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 made 12.4 percent versus the S&P 500’s 12.9 percent. The Nifty Fifty stocks underperformed the average stock, but they produced better business results than the average stock. The Nifty Fifty grew earnings 11 percent during that 25-year period versus 8 percent for the S&P 500 Index companies. In other words, the Nifty Fifty grew their operating earnings nearly 40 percent 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.

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