Portfolio manager’s Letter April 2004
In October of 2003 Charlie Munger gave a lecture to the economics students at the University of California at Santa Barbara in which he discussed problems with the way that economics is taught in universities. One of the problems he described was based on what he called “Physics Envy”. This, Charlie Munger says, is “the craving for a false precision. The wanting of formula …”
The problem, Charley goes on, is, “that it’s not going to happen by and large in economics. It’s too complex a system. And the craving for that physics – style precision does nothing but get you in terrible trouble.”
A monumental example of this problem is the efficient market theory. The is the result of trying to impose the discipline of a hard science on economics, which is not a hard science – it is a social science. Equity markets are about human behavior and while the markets are very efficient at valuing data, they are certainly not rational. They are much too complex and reactive to lend themselves to the kind of discipline that rules the hard sciences.
When you combine Physics Envy with Charley’s “man with a hammer syndrome,” the result is the tendency for people to overweight things that can be counted.
“This is terrible not only in economics, but practically everywhere else, including business; it’s really terrible in business – and that is you’ve got a complex system and it spews out a lot of wonderful numbers [that] enable you to measure some factors. But there are other factors that are terribly important. There’s no precise numbering where you can put to these factors. You know they’re important, you don’t have the numbers. Well practically everybody just overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in places like this, and doesn’t mix in the hard-to-measure stuff that may be more important. That is a mistake I’ve tried all my life to avoid, and I have no regrets for having done that.”
As Charlie Munger says, this problem not only applies to the field of economics, but is huge consideration in security analysis. Here it can give rise to the “man with a spread sheet syndrome” which is loosely defined as, “Since I have this really neat spread sheet it must mean something.”
Warren Buffett has defined intrinsic value of a business as the amount of cash that would be generated by that business in the future, discounted by the dollars that would be generated if the cash necessary to buy that business were invested in risk free government bonds.
To the man with a spread sheet this looks like a mathematical (hard science) problem, but the calculation of future cash flows is more art than it is hard science. It involves a lot analysis that has nothing to do with numbers. In a great many cases (for me, probably most cases) involves a lot of guessing. It is my opinion that most cash flow spread sheets are a waste of time because most companies do not really have a predictable future cash flow. This is why, and to some extent how, Warren Buffett limits his universe.
In security analysis it is way too easy to overweight the numbers, so when analyzing companies it is best we have check lists of questions to ask ourselves before we start looking at numbers and running spread sheets. My preference for the first check list is one that deals with the character of the people running the business. If we can get though this first list with a positive result, then the next step is to concentrate on predictability. The broader question of predictability is a lot more difficult than plugging numbers into a spread sheet, and it is a test that most companies will fail.
The list below is tentative, and will change as we have further opportunity to observe management behavior. These factors are based on information that is generally availably to the public, and do not require a personal visit to corporate headquarters.
One of the easy ways for a corrupt CEO to control the board of directors is to provide directors with lavish perks, consulting fees, contracts with the a business owned by the director, directors fees, and expense accounts. The conflicts of interest here are obvious and odious. Directors are supposed to represent the interests of shareholder. However, if the CEO is using shareholders money to pass around very nice cookies to directors, it is likely that the directors will end up more interested in the CEO’s welfare than they are in protecting the shareholders’ interest. We know that Munger’s “modest proposal” has no chance of acceptance, but he certainly has done a good job at identifying at huge problem.
Does Losch Asset Management Company expect to find a lot of companies where the management displays all of the above behavior? Not really — many good potential investments are weak in one or two of the above items. We are not looking for absolutes here, just a general “leaning toward the light.”
The strongest positive indicator is stock ownership by management and the strongest negative indicators are large stock option programs, and egregious CEO compensation, either one of which will immediately remove a company from my consideration as an investment. Keep in mind that a good portfolio does not need 300 stocks. Warren Buffett says that all new money managers should be given a ticket with twenty punches, and told that was the limit of stock selections for their career. This is an exaggeration, but the point he is trying to make, is that you do not need to own lots of stocks, all you need is a few good ones. In every investment the investor has to have faith in the people that are handing his money, so if the management fails the integrity test, the investor needs to find a new home for the money.
The biggest quibble I have with the “Efficient Market” people is the way the stock market deals with predictability. Generally investors equate uncertainty with risk and risk with high returns. The stocks with the highest P.E.s always have a great story, high risk, and all kinds of uncertainty. Yet, investors buy these stories on the assumption, I guess, that the risk will fetch you a greater return. The market in effect seems to always place a premium on uncertainty. So, when it comes to predictability, the market basically has everything backwards. Instead of discounting uncertainty and pricing in a premium for predictability, the market mostly does the opposite. Boring stocks are more predictable but investors prefer to pay a premium for risk.
This prevalent inefficiency in equity markets is one that Warren Buffett has used to his advantage for fifty years. You make more money buying boring, predictable stocks. Warren Buffett has been telling anyone that would listen that unpredictability is bad, but basically, almost nobody listens. They buy their stories; they chase the sexy stocks; who cares if the PE is 173? The assumption is that a sexy stock will someday make you rich. “Nothing ventured, nothing gained.” “The higher the risk the better the return.” But in Warren Buffett’s opinion:
“Severe change and exceptional returns usually don’t mix. Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today’s business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be.” – 1987 letter to Berkshire Hathaway shareholders.
The argument could be made the market in general does not understand the real nature of risk. In a market that was truly efficient, predictability would sell at a premium and stocks of companies whose future was difficult to forecast would sell at a price that reflected risk inherent in that uncertainly. In this world, if Coke’s PE was 24, Cisco’s PE would be around 3½.
Predictability is mostly about moats (a sustainable competitive advantage). There are many different kinds of moats, and identifying and understanding a company’s moats can take a lot of study.