How much do real businessmen value real businesses? It is amazing just how wrong Wall Street can really be sometimes…
"Speculation buys up, in a very practical way, the intelligence of those involved."
– John Kenneth Galbraith, A Short History of Financial
Little girls’ softball games are excruciating. Bats are often swung, balls rarely hit. Balls are thrown regularly, caught seldom. The latter happens so seldom, in fact, that base stealing is de rigueur. Fielders run up to ground balls hit in their direction apparently for the sole purpose of guiding them successfully through their legs and beyond.
It’s like watching the Harlem Globetrotters on ice…without skates on their feet. Without a book in my hand, I believe that only small acts of self-mutilation would keep my eyelids taut enough to remain open. That the girls struggle earnestly and heroically makes it no less comical. It simply accounts for the cheers when someone manages to do something like hit or catch a ball.
The book that saved me last Sunday was Roger Lowenstein’s excellent work, "When Genius Failed." It’s the story of the rise and fall of Long Term Capital Management. Seated next to me was a friend, Pat, father of my daughter Rachel’s best friend, Kathleen. Since there was nothing to say about what was happening (or not) in front of us, Pat asked instead about the book.
Roger Lowenstein: When Nobel Prize Winners Go Wrong
I did my best to confuse Pat with descriptions of repo-financed, leveraged trading strategies intelligible only to the Nobel Prize winners who used them so effectively to lose money. I told him that what LTCM did was like taking ownership of a $30,000 car with a single deposit of $300, and hanging onto it just long enough to sell it for $31,000. With only $300 tied up, you make $1,000, more than three times your money.
Metaphorically speaking, Long Term Capital did this with a million cars.
Then, quite unexpectedly, all of the cars were totaled. It turns out that the Nobel Prize-winning mathematics didn’t allow for events like a million teenagers drinking a million bottles of whiskey and stealing and wrecking a million cars, all over the world and all on the same day.
The story of how leverage goes both ways inspired Pat to relate a personal tale. He once had to liquidate a brokerage account to keep his margin account whole…and swore off leverage from then on. I told him that was smart. I didn’t tell him that I once lost my ass – or at least 86% of it – about 12 years ago, trading commodity futures with maximum leverage. I wasn’t able to sit down for months while it grew back.
Pat is a civil engineer. He designs buildings and bridges and the like. He’s the principal of his own company, which is now 11 years old. He’s had a great run, to he estimates that his business has grown at a rate of at least 50% a year for all 11 years. Business is really booming. I congratulated him, and he smiled.
Roger Lowenstein: Pricing a Business Reasonably
Recently Pat took on some partners. In doing so, he had to price the business to decide what they should each contribute in exchange for their portion of the profits.
The 50% growth rate Pat cited is a ballpark figure. Believe it or not, most businessmen aren’t obsessed with the price of their business every minute of every day. Pricing the business is a subject that only occasionally comes up for the vast majority of businesses in existence. The idea of selling the business for the sole purpose of realizing a capital gain seems, as often as not, just…well…stupid.
So what price did Pat, this successful entrepreneur, assign to his business, to his 50%-a-year money machine, his crowning achievement?
20-times earnings? 30-times earnings?
Peter Lynch says that if you find a 25%-a-year growth business selling for less than 20 times earnings, you should "back up the truck," meaning buy as many shares as you can afford. We’re led to believe that 20 times earnings is a bargain for a business growing at half the rate of Pat’s design firm.
And what about the wunderkinder of the new era? Should Pat charge E-Bay prices for his business, or Yahoo prices? 50-times earnings? 100-times? He’s made a growing profit every year for 11 years. Amazon hasn’t made a dime, and it’s "worth" $18 billion.
Pat charged his partners 5 times earnings. I heard that and nodded, unfazed. It’s a rather typical, reasonable private market valuation for a good business.
Five times earnings.
Mind you, Pat didn’t think this was a bargain-basement price. He thought it was reasonable, a win/win situation, for both himself and his new partners. (Try getting any organism on Wall Street to think like that!)
Here’s a guy who has never studied a thing about finance or investing. But he’s smart. Most people just don’t ever look at the stock market as a place where businesses trade hands.
"Every day you hear about mergers and acquisitions…" Pat said. "What are all these prices big corporations are paying for all these big mergers and acquisitions? They’re never lower than the stock price…and the stocks are all way overpriced! How on earth do they justify these prices?"
I kept myself from giving my spiel on the investment bankers who live to force these deals through…
Roger Lowenstein: Some Other Idiot
Pat went on, "Small investors are no different. People are buying stocks solely because they think they’ll be able to sell them to some other idiot at a higher price three months later."
Three months…? I let the words pass without comment. He continued: "If you’re going to do that, why not drive down the road to the casino?"
I just nodded as Pat asked his rhetorical questions. He got it. He understood. I realized how rare it is to find anyone who understands how absolutely efficient the stock market is at reflecting the pervasive lack of plain business sense that characterizes the average person’s approach to investing.
And if you think there’s some wiry-haired genius out there who knows how to predict which stocks will go up and which ones will go down and can easily profit from his knowledge, well…there’s no such person. If there were, he would have been at Long Term Capital. They had the brainiest mathematical geniuses in finance…but they lost their asses and the asses of their 100 clients. They had to be bailed out by a group of other banks for $3.6 billion.
Think of what you’d call a place where people pay more for something because it’s easy to sell, as if McDonald’s hamburgers were really worth $10 each because they have a drive-through window and you can buy one every three seconds.
(I’m sure some financial genius will read that and say, "Ah! But you can’t resell the burger every three seconds ad infinitum." To which I would reply, "No sh**, Sherlock. What moron would want to?")
Think of what you’d call a place where the most lauded, honored mathematical geniuses are destined to fail, with their level of mathematical ability practically representing the relative amount of money they’ll lose, as if some investing god had decreed, "the smarter they are, the harder they fall."
What would you call a place where the buying and selling is literally worth more than that which is bought and sold?
A circus? A casino? The home for the terminally stupid? Suckers Alley?
Not that these aren’t all good names for that place, but it’s already got a name.
It’s called Wall Street. And more than 50% of all Americans think they’re going to get rich buying its perpetually, systematically, purposely overpriced offerings – which they think they’ll quickly sell to someone who’ll pay even more.
for The Daily Reckoning
May 5, 2004
Editor’s Note: Dan Ferris is the editor of Extreme Value, an investment advisory service that uncovers the safest, cheapest shares in the market. Following the wisdom of original value investors Benjamin Graham and Warren Buffett, Ferris takes investors behind the numbers to learn the true value of a business – and to point out from a ‘bottom-up’ perspective which individual companies are trading at prices simply too cheap and safe to pass up.
Today, en route to Madrid, we reflected on WWWD.
What would Warren do, we wondered.
But what we really found remarkable was not WWWD but WEED – what everyone else does.
What Warren does seems completely ordinary; what everyone else is doing seems outrageous.
Buffett finds good businesses and buys them. If he can’t find good business at a good price, he doesn’t buy anything. He holds cash until a good deal comes along.
In the rare case – it has never happened before in the man’s entire life – that the cash itself is suspect, he trades it for some other cash. Currently, Buffett doesn’t trust the dollar…for the many reasons we describe here at the Daily Reckoning. So, Buffett – as if following our advice – has moved a third of his cash into foreign currencies.
While we see nothing extraordinary in Buffett’s actions, what everyone else is doing takes our breath away.
No investor in human history has ever made so much money from investing as Buffett. He is the second-richest man in the world, and he made every penny without ever breaking a sweat or punching a time clock. He invented nothing. He wrote no hit songs. He never played professional soccer or endorsed a shaving cream. Nor did he ever work on Wall Street or run for public office. His hands and his conscience – as far as we know – are clean.
What better model could an investor want?
And yet, even smokers are more in fashion. Like Marlboros and good manners, Buffett has gone out of style. The man from Omaha has been left behind by the times. He has started no hedge funds. He has failed to refinance his house. He could have bought every single Google share on the market, yet he passed on the opportunity.
Queried on the subject, the average investor would probably give the Sage of the Plains his due. But confronted by Buffett’s advice, he would ignore it.
And you, dear reader?
Here at the Daily Reckoning, our fashion sense stopped evolving even before Warren’s. We do not like Cherry Coke, nor do we read the Washington Post. But we hold onto our Buffett views like narrow ties; when the dollar falls and Google comes back to earth, they are likely to come back into style.
While we wait…here’s our man on Wall Street, sometimes right, sometimes wrong…but always a fashion leader – Eric Fry:
Eric Fry, back from a junket to the City of Angels…
– Alan Greenspan never tires of demonstrating his irrelevance…yesterday, after convening for several hours with his colleagues at the Federal Open Market Committee, Greenspan and his fellow bankers announced, "At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured."
– In plain English, the Fed implied that it would begin hiking interest rates over the next several months. Should anyone care? The bond market is hiking interest rates already. Yesterday, the 10-year note yield jumped to 4.53% from 4.50% on Monday. That’s up dramatically from the 3.68% yield that the 10-year yielded less than two months ago.
– Although the rising rate trend has been battering and abusing the stock market of late, the Nasdaq struggled to a second straight gain yesterday, adding 12 points to 1,950, while the Dow inched ahead 3 points to 10,317.
– In the currency markets, the U.S. dollar tumbled sharply against all major currencies – hitting a 4-week low of $1.21 per euro. The dollar’s drop inspired a bit of gold-buying, as the yellow metal jumped back above $390 an ounce for the first time in a week. By the end of yesterday’s trading, gold fetched $391.80 an ounce, $4.30 higher than Monday’s closing price on the New York Mercantile Exchange…
– Your New York editor skipped town late last week to visit Los Angeles, the city of his youth – the pre-30 portion of his youth, that is. Exchanging his Brooks Brothers suit for the Billabong variety, he hung out in Santa Monica for two days, then headed out to Pasadena to attend his father’s 80th birthday party.
– The weather was spectacular all weekend…brilliant sunshine illumined the ubiquitous Bougainvillea, while glistening off the endless procession of Ferraris, Maseratis and other automotive exotica that motored along Montana Ave. But in this beachside city of stark contrasts, the sun also glistens off the many stainless steel shopping carts that homeless men and women maneuver along the downtown sidewalks…and in many of the areas close to the Santa Monica Pier, the sweet scent of jasmine competes for olfactory "shelf space" with the off-putting odors of homelessness.
– Still, in all, Santa Monica is a wonderful city…your editor finds the place just as alluring as he did in the 1980s when he last lived there.
– Saturday morning, your editor hooked up with several of his old friends to play beach volleyball. This 40-something group of volleyball buddies still plays the game several times a week and still plays the game very well…however, the between-game conversations have aged much more dramatically than the level of play. No one talked about "girls" or "parties." Instead the conversations tended toward the stock market and interest rates.
– "Hey, I saw you on CNN," one of the guys said to your New York editor. "Do you really think that the bond market is in trouble?"
– "Yeah, it looks that way," came the reply.
– "So you think inflation is coming back?" the questioner persisted.
– "Well, that’s what the bond market seems to be saying," your editor continued. "So I’m just repeating the message from the bond market. 10-year Treasury yields have jumped from 3.7% to 4.5% in just a few weeks. So the bond market seems to be seeing some kind of inflation, even if Alan Greenspan doesn’t."
– "What about the housing market, then?" asked another friend, who also happens to sell real estate. "I mean, the housing market in LA is red-hot…blazing-hot. Do you really think that rising rates are going to make much of a difference?"
– "I don’t know, you tell me," your editor replied. "You’re the housing expert. I’m just a journalist. At the Daily Reckoning we specialize in highlighting the obvious. The future direction of housing prices is not obvious. But what is very obvious is that rising interest rates will not HELP prices move higher…c’mon, let’s play another game."
– The final volleyball game ended around noontime, after which your editor took a dip in the filthy Santa Monica Bay, dried himself off, hopped into his rented convertible and drove out to Pasadena for the birthday party.
– The change of venue did not produce a dramatic change of subject matter. The topic of interest rates and the housing market surfaced repeatedly at the party. Part of the "problem" was that the guest list included folks who are both faithful friends of the family and faithful readers of the Daily Reckoning. As your editor strode into the party that evening, the first guest to greet him shouted, "Eric!…wow!…it’s great to see you; it’s been a long time…you know I read the Daily Reckoning almost every day…do you really think the housing market is in trouble?"
– "I don’t know. What do you think?" came the reply.
– "Well, rising rates can’t possibly be a good thing for home prices," the party guest asserted.
– "I can’t argue with that," said your editor. "How’s the shrimp cocktail?"
Bill Bonner, back in Madrid…
*** "What’s the point?" asked a London colleague, referring to Warren Buffett.
"The man earns all that money, but he lives in a dreary house in a dreary city with his dreary housekeeper. At least he could get a place in London and live a little. At his age, what’s he waiting for? The whole story is depressing…it shows how worthless money really is if you don’t have any idea what to do with it…"
*** The French were in the financial news a few weeks ago. James Grant reports:
"On April 14th, the Bank of France dropped a bombshell. For the first time since Napoleon, it said, it is planning to become a seller of gold, perhaps as much as 16% of its hoard. The bank observed that gold pays no interest (when did it find out?) It would, it said, convert some of this bullion ‘into a more lucrative investment.’"
We will watch the French central bank; we would like to know what investment will be more lucrative than gold.
It was the French, we recall, who set in motion – albeit indirectly – today’s Dollar Standard system. Back in the ’60s the U.S. government still honored its pledge to exchange 35 U.S. dollars for an ounce of gold.
Charles de Gaulle noticed that then, as now, American spending was running a little ahead of itself. For that was the period of the first Guns and Butter administration in America – that of Lyndon B. Johnson. De Gaulle was suspicious. He had warned America not to get too deeply involved in Vietnam. Now he saw that whatever the outcome of the war, the U.S. dollar was likely to suffer collateral damage. "What the United States owes to foreign countries," he observed, "it pays – at least in part – with dollars it simply issues if it chooses to."
De Gaulle demanded gold. Now America has a new Guns & Butter administration in Washington…and, this time, the French government sells its gold.
But de Gaulle was right. Gold was underpriced in 1965. Compared to the dollar, it has gone up more than 12 times. Our guess is that it is still under-priced…or under-priced again…and that the French will soon wish de Gaulle were still alive.