by Gary North
You may have read that Fitch, a firm that rates the credit-worthiness of the debt of publicly traded corporations, has downgraded Berkshire-Hathaway, the investment holding company run by Warren Buffett.
Berkshire-Hathaway has exceeded the return of the Standard & Poor's 500 index in 34 of the last 40 years. This success is understandably attributed by the public to Buffett's skill in picking companies whose shares his holding company buys. So phenomenal is Buffett's success that economists, who are committed to the premise that nobody can consistently outperform the stock market, either ignore Buffett or else invent a new category of performance: a five-sigma man. This is someone who beats the odds by millions to one, for no known reason — just pure blind luck. Warren Buffett is living proof that the economists are wrong. This upsets them, especially when the Nobel Prize-winners are such poor investors personally. As an article in The Economist put it recently:
Mr Buffett — an investor who famously thinks of a stock as "part of a business rather than a thing that moves around on a chart" — has always stuck in the craws of those theorists who concluded that in efficient markets stock-picking was a waste of time. He has had far more successes than failures. As a result, the per-share book value of Berkshire has gained 286,865% since 1965, while the S&P 500, with dividends included, has risen by 5,318%.
Buffett's success is in part due to his partner, Charles Munger. The problem is, Munger is seven years older than Buffett ("the kid"). Buffett is 74. At this year's annual meeting of investors — paid attendance was 19,000 — Buffett began with this repartee:
I'm Warren. He's Charlie. We work together. We really don't have any choice, because he can hear and I can see.
But then they fielded questions for six hours. This is not just stamina. This is bladder control.
The Economist sent an anonymous reporter to cover the event. Anonymity is normal. There are never any by-lines in the Economist. Even the editor's name is published only twice in his career: in the issue after he becomes editor and the issue after he is replaced.
Mr. Buffett used to have more ideas than capital, he says. "Unfortunately, in recent years my capital has outrun my ideas." As long as what ideas he has are good ones, that may not matter, and the octogenarian Mr Munger is no slouch either. But it is beginning to affect public perceptions. Last month, Fitch, a credit-rating agency, downgraded the outlook for the triple-A rated firm to "negative", citing Mr Buffett's age as the main reason. "They discovered that I was mortal — though I hope to prove them wrong," he says. The emphasis at this year's AGM was on continuity, and on fireproofing Berkshire so that, come what may, it will continue to embody the culture and characteristics that it has today. But can that be guaranteed?
Obviously, if the economists are right, it cannot be guaranteed. A five-sigma man is hard to replace.
Investors obviously retain their confidence in Buffett and Munger. They think that there is more where that came from, despite losses recently sustained by Berkshire-Hathaway's portfolio of AIG shares. They are confident in both the man and his system of investing. Otherwise, they would sell their shares, which are in the range of $83,000 per share. This is down from $92,000 in February. (Mr. Buffett never splits shares.)
But this raises a key conceptual problem. Are the economists correct? Is he a five-sigma man? In other words, is his investment strategy a function of his own five-sigma abilities? Or is his system as such the primary source of all these gains? If it is his system, then why hasn't anyone else matched his performance? Why is he all alone?
BETTING ON THE MAN
If investors are betting on the man, then the mortality problem raises its ugly head. How much longer can he go on?
Because the American stock market is remarkably short-run oriented, the share price today reflects mainly short-term expectations. This short-run outlook is so common that the market applies low discounts to long-run problems. This, after all, is the American way. Americans have confidence that all problems can be overcome by good, old-fashioned American know-how. This outlook, coupled with a short-run time horizon, has reduced the personal savings rate to the low single-digits.
If Buffett were to drop dead, that would be bad for the company. If he were to falter mentally, that would be much worse. He would stay in power much longer. The thought of a corporate raid on Berkshire-Hathaway is ludicrous. Who would be nutty enough to position himself as a man wiser in investing than Buffett? Who would trust someone who would claim this?
So, Buffett is here for the duration . . . his duration. But when he departs from the scene, what happens to liquidity? At $83,000 per share, there could be liquidity problems down the road. Sell orders at this price in the wake of the wake might create problems.
This is the problem of continuity. Fitch decided that the issue should no longer be deferred. The other credit rating services have not followed Fitch.
There are two issues here: continuity of performance and continuity of investors' confidence. Performance depends more on Buffett than his system of stock-picking. That is Fitch's assessment. Then there is the question of investors' confidence. Will shareholders retain their confidence in the performance of his successor? No successor is ever publicly mentioned by Buffett. This is also an aspect of continuity. It points to discontinuity.
The advantage we have as non-investors in Berkshire-Hathaway is that the outcome of investors' sentiment regarding the firm will not affect us directly. Others have borne the risk of his death and the uncertainty of the aftermath.
We cannot say the same about Greenspan.
O CAPTAIN, MY CAPTAIN
Greenspan's tour of duty is up early in 2006. If he retires at that time, he will not break the all-time record set by William McChesney Martin, who was Chairman from Truman through Nixon. He will get close — within months. But unless there is a delay in finding a replacement, he will depart from the FED without the record.
Again, the issue is continuity. Greenspan has been Chairman ever since October, 1987 — days before the world's stock markets fell in one day by over 20%. He was there during Bush I's recession. He was there during the 1995 Mexican currency crisis, the 1997-98 Asian currency crisis, and the near-gridlock effect of the near-default by Long-term Capital Management. He was there during Bush II's recession. He was there during 9/11 and the aftermath.
The public has seen his face on TV for a long time. He seems so calm. He speaks that peculiar dialect of central bankers' Esperanto. Congress treats him with kid gloves. (Congress treats all FED Chairmen with kid gloves.)
He is the only central banker known throughout the investment world. He is perceived as the leader of the band, the maestro. As in the case of Buffett, he is perceived as the possessor of an analytical system that is beyond the capabilities of one-sigma fellows, however bright they may be.
This raises the question of continuity. The dollar has been turbulent in recent years. The United States is at war. The trade deficit is astronomical, and the U.S. government's deficit is in the same league. While the public still trusts the President on military matters, it has never trusted him on the economy.
The public is asked to place great trust in the day-to-day operations of both the economy and the political order that oversees it. People personify any system through its leaders. They may trust the system, but this implies trust in the ability of the system to recruit future leaders, identify their abilities, and elevate them to decision-making power. The degree of trust in the political system does not match Catholics' degree of trust in the cardinals at the conclave.
Investors have trusted Greenspan as they have trusted no previous FED Chairman. Prior to Paul Volcker, hardly anyone even knew who was the FED Chairman. Volcker's cigars made a much greater impression than Arthur Burns' pipe. So did his elevation. He was a steamroller of a man.
Greenspan has a different style — enigmatic, reserved. Call him the Federal reserved Chairman. But there is no doubt in my mind that the public trusts him. Investors have confidence that he is somehow on top of things, that he can crunch the numbers mentally and come up with policy prescriptions that will prevent chaos during a crisis.
It goes deeper than this. He has been Chairman for so long that other central bankers have looked up to him. Long before the chairmen of other central banks became chairmen, Greenspan was holding forth.
The problem is, he holds out when he holds forth. Like a skilled poker player, he never shows his cards after a successful bluff. He does not articulate his formulas, if any. He does not go into detail regarding his decision-making process.
We are now facing a transition in FED leadership at a time of uncertainty. This is not just economic uncertainty. It is the insecurity of public safety. What would be the effect on the fractional reserve banking system of a terrorist attack on New York City that used anthrax as a weapon of mass destruction? What if it was followed the next day by a similar attack on the City of London — the banking district at the center of the city?
These are not idle speculations of a madman. On May 10, the U.S. Senate voted 100 to zero to impose a national identity card system on this country. You and I are going into the Federal government's soon-to-be-universal data base. The House had already voted for it 388 to 44. The President will sign the bill soon. This was done in the name of fighting terrorism. If there is no such threat, then why did Congress pass such a law?
The government is telling us that such a threat exists. It is spending tax money like mad to solve it. Result? A stack of paid bills and equipment that does not work. On May 8, this story appeared in the New York Times and was picked up by other newspapers.
After spending more than $4.5 billion on screening devices to monitor the nation's ports, borders, airports, mail and air, the federal government is moving to replace or alter much of the antiterrorism equipment, concluding that it is ineffective, unreliable or too expensive to operate.
Many of the monitoring tools — intended to detect guns, explosives and nuclear and biological weapons — were bought during the blitz of spending after the attacks of Sept. 11, 2001.
In its effort to create a virtual shield around America, the Department of Homeland Security now plans to spend billions of dollars more. Although some changes are being made because of technology that has emerged in the last couple of years, many of them are planned because devices currently in use have done little to improve the nation's security, according to a review of agency documents and interviews with federal officials and outside experts.
"Everyone was standing in line with their silver bullets to make us more secure after September 11," said Randall Larsen, a retired Air Force colonel and former government adviser on scientific issues. "We bought a lot of stuff off the shelf that wasn't effective."
Greenspan's timing poses problems. If Warren Buffett loses his five-sigma magic touch, this will harm investors in Berkshire-Hathaway. I am not convinced that Greenspan has a five-sigma magic touch, except in his ability to deal with Congress, which I think a one-sigma man could do just fine. But whether five sigmas or fewer, he will be departing soon. We have no idea who will replace him. We do know this: he will not be perceived as a five-sigma man.
THE ILLUSION OF BEING IN CONTROL
Warren Buffett is in control. He has been in control for five decades. He has the track record and the net worth to prove it.
Alan Greenspan may not be in control of anything other than Congress. He influences the Board of Governors, but he cannot outvote them. The Board, through the Federal Open Market Committee (FOMC), is in control of the monetary base. As to what the financial system will do in response to changes in the monetary base is anyone's guess, as testified to by M-1, M-2, M-3, MZM, and the credit system generally.
Voters believe that governments are capable of balancing and protecting their respective national economies. Two groups adamantly deny this: Austrian School economists, who do not trust politicians as economic planners, and central bankers, who also do not trust politicians, and who have kept free of control by the very political order that grants them their legal monopoly over the monetary base.
This confidence in government spills over into confidence regarding the Federal Reserve System. But this means confidence in Greenspan.
Greenspan will soon depart. What will happen to public confidence? What will happen to continuity? No one in authority is asking these questions publicly, despite the fact that his departure is only a few months away.
I think that the next FED Chairman will have a much harder time of it than Greenspan had. For one thing, Greenspan will be a tough act to follow.
Over 30 years ago, the head basketball coach at Louisville, Denny Crum, was asked if he wanted to replace John Wooden after Wooden's retirement. Crum had served under Wooden. Crum remarked: "I would prefer to replace the man who replaces Coach Wooden." (Anyway, I think it was Crum. My memory has faded.)
The crucial economic issue today is the continuity of the dollar as the world's reserve currency. The world's economy is pegged to the dollar. What if the market forces an unpegging?
This issue can be deferred for a while longer. It cannot be deferred for as long as Greenspan has served as Chairman, let alone for as long as Buffett has beaten the S&P 500.
Faith in Buffett has paid off hugely for long-term investors in his company. Faith in Greenspan has paid off hugely for speculators who could predict the next bubble — something that Greenspan says central bankers cannot do.
Buffett has a system: value investing — the Graham-Dodd system. Greenspan has a system: inflate the money supply whenever equity markets plummet. Buffett's system is good for the economy. It moves capital to its highest known uses — and no one in history has been able to identify highest uses with the skill of Buffett. Greenspan's system keeps capital invested in lower uses than the free market would otherwise determine.
I hope Buffett stays. I am happy to see Greenspan depart. The man who replaces him may be incompetent, but that's not all bad. This would reduce men's faith in that which should not be trusted: a government-created monopoly over money.
May 14, 2005
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