Objectives

Formed in 1999, Leithner & Company Pty Ltd (“Leithner”) adheres strictly to the traditional “value” approach to investment pioneered by Benjamin Graham and adapted by his colleagues Warren Buffett, Thomas Knapp and Walter Schloss. Its motto is its method: to undertake investment operations that are based upon thorough research; to provide reasonable safety of principal and offer an adequate return; and to inform its shareholders regularly, fully and in plain language about these investment operations. Leithner has two objectives:

1. to preserve wealth – that is, to preserve the value of its shareholders’ capital by compounding it at a rate which compensates for the effects of inflation.
   
   
2. to build wealth – that is, to invest its shareholders’ capital in a portfolio of securities whose rate of return, given cautious assumptions, can reasonably be expected to exceed the returns offered by 5-year Commonwealth Government bonds (see Table 1b). When securities capable of generating bond-beating returns are difficult to locate, as was the case during the second half of calendar 2004, prudence demands that the Company accumulate bonds and cash until securities become available at attractive prices.

A General Caution

These objectives have significant implications for Leithner shareholders’ possible results. Most importantly, given

• the risks that inhere in the investment operations it undertakes; the great volatility of results encountered even by the Superinvestors of Graham-and-Doddsville; and
• average (“benchmark”) results generated since the 1920s,

it is not realistic or reasonable for shareholders to expect a medium-term (minimum 5-year time horizon) return on their investment of more than 8-12% per annum (see Table 1b and Table 4).

A Few Specific Starting Points

In considering Leithner’s objectives and possible results, potential shareholders should keep several points in mind:

• the greater their expectations, the greater the likelihood that they will be disappointed; it is very unlikely that the results obtained during the “The Great Bubble” (as Mr Buffett has called it) of the late 1990s and early 2000s can be extrapolated into the indefinite future (this is because Regression to the Mean, or something very similar to it, exists in financial markets); value investors can and often do receive reasonable long-term results. Results obtained by Leithner’s role models (such as Benjamin Graham, Thomas Knapp and Walter Schloss) tend to be greater over the long term – but considerably more volatile over the short-term – than benchmarks; value investors encounter short-term “under-performance” (i.e., achieve year-to-year results which are inferior to the relevant benchmark) on average in one of every three years (specifically, they also tend to “under-perform” during periods of economic boom and euphoria in financial markets);
  
  
• the frugality of Leithner’s operations, together with the fact that it levies no management fees will, other things equal, tend to boost its shareholders’ results.

Considering each rolling ten-year period, the worst result is a compound return of minus 1% and the average (“benchmark”) return is 11%. And in no twenty-year period since 1925 – including the period encompassing the Great Depression – has a negative benchmark return been obtained. Obviously, very few portfolios mirror the S&P 500, All Ordinaries or other index. But the underlying tendency is clear: the longer the period of investment, the less volatile the average annualised results and the more likely that it will be a positive result. Equally clearly, investors have no reason to expect long-term compound returns more than (and do have grounds to expect returns less than) 10-11%.

Table 1a: Total Returns, Standard & Poor’s 500, 1925-1996

Although some investors have from time to time obtained results that exceed an overall market benchmark, experience shows that in the long run few do so. Indeed, many investors who produce better than average results in periods of one, five and even ten years tend in subsequent periods to “regress to the mean.” Perhaps for this reason, in recent years index funds (i.e., investments whose portfolios aim to mirror or replicate a market benchmark index such as the S&P 500 or All Ordinaries Index) have become more prominent. What is an average (“benchmark”) investment result? The answer to this question also depends upon the type of asset under consideration. Some are riskier than others (for an overview of conventional and Grahamite conceptions of risk, see What Are the Risks? and Value Investing, Risk and Risk Management).

Table 1b compares the returns achieved by conventional categories of asset over the very short term (i.e., the year to 30 June 2004) and the very long term (i.e., the half-century to 30 June 2004). It shows that short-term results tend to be volatile, and that the year to 30 June 2004 was, historically speaking, a very good year for most assets. It also shows that medium term (i.e., five-year) results need not be positive: losses, in other words, are possible in the medium as well as the short-term. It also implies that the past 20-30 years have been kind to Australian investors: for example, he who purchased a perfectly representative portfolio of Australian stocks on 30 June 1994 and held it for ten years earned an averaged compound return of 10.0%. Finally, Table 1b corroborates Table 1a: given the different results from class to class, and as a very rough rule of thumb, investors should not expect long-term compound returns of more than 10-11%.

Table 1b: Average Total Investment Returns (to 30 June 2004)
by Time and Asset Category

Role Models’ Results

In light of most investors’ inability to surpass market benchmarks, and given Leithner’s Graham-style value approach (see also its Investment Philosophy), it is useful to examine the records of the most prominent and successful value investors. These results are summarised in Table 2. Two key tendencies are apparent. First, over the long term and unlike most other investors, élite value investors exceed market benchmarks. Indeed, the “Superinvestors of Graham-and-Doddsville” (as Buffett dubbed them) earn average returns of 21% per year and outperform relevant benchmark by nine percentage points.

Table 2: Annualised Results,
Graham-Style Value Investors

John Maynard Keynes

John Maynard (later Lord) Keynes was one of the twentieth century’s most influential economists. In his capacity as Bursar of King’s College, Cambridge, he was also an excellent investor; and as demonstrated by Robert Hagstrom (The Warren Buffett Portfolio: Mastering the Power of the Focus Investment Strategy, John Wiley, 1999, ISBN: 0471247669) Keynes’ approach to investment bore some similarities to Graham’s. During the period 1928-45, Keynes achieved an average percent return of 13% compared the British market return of minus 0.5%. Considering the challenges to investors – most notably the Great Depression and Second World War – that occurred during these years, Keynes’ results were impressive. Even so, the College’s investment returns were almost three times more volatile than the overall British market’s return. Accordingly, in exchange for good long-term results King’s often endured significant short-term pain. In three years (1930, 1938 and 1940), for example, the capitalisation of its portfolio decreased much more than that of the overall market. Its ride was bumpy, earning returns of +56% in 1936 and minus 40% in 1938; but over the entire period its return outperformed the British market (which fell marginally) by a significant margin.

Schloss Partnership

Charles Munger Partnership

Warren Buffett is rightly regarded as the world’s most gifted investor. Yet the outstanding record compiled by Buffett Partnership Ltd and later by Berkshire Hathaway, Inc., should not obscure the outstanding record achieved by Berkshire’s Vice Chairman, Charles Munger, between 1962 and 1975. During those years, Munger surpassed the Dow Jones Industrial Average by an average of 18 percentage points per year. Like Keynes’ results, however, Munger’s were much more volatile than the benchmark. In the worst year, 1973, the capitalisation of Munger’s portfolio fell by 32% (compared to minus 13% for the benchmark); and in his best year, 1975, it increased by 73% (compared to 44% for the benchmark).

Even the Best Regularly “Underperform”

Given the figures in Table 3, it is inappropriate to judge a Graham-style value investor’s results – indeed, it is improper to judge any investor’s results – on a short-term basis. With the exception of Buffett, in roughly one year in three “Superinvestors” generate results that are inferior to the relevant benchmark. Clearly, the outstanding long-term results of Graham-style investors have thus been compiled in conjunction with – and possibly thanks to – short-term volatility.

Table 3: Even Superinvestors Under-perform Regularly

         Source: R. Hagstrom, The Warren Buffett Portfolio; T. Vick, Wall Street On Sale

Leithner’s Results

Leithner & Company Pty. Ltd. is a private investment company and not a managed fund (unit trust). This structure has important implications for its operations and the measurement of its results. An investor exits (“cashes out”) a managed fund by selling its units back to the fund – which in extreme cases may oblige the fund to sell assets in order to meet requests for redemption. One can typically exit a managed fund within a few working days. In sharp contrast, the shareholder of a private company sells his shares not to the company but to a third party that agrees to buy them. Like selling real estate, this process can take an extended period of time.

As a company, Leithner’s results derive from dividends and interest received and capital gains realised – and not from the fluctuations of the market prices of the businesses in its portfolio. A managed fund’s results, on the other hand, derive from dividends, interest and capital gains and losses – whether realised or unrealised. Given identical portfolios, over time a company’s results would tend to be steadier and the fund’s results more subject to the market’s up and downs. Accordingly, Leithner’s results, which are summarised in Table 4, have everything to do with the income received from the businesses of which it is a part-owner – and nothing to do with either the price volatility of these shares, bonds, etc., or their price level at a given point in time.

Table 4:
Leithner’s Cumulative Results
Six-Month Periods Since Inception

Comparing this result with its counterparts in Tables 1a-1b and Table 2, several points emerge. First, it exceeds the five-year rolling average in Table 1a (i.e., 10.0%) and the average results achieved by Australian shares during the five years to 30 June 2004 (i.e., 7.4% in Table 1b). But bearing in mind that it is not reasonable for shareholders to expect a medium-term (minimum 5-year time horizon) return on their investment of more than 8-12%, and also bearing in mind that regression to the mean (or something very similar to it) exists in financial markets, shareholders should not expect that the results achieved in 1999-2004 will continue into the future. Investment operations, including those undertaken by Leithner, are inherently risky. Therefore the results of investment operations will fluctuate and the results of past operations are not reliable indicators of future results. As the important saying goes, “past performance is not a guarantee of future performance.”

Second, Leithner is clearly no “superinvestor.” The results generated for its Class E shareholders are only 70% of the average achieved by “superinvestors” over much longer periods. They are somewhat better than Keynes’ (bearing in mind that he faced a much more hostile economic and geopolitical environment) and approach those of Schloss (who generated a better result over a much longer period), but it is not even close to Buffett’s and Munger’s. Thirdly, mitigating Leithner’s shortfall is the relative stability of its results. (Note, however, that its results can also fluctuate from one six-month period to the next: from the first to the second half of 2002-2003, for example, they fell 38% from $0.097 to $0.060.) As another mitigating factor, for much of the period since inception cash and rough cash-equivalents have comprised at least 40% and as much as 50% of its assets.

Conclusions and Implications for Leithner & Co. Shareholders

We are now in a position to state (but hardly guarantee) Leithner’s possible future returns to shareholders. Value investing does not – because it simply cannot – promise quick riches. It does, however, extend the considered possibility of cautious and reasonable growth of capital over the medium and long terms. Accordingly, shareholders must expect to wait for the full benefits of Leithner’s investments to manifest themselves; they should therefore refrain in the short term (i.e., during an investment period of fewer than five years) from taking precipitate action purely in response to short-term market price volatility. In summary, given

• the risks which inhere in investing in the Company; the volatility of results encountered even by the Superinvestors of Graham-and-Doddsville; and
• average share market returns over the past 75 years,

it is not reasonable for Leithner’s shareholders to expect a medium-term (5-10 year time horizon) return on their investment of more than 8-12% per annum. It is also quite possible that their results will fall short of these percentages.

The Most Important Benefit of All

Securities markets have their optimists and pessimists. The optimists, known as bulls, buy in anticipation of price increases; and the pessimists, known as bears, sell in anticipation of price decreases. Each of these crowds benefits only when the market moves in “their” direction. Graham-style value investors stand apart from these crowds and attempt to benefit regardless of any short-term movement of market prices. An increase may provide the chance to realise some capital gains; and a decrease may create opportunities to buy parts of good businesses. There is no need to favour any particular direction of prices because such a change has no influence upon the underlying value of one’s investments. Graham-style value investors’ estimate of the value of their investments is independent of market prices. For this reason, these investors do not rely upon current market sentiment to verify that value.

Irrespective of the short-term volatility of investment markets, owners of quality securities tend over the long-term to prosper. They also tend to lead unfettered and relatively stress-free lives – or, at any rate, their investments do not cause them to lose sleep. Leithner’s vision, then, is that the cautious and long-term accumulation of wealth, through a personal and personable vehicle that harnesses the enlightened self-interest of both Director and shareholders, will provide the Company’s greatest benefit.

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