The Voting Machine vs. The Weighing Machine
Dear fellow investors,
The patriarch of value investing, Ben Graham, once said, “In the short run the market is a voting machine, but in the long run it is a weighing machine.” His statement is just as profound as the day it was first spoken. However, it is timelessly mystifying to most investors. Graham used the statement to highlight that from time-to-time the stock market can become nothing more than a beauty pageant, slapping high price to earnings ratios and valuations on the current darlings. We believe in sustainable wealth creation and looking for meritorious companies that for one reason or another are considered ugly or unglamorous. The fundamental value which underlies them in the marketplace could produce sustainable value to the owners.
At the 2018 Berkshire Hathaway Annual Shareholder Meeting, Charlie Munger made a confident and seemingly welcoming statement to shareholders. We think few people in attendance contemplated the irony. Munger said:
Well, it really wasn’t fair for our monetary authorities. It was the savings rates paid to mostly old people with savings accounts as much as they did, but they probably had to do it to fight the great recession appropriately. But it clearly wasn’t fair and the conditions were weird. In my whole lifetime, it has only happened once that interest rates went down so low and stayed low for a long time. It was quite unfair to a lot of people and it benefited the people in this room enormously because it drove asset prices up, including the price of Berkshire Hathaway Stock. So we’re all a bunch of undeserving people.
Munger said that they had “benefited” from rates staying low. In this missive, we would like to unpack what Smead Capital Management believes are the long-term practical implications of what Munger said. We will use the paradox of the voting machine versus the weighing machine to understand Munger’s comments.
The voting machine is a short-term scoreboard of how investors feel about the prospects of a business or stock at any given moment. This can be heavily influenced by factors like quarterly earnings reports, the price targets peddled by Wall Street analysts and the media’s conversation of the day. The voting machine can be loud, boisterous and outright dangerous in some eras.
One of those eras was the episode that climaxed in 1972. The Nifty Fifty traded at 41.9 times earnings. The voting machine was excited about the future of these companies. As Professor Jeremy Siegel pointed out in his book Stocks for the Long Run, the Nifty Fifty did have a bright future ahead of them. According to his work, if you had bought this basket of stocks at the peak in 1972 and held them for the next 25 years, you would have produced a total return of 12.4% versus the S&P 500’s 12.9%. The Nifty Fifty stocks underperformed the average stock, but they produced better business results than the average stock. The Nifty Fifty grew earnings 11% during that 25-year period versus 8% for the S&P 500 Index companies. In other words, the Nifty Fifty grew their operating earnings nearly 40% more on a compounded basis. We would define that as superior operating results.
The earnings growth of that period is a great introduction to the weighing machine that Graham introduced. The weighing machine is the present value of the future earnings of the business. Factors that affect the weighing machine of a business are the growth of that business, the duration of that business and how much capital can be returned to its owners in the future. What investors should see in this description is how little today’s popularity has on the weighing machine.
In other words, the voting machine deals with expectations and the weighing machine deals with the actual economic benefits provided to the owners. The weighing machine was not on the side of the Nifty Fifty in 1972, even though the voting machine was. It wasn’t the future of these businesses that made the difference, it was the price that investors paid for the shares that affected long-term returns.
When Munger told Berkshire shareholders they had benefitted, he tied high share prices to the abnormally low interest rates which he argued pleased the voting machine. We disagree with this notion. To explain, let’s revisit the weighing machine factors. Anything that affects the growth, duration or capital return of a business affects the weighing machine. Rates going lower can appease the voting machine, causing asset prices to rise, but affect operating companies with strong balance sheets very little.
The factor that sits between these two machines is competition. Competition that enters the market can affect the weighing machine because it could cause lower long-term growth, earlier extinction or less cash flow to owners that instead get reinvested to fend off competition.
Low interest rates cause larger amounts of competition with incumbent companies because the hurdle rate needed to provide sufficient returns is so low. There is also the benefit of having businesses priced higher across public and private markets, due to the lower rates. In other words, we believe Munger is wrong that he has “benefitted” from these low rates “undeservedly.” The low rates that the voting machine is applauding towards a higher price on Berkshire Hathaway’s stock could also be the precise invitation for competition to enter the market and compete with their operating companies. This in turn would hurt the weighing machine for their businesses.
During the Berkshire Hathaway meeting, Buffett was asked about the squeeze on the profit margin of McLane Trucking. He commented that it was a 1% profit margin business in grocery distribution for the trucks, even prior to this episode. He showed disappointment in the collapse of the trucking company’s margins.
When commenting on moats later in the meeting, Buffett stated:
There’s certainly a great number of businesses. This has always been true, but it does seem like the pace has accelerated in recent years. There has been more moats that have become susceptible to invasion, ah, that seems to be the case earlier, but there’s always been the attempt to do it. And there, here and there are probably places where the moat is strong as ever, but you certainly should be working at improving your own moat and defending your own moat all the time.
Buffett later commented that technology wouldn’t be what kills Berkshire Hathaway. We would argue that the large number of moats which have been affected in the interim is closely tied to the cost of capital. McLane may have weak competitors who have lower margins and are holding on to market share due to the low cost of capital. When interest rates are historically low, it’s much easier for even marginal companies to raise money via debt markets.
Newer and untested market entrants with capital in-hand are creating new competition and are a hallmark of this era. If somehow technology is connected to the story behind the company, it seems as easy as finding oxygen on planet earth. We will argue that the numerous moats being “invaded” is tied closely to an abundance of money tied to the historically low rates.
To summarize, the voting machine’s willingness to price companies higher based on low rates is directly affecting the long-run value of businesses which ultimately gets weighed. The great equalizer is that change will happen and rates will rise.
The voting machine vs. the weighing machine in our holdings
We own banks that are affected by the low rates and get low applause from the voting machine. We own media companies that get low levels of appeal from the voting machine because of low margin competitors that think that they will win based on the total addressable market of tomorrow. We think these company’s moats, and thus value, only increase with the cost of capital rising.
We also own businesses that aren’t affected by rates, but instead know-how. The homebuilding business is a people, plant and equipment business. Capital and technology can help somewhat on the margin, but they cannot solve the woes of this business. It still is labor, land and demand for homes. We own Disney (DIS), who owns vast content libraries for all ages of consumers. Disney’s business isn’t based on the price of money, but instead the customer appeal for their characters and stories. We like to think of those as non-tangible and non-duplicable.
Though the homebuilders and Disney benefit from other factors than our banking and media businesses, which are being more so affected by the voting machine in the interim, the weighing machine might grow more for our banking and media companies as the cost of capital rises and competitors disappear. Cheap money for our company’s competitors is like a mirage. It looks so great, but it eventually vanishes and leaves you without liquidity just when you need it. All you are left with are the sands of time.
Stay thirsty my friends,
Cole Smead, CFA
The information contained in this missive represents Smead Capital Management's opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Cole Smead, CFA, Managing Director and Portfolio Manager, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.
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