretically good for savings, they will remain expensive unless the gatekeepers can be converted to a more transparent and professional fee-for-service and the managers can be forced to more honestly describe the cost implications of their management style. Until that time, caveat emptor applies! “Managers’ investment styles may create significant costs for investors. Active managers tend to buy and sell shares and bonds (“churn their portfolio”) much more frequently than do passive managers who follow a “buy-and-hold” strategy. There are two “hidden costs” that are attributable to overactive managers:
8. Ignoring the Institutional Imperative Points 1-7 above place Leithner & Co. in an excellent position (in sharp contrast to the vast majority of other custodians of capital) to ignore the “institutional imperative” – the lemming-like tendency to imitate others’ behaviour, no matter how apparently silly or self-destructive that behaviour might be. At first glance it seems reasonable to suppose that investment managers within large organisations, having considerable resources and expertise at their disposal, will achieve better results than their counterparts in small organisations. Alas, not necessarily so. Indeed, a variety of studies (cited regularly in Barrie Dunstan’s Portfolio column in the Australian Financial Review) find that a significant number of large institutional investors have difficulty adding significant value to their clients’ funds. For a clue as to why this is so, consider the words of Lord Keynes (one of the twentieth century’s most influential economists and a shrewd investor):
Lemmings are small rodents, native to Scandinavia, which are noted for their periodic and inexplicable mass suicides. During their normal spring migrations, lemmings search for food and shelter. Every three or four years, however, strange things happen. As a consequence of high rates of breeding and low rates of mortality, the population of lemmings rises. As their ranks swell they commence an erratic movement under cover of darkness. Soon they become bolder and continue these erratic movements during daylight hours. When confronted by barriers, a frenzied reaction drives them forward; and as this behaviour intensifies, they start to challenge creatures who they would otherwise avoid. Although some lemmings die of starvation, are consumed on land by predators or succumb to accidents during their mass movement, most reach the sea. There they plunge into the water and swim from shore until they die of exhaustion. As with lemmings, so too with many large-scale institutional investors: each moves periodically, dramatically and irrationally in response to the behaviour of their peers. Indeed, as Warren Buffett has noted, periodic wild swings in share prices have much to do with the lemming-like actions and reactions of institutional investors. As Buffett also noted, neither this erratic behaviour nor the failure of many institutions to create significant wealth for their clients is a product of poor intelligence. Rather, it is a symptom of decision-making within large-scale institutions. Most decisions within large organisations are made by groups or committees. Committee membership, in turn, and as the psychologist Irving Janis has demonstrated, encourages a desire to conform to certain norms, standards and articles of conventional wisdom. Within a closely-knit group, adherence to standard practices (whether they are sensible or not) tends to be rewarded, and independent thinking (no matter how firmly justified by logic and evidence) which challenges the group’s cohesion is often discouraged. Given these group and organisational dynamics, what investment managers in large organisations ultimately fear is not so much the possibility of being wrong but of the possibility of being out of step with their peers and competitors. For these managers, in other words, failing conventionally is a rational and sensible route. As Buffett reminds us, “lemmings as a group have a bad reputation, but no individual lemming has ever been ridiculed or received a bad press.” And as Keynes stated: “investment is a field where plaudits tend to go to those who are conventionally unsuccessful, rather than to those who succeed by unconventional means.” Richard FitzHerbert, in a paper presented in 1998 to the Australian Instituteof Actuaries, has provided Australian evidence of this “investment groupthink” phenomenon (see also his excellent book Blueprint for Investment: An Approach for Serious Long-Term Investors, Wrightbooks, 1994, ISBN: 0947351663). FitzHerbert found that the environment in which large Australian funds managers work virtually precludes them from making dispassionate analyses and decisions about investments. This is because they tend to give more weight to their own interests and careers than to their clients’ money. FitzHerbert finds that institutional managers “know that they risk losing clients and their jobs if their portfolios are significantly different from [those of] their peers” and concludes that rational investment decisions are short-circuited by the managers’ self-interest so that “rational assessment of risk may no longer be an important part of the investment decision-making process.” According to Buffett and FitzHerbert, then, decision-making within large-scale institutions encourages investment managers to focus upon their careers at least as much as their clients’ money, and encourages short-term speculating rather than long-term investing. These managers act to protect themselves from being out of step with “the market” rather than from any deeply-felt sense that the securities they have selected represent good value.
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