Warren Buffet On Pins And Needles
Warren Buffett proves that a man can be two very different things at once. He is an idiot in matters of public policy — arguing in favor of taking money from corpses. Indeed, he refused to sign Bill Gates Sr.’s petition on behalf of keeping the death tax because he thought it didn’t go far enough.
But while Warren the social engineer is a fool, Warren the investor is a genius.
He released his annual report to shareholders over the weekend. As usual, it was a masterpiece of good sense and folksy humor.
For example, Buffett writes that last year he “embraced the 21st century by entering such cutting edge industries as bricks, carpet, insulation and paint.”
“A bird in the hand is worth two in the bush,” explains the Oracle of Omaha, quoting a Greek philosopher. “Aesop’s investment axiom,” he continues, “is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota ?? nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.”
Thus, when investors decided to pay very high prices for the birds that were supposed to lurk in the branches of the Internet and tech stocks… they made such a gross and obvious error that it screamed out for correction.
This is not an error that Buffett made. Instead, he stuck to the birds he had in his hand:
“Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates,” he explained, “have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to ‘growth’ and ‘value’ styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component ?? usually a plus, sometimes a minus ?? in the value equation.”
The idea is to figure out how much cash an investment is likely to provide you. When you have the bird in hand, you don’t need “blinding insights” to figure this out — just a lot of work with paper and pencil.
But trying to guess about how many birds are hidden in a bush is a different matter. “There are many times,” Buffett continues, “when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.”
(I will quote Buffett at length — sparing me the trouble of having to write anything myself:)
“Now, speculation — in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it — is neither illegal, immoral nor un-American. But it is not a game in which Charlie [Munger] and I wish to play. We bring nothing to the party, so why should we expect to take anything home?
“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.
“Last year, we commented on the exuberance — and, yes, it was irrational — that prevailed, noting that investor expectations had grown to be several multiples of probable returns. One piece of evidence came from a Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the annual returns investors could expect to realize over the decade ahead. Their answers averaged 19%. That, for sure, was an irrational expectation: For American business as a whole, there couldn’t possibly be enough birds in the 2009 bush to deliver such a return.
“Far more irrational still were the huge valuations that market participants were then putting on businesses almost certain to end up being of modest or no value. Yet investors, mesmerized by soaring stock prices and ignoring all else, piled into these enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them.
“This surreal scene was accompanied by much loose talk a bout ‘value creation.’ We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get.
“What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the ‘business model’ for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.
“But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street — a community in which quality control is not prized — will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.”
The pin and the bubble have met. They may not have consummated their union yet, but there has certainly been some foreplay.
Is there more to come?
I don’t know, dear reader. But so far, it looks as though only the most outrageous excesses have been corrected — Internet and Tech stocks have come down in price. That may not be the end of the correction, but only the beginning.
Stock prices will probably fall much further. But there are other bubbles too. Since WWII, America has played an exaggerated role as the spender and lender of last resort. Savings have become excessively small while debt has become excessively large. Confidence in the dollar is overdone. Faith in the Information Age is misplaced. And since the fall of the Berlin Wall, America has enjoyed a near monopoly on Superpower status. Surely there is a pin for each of these bubbles. Surely, they will be corrected too.
Bill Bonner Paris, France March 13, 2001
*** What can I say about yesterday’s market action? Addison proposes a single word: “schadenfreude” — which means “I told you so” in German. No, it doesn’t really mean that. Instead, it describes that naughty emotion you feel when you see other people get what you think they’ve got coming… after they had what you never got.
*** Of course, I didn’t know the market would go down — I was just guessing, like everybody else. No one knows which way the market is going… and the most dangerous market is the one you think you understand.
*** Remember, Mr. Market’s job is to correct exaggerated sentiments. Greed, fear, vanity, pretension, self-confidence, despair — Mr. Market corrects them all… and everything else too. What grows up is cut down. Empires are reduced to ashes. And from the ashes… well, you get the idea. Every yin has its yang, and every bull market its bear. It is Nature’s Way… more below.
*** The news media has finally caught on to the bear market. At least, they have figured out that stock prices can go down for more than a couple months at a time. What they are wondering now is, quoting a headline on TheStreet.com — “How much worse can this get?”
*** “The public is worried,” writes Gerald Appel in a recent issue of his Systems and Forecasts newsletter, “but not yet worried enough to give up on the stock market.”
*** Ameritrade reports that one out of four of its customers bought Cisco on Friday’s dip.
*** Ned Schmidt, another newsletter writer, elaborates: “Until disgust and revulsion are common, no bottom will be in sight for the previously popular ‘growth’ dogs.”
*** The public is still at the resignation stage. “OK,” they say to themselves, “it isn’t what I expected, but it will improve… sooner or later.” My guess is that contempt and revulsion are about 5,000 Dow points, and maybe another 1,500 Nasdaq points, further down.
*** GE, for example, which I warned you about months ago, was the biggest loser of the day. It fell 10% to $40. Last August, bids of $60 were the rule. But even at yesterday’s price, GE is still priced at 34 times earnings.
*** Who would pay 34 times earnings for GE? Only someone in need of correction.
*** The Dow fell 436 points yesterday… the Nasdaq fell 129. The Nasdaq is now below 2,000… and the Dow seems to be headed for the 10,000 mark.
*** Advances were only one-third of decliners on the NYSE yesterday. On the Nasdaq, there were 4 times as many declining stocks as advancing ones. But volume was moderate. There was no “selling climax” — when everyone who might sell comes into the market. There are still many potential sellers in this market.
*** This is a very dangerous situation. Shares are still overpriced. Earnings are poor. The economy may or may not be on the verge of a major recession.
*** So far, investors have not panicked. The average investor made a lot of money in 1998 and 1999. While he’s lost a lot since then, most of it was “on paper” — or “the house’s money,” as you would say in Las Vegas.
*** But as prices go down, soon he is going to feel that he is losing his savings. He is going to worry that even if the stock market does eventually turn around, it may not do so soon enough for him. He may learn that it took 25 years for the ’29 correction to right itself… and a bout the same time (in real terms) for prices to return to their values after the high of 1966. Will he panic? How about foreign investors — will they suddenly lose faith in U.S. stocks, bonds and the dollar? Will the attrition we’ve seen for the last 12 months end in a sharp break downwards… a real “selling climax”? We’ll see, dear reader, we’ll see.
*** But if I were Mr. Bear… I would try to engineer a rally — just to keep people guessing.
*** Just about all the techs and Nets were down yesterday. Cisco is selling for $18 — the same price as Newmont.
*** Jeff Bezos told the BBC that Amazon is not “a stock you can sleep well with at night. We think over time we’ll build a very valuable company. But for a short-term investor or a small investor, I would not invest in Internet stocks.” This counsel might have been more greatly appreciated if it had been delivered when AMZN was selling for $200, rather than now, when the price is barely above $10.
*** Gold rose 80 cents yesterday. Gold mining shares rose slightly.
*** Japan’s bottomless stock market continued to sink yesterday — to a level not seen since 1985. Sixteen years of capital gains have been erased.
*** The whole world seems to be in a bear market, as the “cult of equities” is corrected globally. Stock market valuations equaled 40% of world GDP in 1990. By 2000, stock market capitalization had risen above 110% of GDP.
*** In July 2000, the Dow Jones World Index was at 18,233. Now it is 14,297 – 22% lower.
*** The Internet incubus… I mean incubator… company CMGI is said to be out of cash. The company denies it. But shares fell to $3 and change yesterday — after having traded as high as $150 a year ago. Earnings per share? Negative $6.79.
*** Last night, I went up to the theater district — near the Moulin Rouge — to see The Marriage of Figaro, the play by Beaumarchais, not the opera. It is amazing how much infidelity people were able to get away with in the early 18th century. We take adultery and sanitation much more seriously today.