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Berkshire Hathaway
Physics Envy

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By rclosch
March 24, 2004

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In October of 2003 Charlie gave a lecture to the Economics to 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 terrible trouble is the efficient market theory. The stupidity generated by the efficient market theory was 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 that studies human behavior that is much to complex and reactive to lend itself 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 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 also 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 if it were invested in risk free government bonds. To the man with a spreadsheet this looks like a mathematical (hard science) problem, but the calculation of future cash flows is not a hard science. It involves an analysis that is a great deal more complicated [than] that. One that in a great many cases (for me, probably most cases) it involves an analysis that is impossible.

I am reminded of a thread on this board a couple of weeks ago, the thread began with a post that contained a twenty year spread sheet of estimated discounted cash flow for Dell Computer. That post reminded me of Buffett's theoretical class of security analysts during the height of the tech bubble. The analysts where asked to estimate the intrinsic value of the leading Internet companies Amazon, EBay etc. The solution to Buffett's quiz was anyone that gave an answer flunked the course.

It is my opinion that most cash flow spreadsheets are a waste of time because most companies do not really have a predictable future cash flow. This is why Buffett limits his universe, and we, as investors, need some way to avoid wasting time by trying to study the unknowable.

Check Lists

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 feeling is that the first checklist that we run should be about the character of the people running the business we are looking at. I am currently finishing an update of my checklist on management character, and I will post it shortly.

If we can get though this first list with a positive result, then we need to concentrate on predictability. The broader question of predictability is a lot more difficult than plugging numbers into spread sheet. And it is one where most companies will fail.

As soon as I finish proof reading my character checklist I will post it, and start working on a list for predictability. In the mean time I would like to hear what other people think on this point. If anyone wants to suggest their ideas on check lists it will make the discussion more interesting.

rc


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