REUTERS/Jim Young
University of Chicago professor
"I am disappointed that a Nobel Prize was awarded to Eugene Fama, who studies only markets and prices; and whom, I daresay, does not focus on Form 10-Ks or the footnotes to a corporation's audited financial statements," Whitman said in the opening of the letter to shareholders.
Fama, a professor at Chicago Booth, won the Nobel Prize in Economic Science last year with Lars Peter Hansen and Robert Shiller.
In the letter, dated October 31, 2013, Whitman proceeded to call Fama's work on Modern Capital Theory "utter nonsense", "sloppy science", "plain stupid" and "unscholarly."
From the letter (emphasis ours):
Dear Fellow Shareholders:
Academics involved with finance restrict their studies to analyzing markets and securities prices. As far as they are concerned, the study of companies and the securities they issue are someone else's business. I am disappointed that a Nobel Prize was awarded to Eugene Fama, who studies only markets and prices; and whom, I daresay, does not focus on Form 10-Ks or the footnotes to a corporation's audited financial statements. In fact there is no way of determining whether any market is efficient or not in measuring underlying values unless the analyst understands, and analyzes, the specific securities that are the components of that specific market.
Market participants make two types of decisions-market decisions and investment decisions. Market decisions involve predicting security prices and are, virtually, always very short-run oriented. Investment decisions involve, inter alia, determining underlying value, resource conversion probabilities; terms of securities; credit analysis, and probable access to capital markets particularly for providing bailouts to public markets at high prices (versus cost) for promoters, insiders and private investors.
Modern Capital Theory ("MCT") concentrates on market decisions and provides valuable lessons for specific markets consisting of Outside Passive Minority Investors ("OPMIs") who deal in "sudden death" securities, i.e., options, warrants, risk arbitrage, heavily margined portfolios, trading strategies and performing loans with short-fuse maturities. MCT is of little or no help to those involved primarily with making investment decisions-value investors, control investors, most distress investors, credit analysts, and first and second stage venture capital investors.
The most basic problem for MCT, and all believers in efficient markets, is that they take a very narrow special case-OPMIs dealing in "sudden death" securities, and claim, as the Nobel Prize winner does, that their theories apply to all markets universally. What utter nonsense! Most of the activity-and money-on Wall Street is in the hands of people making investment decisions, not market decisions. For the activist, and value investor, the market is a place for a bail-out at high prices (versus cost), not a place where underlying values are determined. MCT, in looking at Wall Street, concentrates on mutual funds which trade marketable securities. MCT seems oblivious to activists, not studying what activists do, and why they do it.
MCT, not only misdefines markets, but also seems to be sloppy science. The theory embodies the correct observation that almost no one outperforms relevant market indexes consistently. Consistently is a dirty word; it means all the time. In justifying and promoting Index Funds, MCT points to this failure of actively managed funds to outperform consistently. MCT acolytes, however, forget that many managed funds do tend to outperform relative benchmarks, over the long term, on average, and most of the time, notwithstanding their higher expense ratios. It's just plain stupid to state that the quality of money management is tested by looking at consistency. Insofar as MCT identifies what it describes as performance outliers, e.g., Berkshire Hathaway, no attempt is made to study what it is that outliers do that make them outliers, since this would entail the detailed analysis of portfolio companies and the securities they issue. How unscholarly!
MCT cannot possibly be helpful almost all the time to those focusing primarily on investment decisions, i.e., understanding a company and the securities it issues. This is because in MCT four factors are overemphasized to such an extent that economic reality is blurred.
1. A belief in the primacy of the income account with some emphasis on cash flow from operations rather than earnings. (Earnings are defined as creating wealth while consuming cash). If there is a primacy of anything in understanding a business, at least subsequent to the 2008 financial meltdown, it is creditworthiness, not periodic cash flows or periodic earnings.
2. An emphasis on short-termism. I think it is impossible to be market conscious about publicly-traded securities without emphasizing the immediate outlook at the expense of a longer-term view.
3. Overemphasis on top-down macro-factors such as forecasts for the economy, interest rates, the Dow Jones Industrial Average, with a consequent de-emphasis of bottom-up factors such as the financial strength of an enterprise, the relationship of a security's price to readily ascertainable net asset value ("NAV"), or the covenants in loan agreements. It is easy to appear wise and profound, for example, by forecasting outlooks for the general economy. Forecasting about the general economy almost all the time tends to be a lot less important for long-term buy-and-hold investors than are nitty-gritty details about an issuer. Indeed, it seems as if macro forecasts dominated in importance in the last 85 years only in 1929, 1974 and 2008-2009. Even in those years of dramatic down-drafts in the U.S., macro factors tended to be non-important (outside of immediate market prices) for adequately secured creditors seeking interest income or for well-financed companies with opportunistic managements seeking acquisitions.
4. A belief in equilibrium pricing. An OPMI market price is believed to value correctly and OPMI market prices change as the market receives new information. Such a view, though widely held, is ludicrous. The fact that the common stocks of many well financed, growing, companies sell at 25% to 75% discounts from readily ascertainable NAV is mostly lost on finance academics who believe in efficient markets. They do not believe that such pricing can exist, though it does.