Cinderella at the Ball. Warning investors about the "sedation of effortless money".

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs.  Nothing sedates rationality like large dose of effortless money.  After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball.  They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future - will eventually bring on pumpkins and mice.  But they nevertheless hate to miss a single minute of what is one helluva party.  Therefore, the giddy participants all plan to leave just seconds before mid-night.  There's a problem, though:  They are dancing in a room in which the clocks have no hands. 


Warren Buffett's Cinderella parable in his 2000 shareholder letter.

Buffett (1987): "If you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game."

We saw the master expand upon his concept of owner earnings and the only two basic jobs that he and his partner Charlie Munger engage in through his 1986 letter to his shareholders. Let us see what investment wisdom he brings to the table in his 1987 letter.

We are living in a fast changing world and every few years there comes a technology or a product that just brings about a revolution and spreads across the globe like a mania. Few examples that come to mind are the automobiles and aeroplanes in the US in the early 20th century or the recent Internet and dot-com mania. However, the fact that the companies in such revolutionary industries rake up equally impressive returns on the stock market is far from truth. While loss making abilities of the US auto companies and airliners are legendary, not less infamous either is the amount of wealth that has been destroyed in the Internet bubble at the cusp of the 21st century. No wonder this is what the master has to say on which companies end up winners in the stock market.

"Experience indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns."

"Berkshire's experience has been similar. Our managers have produced extraordinary results by doing rather ordinary things - but doing them exceptionally well. Our managers protect their franchises, they control costs, they search for new products and markets that build on their existing strengths and they don't get diverted. They work exceptionally hard at the details of their businesses, and it shows."

Indeed, with technology changing so fast in industries such as auto and Internet, it becomes really difficult to zero in on a company that will continue to exist ten years from now and in the process still give attractive returns. This is definitely not the case with a single product company existing in an industry, where more the things change more they remain the same.

In an era when investing in equities had been reduced to nothing more than moving in and out of companies based on their quotations, the master was a breed different from the rest. He did not let fluctuations in stock prices influence his investment decisions but rather viewed investments from the point of view of a business analyst, judging companies on the basis of their operating results and viewing stock market not as a guide but as a servant. Laid out below is what perhaps is one of the most lucid yet one of the most effective explanations of how one should view the stock market.

The master says, "Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic - he doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice - Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game."

http://www.equitymaster.com/detail.asp?date=9/6/2007&story=4

Tulipomania: A tulip bulb priced an equivalent of 12 acres of good land became as worthless as an onion

17th century Holland.

Belonging to the onion family, the tulip flowers are grown from bulbs.  Propagation is very slow for it takes a season for a plant to reproduce itself. 

The 17th century Dutchmen developed a great passion for tulips and rich people showed off their tulip collection with as much pride as their rare paintings.l 

As is usual for all speculative manias, there were sound economic reasons to begin with.  Tulips are indeed beautiful flowers and were in much demand all  over Europe.  Growing tulips was indeed a very profitable industry.  However, as with all manias, the profits of the pioneers attracted more and more people into the business.  (Reminds me of the MLM model too.)  The latecomers, not willing to undergo the long period necessary for the establishment of a nursery, bidded up the price of the existing limited supply.

By the 1620s, some of the rare varieties were beginning to command astronomical prices.  Semper Augustus (a beautiful white and blue flower with red stripes) were being sold for 1,200 florins.  In perspective, this was equivalent to the cost of 10,000 pounds of cheese or 120 sheep!  At this price level, the earlier entrants to the business were making incredible profits and tales of such gains naturally pulled in even more people.  By 1634, the race among the Dutch to cultivate tulips was so great that the ordinary businesses of the country were neglected.  The same Sempler Augustus had by then reached an incredible price of 5,500 florins, an equivalent of 12 acres of good land. 

By 1636, the trade in tulips became so great that regular markets were established for them in Amsterdam, Rotterdam, Harleem, Leyden, Alkmar and other towns.  For the first time, symptoms of gambling became apparent.  The stock brokers, always alert for a new speculation, switched to tulips and used every means at their disposal to cause fluctuations in  prices. 

As in all manias, confidence and prices soared to their highest just before the collapse of the market.  Everyone imagined that the passion for tulips would last forever.  Wealthy people from all over the world sent in large sums of money to Holland to invest in the boom.  Houses, land, and valuables were sold at ruinously low prices so that their owners could take part in tulip speculation. 

However, the seed of its destruction had by then been sown.  The huge increase in money supply and the sense of prosperity created by populace's holding of tulip bulbs caused the prices of everyday necessities to increase by considerable degrees.

Like all wonderful dreams or delightful parties, good things do eventually come to an end.  On a day in February 1637, about FIFTEEN years after the beginning of the mania, a speculator bought a bulb and found that he could not resell it for a higher price.  He was then forced to reduce its price to dispose of it.  This move caused a panic among all other speculators and the rush to sell became increasingly intense.  The prices fell drastically and within a short time, tulips which once commanded the price of houses became as worthless as onions.

Ref:  Stock Market Investment in Malaysia and Singapore by Neoh Soon Kean

All the clocks have no hands

We are all at a wonderful ball where champagne sparkles in every glass and soft laughter falls upon the summer air.  We know, by the rules, that at some moment, terrorists will burst in through the terrace doors, killing many and scattering the survivors.  Those who leave early will be saved, but the ball is so splended that no one wants to leave while there is still time.  Everyone wants to enjoy one more dance and sip one more glass of champagne.  So everyone keeps asking:  "What time is it?  What time is it?"  We look around and find that all the clocks have no hands.