Aesop, helluva, Cinderella, and the girl in a convertible

From: scerir (
Date: Tue Mar 13 2001 - 06:16:40 MST

These days the 'new' economy (p/e ratios >> 40) is getting 'old'
(p/e ratios < 20) and, fortunately, the 'old' economy is getting
''new' (AOL-Time Warner, the Vivendi-Yahoo! hypothesis, etc.).

Herewith a very smart speech by the Oracle of Omaha: Mr. W.E. Buffett,
(feb, 28th )

But I will tell you now that we have embraced the 21th century by entering
such cutting-edge industries as brick, carpet, insulation and paint. Try to
control your excitement.

Leaving aside tax factors, the formula we use for evaluating stocks and
businesses is identical. Indeed, the formula for valuing all assets that are
purchased for financial gain has been unchanged since it was first laid out
by a very smart man in about 600 B.C. (Though he wasn't smart enough
to know it was 600 B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete,
investment insight was "a bird in the hand is worth two in the bush." To
flesh out this principle, you must answer only three questions. How certain
are you that there are indeed birds in the bush? When will they emerge and
how many will there be? What is the risk-free interest rate (which we
consider to be the yield on long-term U.S. bonds)? If you can answer these
three questions, you will know the maximum value of the bush - and the
maximum number of the birds you now possess that should be offered for it.
And, of course, don't literally think birds. Think dollars.

Aesop's investment axiom, thus expanded and converted into dollars, 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.

Common yardsticks such as dividend yield, the ratio of price to earnings or
to book value, and even growth rates 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.
Alas, though Aesop's proposition and the third variable - that is, interest
rates - are simple, plugging in numbers for the other two variables is a
difficult task. Using precise numbers is, in fact, foolish; working with a
range of possibilities is the better approach.

Usually, the range must be so wide that no useful conclusion can be reached.
Occasionally, though, even very conservative estimates about the future
emergence of birds reveal that the price quoted is startlingly low in
relation to value. (Let's call this phenomenon the IBT - Inefficient Bush
Theory.) To be sure, an investor needs some general understanding of
business economics as well as the ability to think independently to reach a
well-founded positive conclusion. But the investor does not need brilliance
nor blinding insights.

At the other extreme, there are many times 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.

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 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 about "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.

At Berkshire, we make no attempt to pick the few winners that will emerge
from an ocean of unproven enterprises. We're not smart enough to do that,
and we know it. Instead, we try to apply Aesop's 2,600-year-old equation to
opportunities in which we have reasonable confidence as to how many birds
are in the bush and when they will emerge (a formulation that my grandsons
would probably update to "A girl in a convertible is worth five in the
phonebook."). Obviously, we can never precisely predict the timing of cash
flows in and out of a business or their exact amount. We try, therefore, to
keep our estimates conservative and to focus on industries where business
surprises are unlikely to wreak havoc on owners. Even so, we make many
mistakes: I'm the fellow, remember, who thought he understood the future
economics of trading stamps, textiles, shoes and second-tier department

Lately, the most promising "bushes" have been negotiated transactions for
entire businesses, and that pleases us. You should clearly understand,
however, that these acquisitions will at best provide us only reasonable
returns. Really juicy results from negotiated deals can be anticipated only
when capital markets are severely constrained and the whole business world
is pessimistic. We are 180 degrees from that point.

[For the record: Berkshire's Corporate annual average performance, after
taxes, was 23.6%, during 35 years!]

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