Physics Envy by Charlie Munger

Portfolio manager’s Letter April 2004

In October of 2003 Charlie Munger gave a lecture to the economics students at the University of California at Santa Barbara in which he discussed problems with the way that economics is taught in universities. One of the problems he described was based on what he called “Physics Envy”. This, Charlie Munger says, is “the craving for a false precision. The wanting of formula …”

The problem, Charley goes on, is, “that it’s not going to happen by and large in economics. It’s too complex a system. And the craving for that physics – style precision does nothing but get you in terrible trouble.”

A monumental example of this problem is the efficient market theory. The is the result of trying to impose the discipline of a hard science on economics, which is not a hard science – it is a social science. Equity markets are about human behavior and while the markets are very efficient at valuing data, they are certainly not rational. They are much too complex and reactive to lend themselves to the kind of discipline that rules the hard sciences.

Physics Envy – Overweighing Numbers

When you combine Physics Envy with Charley’s “man with a hammer syndrome,” the result is the tendency for people to overweight things that can be counted.

“This is terrible not only in economics, but practically everywhere else, including business; it’s really terrible in business – and that is you’ve got a complex system and it spews out a lot of wonderful numbers [that] enable you to measure some factors. But there are other factors that are terribly important. There’s no precise numbering where you can put to these factors.

You know they’re important, you don’t have the numbers. Well practically everybody just overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in places like this, and doesn’t mix in the hard-to-measure stuff that may be more important. That is a mistake I’ve tried all my life to avoid, and I have no regrets for having done that.”

As Charlie Munger says, this problem not only applies to the field of economics, but is huge consideration in security analysis. Here it can give rise to the “man with a spread sheet syndrome” which is loosely defined as, “Since I have this really neat spread sheet it must mean something.”

Warren Buffett has defined intrinsic value of a business as the amount of cash that would be generated by that business in the future, discounted by the dollars that would be generated if the cash necessary to buy that business were invested in risk free government bonds.

To the man with a spread sheet this looks like a mathematical (hard science) problem, but the calculation of future cash flows is more art than it is hard science. It involves a lot analysis that has nothing to do with numbers. In a great many cases (for me, probably most cases) involves a lot of guessing. It is my opinion that most cash flow spread sheets are a waste of time because most companies do not really have a predictable future cash flow. This is why, and to some extent how, Warren Buffett limits his universe.

Physics Envy – Security Analysis

In security analysis it is way too easy to overweight the numbers, so when analyzing companies it is best we have check lists of questions to ask ourselves before we start looking at numbers and running spread sheets. My preference for the first check list is one that deals with the character of the people running the business. If we can get though this first list with a positive result, then the next step is to concentrate on predictability. The broader question of predictability is a lot more difficult than plugging numbers into a spread sheet, and it is a test that most companies will fail.

Physics Envy – Character Check List

The list below is tentative, and will change as we have further opportunity to observe management behavior. These factors are based on information that is generally availably to the public, and do not require a personal visit to corporate headquarters.

1. Ownership. We want are managers to act like owners. Perhaps the best indicator for this behavior is when the CEO owns a big piece (10% or better) of the company. Warren Buffett owns 39.1% of Berkshire Hathaway, the Arison Family owns 39% of Carnival Corp., and Russell Gerdin owns 40.4% of Heartland Express.
2. Options. Ownership of options is not the same thing as owning the stock. If you own a lot of the company’s stock you have a lot to lose if the price goes down, or if the company files for chapter 11. If you own options you benefit only if the price goes up, and have much less to loose if the price goes down. These are very different incentives and they can and will result in very different behavior. Recently there has been a movement among some of the better managed companies to expense options voluntarily, and to convert opinion programs to outright stock ownership. This kind of behavior is a strong positive indicator of management character. The voluntary expensing of options is a good indication that management is friendly to shareholders.
3. Executive Compensation. Options or cash, executive compensation is an expense that the shareholders pay. Obscene compensation is an indication that the managers love theirs paychecks more than they do the business. In his 2001 chairman’s letter, Warren Buffett promised Berkshire Hathaway stockholders his personal economic results will continue to parallel theirs. “We will not take cash compensation, restricted stock or option grants that would make our results superior to yours,” Warren Buffett said. Additionally, I will keep well over 99 percent of my net worth in Berkshire Hathaway. My wife and I have never sold a share, nor do we intend to.” If the company’s CEO compensation package makes you want to hold you nose, it is time to move on to the next idea.
4. Earnings Projections. Time and again the disasters of the last three years were the result of management trying to meet growth targets that were absurd, unrealistic, and totally unsupported by economic reality. Smooth earnings growth looks pretty, and it makes Wall Street happy, but it is a profoundly unnatural condition. Businesses is cyclical. The economy is cyclical. Pretty earnings are generally a sign that there is an artist at work in the accounting department. ” … Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers). Charlie Munger and I not only don’t know today what our businesses will earn next year—we don’t even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future — and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers.” – Warren Buffett 2002 Chairman’s Letter.
5. Capital Allocation. You can tell a lot about the integrity (and intelligence) of a company’s management by studying how they spend the shareholder’s money. Money that comes from stock offerings and retained earnings is shareholder money. But most CEO’s think that since they can sign a check, the money is theirs to spend as they like. We do not want managers who engage in mergers for ego gratification or who buy back stock to keep their options “in the money.” In either case they are using shareholder money to promote their personal goals.
6. EBITDA. At a Berkshire Hathaway Annual meeting, Charlie Munger said that if some officer connected with a prospective investee starts talking about EBITDA, it “is time to zip up the purse.” The officer is trying to be too optimistic about his company’s prospects. The problem is not so much that he is trying to kid the investor, but far worse, that he may well be successful in kidding himself. In the 2002 Chairman’s Letter, Warren Buffett had the following advice for investors: “Beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen. Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business”. In an article written for the Washington Post in April 2002, Charlie Munger said accountants have no business being optimistic. Accounting rules need to be changed because people will stay the same. Fools and knaves, like those at Enron, will always be with us and will be particularly active where big money can be made — for instance, in reporting ever-higher earnings.” New economy managers feel that pumping the stock is part of their job. But when a stock gets overpriced it means that new shareholders are entering with a lot of risk. In contrast to this, think of Berkshire Hathaway’s famous prospectus for the sale of the B Shares, where Berkshire Hathaway offered stock for sale but Warren Buffett said that neither he nor Charlie Munger would buy the stock at current prices.
7. Annual Reports. What would you rather see in a company’s annual report, an accurate presentation of the financial records, or lots of pretty pictures? At the SEC Roundtable on Financial Disclosure and Auditor Oversight on March 4, 2002, Warren Buffett indicated that the real problem was not so much a matter of more disclosure as was a matter of the quality of the disclosures to be made. He went on to list exactly what it was he would to like see in all annual reports: “And, the CEO should write that letter as if he had one partner, and that partner has been away for a year. The partner is intelligent. He’s somewhat versed in accounting terminology and finance 8 terminology, but he’s no expert. He’s interested because he has a large section of his net worth in the company. He’s ready to be an indefinite shareholder a shareholder for an indefinite period, if he’s treated well. And, the CEO, if he has that mental picture of that partner, and just writes to that partner what’s happened that year, I think that’s going to be better than all the information that can be required by any rules. Because, the CEO has a definite desire to communicate to that partner.” “And, I say, the CEO’s attitude should be what would I want, if our positions were reversed? It’s that simple. I mean, what do I need to know?”
8. Footnotes. In the 2002 Chairman’s Letter, Warren Buffett said this about financial statement footnotes: “Unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Enron’s descriptions of certain transactions still baffle me.”
9. Director Compensation. Charlie Munger says that the solution to the executive compensation is easy, do not pay directors: “I mean you’ve got the crazy booms and the crooked promotions – all you have to do is read the paper in the last six months. I mean there’s enough vice to make us all choke. And by the way, everybody’s mad about compensation at the top of American corporations, and they should be. Yet all these crazy nostrums invented by lawyers, and a solution is just so obvious they won’t do it: If directors got a pay of zero, you’d be amazed what would happen to the compensation of corporate executives.”

One of the easy ways for a corrupt CEO to control the board of directors is to provide directors with lavish perks, consulting fees, contracts with the a business owned by the director, directors fees, and expense accounts. The conflicts of interest here are obvious and odious. Directors are supposed to represent the interests of shareholder.

However, if the CEO is using shareholders money to pass around very nice cookies to directors, it is likely that the directors will end up more interested in the CEO’s welfare than they are in protecting the shareholders’ interest. We know that Munger’s “modest proposal” has no chance of acceptance, but he certainly has done a good job at identifying at huge problem.

Does Losch Management Company expect to find a lot of companies where the management displays all of the above behavior? Not really — many good potential investments are weak in one or two of the above items. We are not looking for absolutes here, just a general “leaning toward the light.”

Physics Envy – Strongest Indicators

The strongest positive indicator is stock ownership by management and the strongest negative indicators are large stock option programs, and egregious CEO compensation, either one of which will immediately remove a company from my consideration as an investment. Keep in mind that a good portfolio does not need 300 stocks. Warren Buffett says that all new money managers should be given a ticket with twenty punches, and told that was the limit of stock selections for their career.

This is an exaggeration, but the point he is trying to make, is that you do not need to own lots of stocks, all you need is a few good ones. In every investment the investor has to have faith in the people that are handing his money, so if the management fails the integrity test, the investor needs to find a new home for the money.

Physics Envy – The Value of Predictability

The biggest quibble I have with the “Efficient Market” people is the way the stock market deals with predictability. Generally investors equate uncertainty with risk and risk with high returns. The stocks with the highest P.E.s always have a great story, high risk, and all kinds of uncertainty. Yet, investors buy these stories on the assumption, I guess, that the risk will fetch you a greater return.

The market in effect seems to always place a premium on uncertainty. So, when it comes to predictability, the market basically has everything backwards. Instead of discounting uncertainty and pricing in a premium for predictability, the market mostly does the opposite. Boring stocks are more predictable but investors prefer to pay a premium for risk.

This prevalent inefficiency in equity markets is one that Warren Buffett has used to his advantage for fifty years. You make more money buying boring, predictable stocks. Warren Buffett has been telling anyone that would listen that unpredictability is bad, but basically, almost nobody listens. They buy their stories; they chase the sexy stocks; who cares if the PE is 173? The assumption is that a sexy stock will someday make you rich. “Nothing ventured, nothing gained”. “The higher the risk the better the return”. But in Warren Buffett’s opinion:

“Severe change and exceptional returns usually don’t mix. Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today’s business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be.” – 1987 letter to Berkshire Hathaway shareholders.

The argument could be made the market in general does not understand the real nature of risk. In a market that was truly efficient, predictability would sell at a premium and stocks of companies whose future was difficult to forecast would sell at a price that reflected risk inherent in that uncertainly. In this world, if Coke’s PE was 24, Cisco’s PE would be around 3½.

Predictability Check List

Predictability is mostly about moats (a sustainable competitive advantage). There are many different kinds of moats, and identifying and understanding a company’s moats can take a lot of study.

1. Moats.
   1. Does the company have lower costs than its competitors? For retail stores the durable moats come from having the best cost structure: Costco, Wal-Mart, the Nebraska Furniture Mart, Ameritrade, Borsheim’s. In his 1996 Chairman’s Letter, Warren Buffett was discussing building GEICO’s moat: “Our goal, however, is not to widen our profit margin but rather to enlarge the price advantage we offer customers. Given that strategy, we believe that 1997’s growth will easily top that of last year.” This is how you build a moat. The implication that building a moat is more important than profits means that Warren Buffett’s ability to accept short term pain in order build the company’s long term outlook. This is not a view that will find much support on Wall Street. In business after business, building a moat is about lowering your costs. If you want to see what real, operational retail moats look like go to the Berkshire Hathaway annual meeting and spend a couple of days shopping at Nebraska Furniture Mart and Borsheim’s.
   2. Does the company have brand recognition? Retail product moats come from brand recognition, like Coke and Gillette.
   3. Does the company have superior financial strength? Much of the time the company with the best balance sheet in an industry can dominate that industry, if managed correctly. A moat that stems from a dominating balance sheet can last a long time. Sometimes this can be more effect than cause, because the reason that a company has a great balance sheet is because it is doing something better than the competition.
   4. Does the company have patents or copyright protection that gives them an advantage over the competition? Patents are very important in the ethical drug business. Patents provide a high level of profitability which allow the big drug companies to invest large amounts of capital in the development of new drugs. In manufacturing, patents has been a big factor in the success of auto parts maker Gentex, which is consistently more profitable than most of the parts business. Copyright protection on their many early movies and the characters have obviously been a huge advantage for Walt Disney Company.
   5. Does the company have cost advantages derived from locality or nationality? How well does a company use opportunities available to it to relocate operations in order to gain cost advantages? Companies in from emerging counties may have important cost advantages over those in developed countries: cheap labor, low cost physical plant, and low tax rates. Some of these factors are likely to be very important to management. Carnival Corp. uses it offshore status to gain an exemption from US corporate income taxes, high American payroll taxes, and expensive labor regulation.
2. A Simple Business. A business does not have to be simple to have a moat. Berkshire Hathaway is an example. It is hard to think of a company that is more complex or difficult to understand than Berkshire Hathaway. It is a huge company with many operating subsidiaries, but nobody is better at building moats than Berkshire Hathaway. But a simple business is easy to understand, and its moats are easier to understand and identify. This makes it easier to the average investor to predict where the company will be a few years down the road.
3. History. You want companies that have been around for a while. Ten years of steady growth tell you that either the business is good or the management is good. In addition it is almost impossible to cook the books for ten years. If a company has been doing something successfully for ten years, chances are better that it will keep doing things better for the next ten years.