A Different Approach to Investment

1. A Different Approach to Investment Luncheon Talk and Roundtable Discussion Montreal Economic Institute May 19, 2005 By Chris Leithner

2. A “ Thought Experiment”  How much are you willing to pay today for the right to receive $100 in exactly one year? Assume that the receipt of the $100 is absolutely guaranteed – the probability that you will receive it, in other words, is exactly 100%.

3. Benjamin Graham: An Overview • Benjamin Graham (1894-1976) was both an investor and an adjunct academic. • He wrote Security Analysis (1934 and subsequent editions) and The Intelligent Investor (1949). • According to Graham, “investment is most successful when it is most businesslike. An investment operation is one that, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” • Day to day, week to week, etc., the operations of a business are more stable than the assessments of its value.

4. Benjamin Graham: Four More Points • Graham maintained that price and value are distinct things: price is what is paid and value is what is received; • observed that over time price and value gravitate towards one another but that at any given point in time they may diverge (sometimes by a wide margin and for an inconvenient length of time); • and lamented that most people rarely recognise – and more than a few wilfully ignore – the fundamental distinction between value and price. • “Value” investors thus reject the mainstream view that the price and value of a security necessarily coincide at all times.

5. The Austrian School: An Overview • It is not a field of economics; rather, it is an alternative way of looking at production and exchange in the market. • Its founding dates from the publication of Carl Menger’s Principles of Economics (1871). This book, which grounded economics in deductive laws of human action, revolutionised economists’ understanding of valuing and pricing resources (and, by implication, assets and securities). • Austrians see entrepreneurship as critical in economic development, private property as essential to an efficient use of resources, and government intervention in the market as always and everywhere destructive.

6. The Austrian School’s Insights for Investors • Buyers and sellers in the market have different values, preferences, needs and desires, time horizons and goals. • “Markets” do not do anything: only individuals act. It is not possible to collapse the complexity of actions in the market into aggregates (such as stock market indices, CPI and other measures). • Capital is subjective and the capital stock is heterogeneous. • Competition is a process whereby new and better ways to organise production are discovered.

7. A New Approach Based Upon Old Principles • Buy sound assets whose expected rate of return over the medium term (5 years or more) is significantly greater than your “natural rate of interest.” • If you cannot find such assets, place funds into secure, liquid and short-term securities (e.g., 90-day commercial paper). • When you do find such an asset, buy enough such that it comprises 5-10% of your portfolio. • Sell assets whose expected rate of return over the medium term (5 years or more) has become significantly less than your “natural rate of interest.”

8. A New Approach (Continued) • Seek cautious “business entrepreneurs” and avoid “political entrepreneurs.” • When looking for investment opportunities, stand apart from the crowd. • Avoid the crowd’s mainstream economic follies.

9. How Does This Approach Differ from the Mainstream? • Distinction Between Price and Value • Conception of Risk • Scepticism About Mathematical Modelling • The Future Is Largely But Not Radically Uncertain • Value Investors as “Austrian” Entrepreneurs

10. Conclusion: Austrians’ Relevance to Value Investors • It helps to inoculate against absurdity. The next time somebody tells you with a straight face that all investors have the same information, expectations and time horizon; that markets are very liquid, making transaction costs so small that they can be ignored; and that value and price are synonyms, the sane response is to laugh. • It helps to avoid over-optimism and unwarranted pessimism, i.e., bumping into things in the dark. • For capitalists, businessmen and investors, Austrian School economics is neither a necessary nor a sufficient condition of reasonable results – but it certainly helps