Physics Envy
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 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.
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 Charley 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." 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, Buffett limits his universe.
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.
