Aesop and Inefficient Bush Theory, Part 2

Buffett on what happens when price runs away from value

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Feb 14, 2019
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Earlier, we provided some commentary on an excerpt from Warren Buffett (Trades, Portfolio)’s 2000 annual letter to shareholders of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). In it, the Oracle of Omaha used a quote from the ancient Greek storyteller Aesop: “A bird in the hand is worth two in the bush,” to illustrate an important truth about the market: You should invest in solid businesses that you are sure of, instead of chasing after speculative gains. In this second part, we will look at Buffett’s views on said speculative gains, in particular the example of the runaway dot-com market off the late '90s.

Dancing past midnight

“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.”

This is a perfect illustration of the cognitive fallacy suffered by most trend-following market participants. Everyone believes that they will be the ones who are able to leave just before the music stops. Of course, it is mathematically impossible for everyone to be part of this select bunch. Moreover, the ability to get out while a bubble is hot is less to do with skill, and much more to do with luck. As such, this leads to a misallocation of capital towards the fortunate, not the smart. The good news is that no one can remain lucky for very long -- today’s bubble millionaires will be brought down to earth tomorrow.

Wealth transfers and unscrupulous actors

The letter went on to discuss those who take advantage of this irrational exuberance:

“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.”

Beware of excessively bullish analyst estimates and price targets. During the latter part of a bull cycle, there are plenty of bad-faith actors who knowingly pump stocks far beyond the value of the underlying businesses. Do not have your vigilance lulled to sleep by a talking head with an impressive-sounding title, and always ask yourself who stands to benefit from an excessively bullish position.

Buffett closed out this part of the letter by reiterating Berkshire’s position on forecasting the success of new companies. It is clear that he did not believe in his own ability to identify early stage startups -- a quality shared with Benjamin Graham and David Dodd. Certainly, it seems much easier to go for reasonably priced, high-quality businesses, than to bet the house on a long shot with high risk and high reward.

“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 ... 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.”

Disclosure: The author owns no stocks mentioned.