Lynn Stout, RIP, Sparred with Charlie Munger
Charlie Munger met his match in Lynn Stout.
Mr. Munger, Warren Buffett’s best friend since 1959, is a notoriously fierce debater who does not suffer fools gladly. At a symposium on The Essays of Warren Buffett I hosted in 1996 at Cardozo Law School, I had him chair the panel on corporate finance. He lit into most members, trenchantly explaining why much of modern finance theory is”gibberish” and “twaddle.” Panelist Professor Robert Hamilton (U. Texas) commented to me he’d never seen anyone so “scary smart” as Munger.
Lynn Stout, who this week passed away at age 60, was on that panel, and she engaged Munger astutely. An independent thinker, Professor Stout mastered all the doctrinal, technical, and theoretical tricks of the trade, from classical economics to boardroom battles, and staked out her own ground on how corporations and markets work and what corporate law should do about it. She was, as Joan Heminway notes in tribute, both persistent and generous.
On the Munger finance panel, Professor Stout presented her paper, How Efficient Markets Undervalue Stocks: CAPM and ECMH Under Conditions of Uncertainty and Disagreement. In the course of discussion, she also touched on takeover premiums. Professor Stout stressed economic theory throughout her analysis and offered to update some prevailing economic models. Munger pressed on psychological aspects of the puzzle of market mispricing.
Intellectual fireworks flew, with bantering between not only Professor Stout and Mr. Munger, but other panelists, including Professors William Bratton (now at Penn) and William Klein (UCLA), and many other conference goers, including Professors Jeff Gordon (Columbia), Dale Oesterle (now at Ohio State) and Edmund Kitch (Virginia), as well as a young man named Bill Ackman.
Highlighted below is a portion of the colloquy, by turns witty and profound, deep but fun. (There’s one somewhat technical exchange between Professors Oesterle and Stout that may seem arcane but non-experts can skim it and get the gist of the intellectual joust.) Read it for Lynn.
MUNGER: Lynn, what is your personal opinion of those people who would expect inefficiencies–mispricing–to occur because of certain standard cognitive defects of humankind?
STOUT: They’re right.
MUNGER: I certainly agree with that and that means you have to listen to psychologists if you want to predict standard patterns of irrationality, doesn’t it?
STOUT: This is the problem of the mathematician-economist versus the natural science-economist. One reason efficient market theory rose to the pinnacle it did, was there was a group of economists who really wanted to be mathematicians and it gave them a chance to play with Greek letters and show what good mathematicians they were. In the process they forgot the natural scientist’s [mission] which is that you ought to try to come up with models that actually predict what happens in the world. And if in fact you want to come up with models that predict what happens in the world then, yes, indeed we should be listening to the psychologists.
MUNGER: So we really have an extreme example here of a lot of nonsense which is created by the psychological phenomenon in the proverb: “To the man with a hammer every problem tends to look like a nail.”
OESTERLE: A quick response to Lynn Stout on takeover premiums. Assuming that you are correct that the inframarginal shareholder determines the ultimate takeover premium, that still leaves one takeover price, which gives a windfall to everyone else so you still have a net social gain, even under your theory.
Point two: the inframarginal shareholder’s position on why they are optimistic–your argument is circular. Why they are optimistic might be related to the power of bargaining they have versus bidders. I could be that inframarginal shareholder and believe we can extract the last dollar from this bidder and that’s why I’m so optimistic and demand the premium. So, your argument doesn’t explain much to me, and I think its circular.
STOUT: There is a rational expectations aspect to the tussle between the bidder and the target and I think you’re right that part of that can inflate the value attached by the target once they know the bidder is interested. But since bidders have other options and won’t pay infinite prices and target shareholders know that, even though that is a feedback mechanism, the argument is not circular.
I agree completely with your first observation. But where the puzzle comes is the interesting case–not unusual–where the firm does not pay the reservation price of the most optimistic investor but the reservation price of the investor who owns the 51st percentile–they go up the curve enough to buy the first half. People in the first half of the curve benefit. Unfortunately, people on the last part of the curve will, under state merger rules, be forced out at a price they deem low.
MUNGER: Lynn, if you have a corporation 100% owned by one owner and he holds an auction, don’t you often get a very irrationally high price?
STOUT: Winner’s curse?
MUNGER: And that doesn’t have anything to do with your explanation.
STOUT: It is related. You can’t have a winner’s curse unless you presume that people disagree. I flog the heterogeneous expectations theory because in part it is a useful way to get people started down the road of looking at phenomena like the winner’s curse.
MUNGER: Can’t you get a winner’s curse when you’ve got a whole lot of bidders competing? One says: After all, it’s worth 100 to the other guy, and I’ve already decided to do it, so why not bid 101? And the other guy thinks, well, it’s worth 101 to him. Don’t you get a psychological process that creates a lot of social proof and a lot of idiocy that really isn’t related to normal supply and demand curves?
STOUT: Personally I stay away from Sotheby’s.
MUNGER: It’s psychological idiocy you are fearing.
MUNGER: We don’t go to auctions either. But Lynn, if you were playing bridge and you announced that your strategy was going to be to count the diamonds and hearts but not the spades and clubs, would you consider that a rational way to play bridge?
STOUT: Well I’m at a tremendous disadvantage here because I’ve been too busy figuring out Greek letters to learn bridge. But assuming it’s like other card games, if I were to do that I think that wouldn’t be too sensible.
MUNGER: If the world is multidisciplinary, does it make sense to explain these occurrences solely in terms of economics without any psychology?
STOUT: Use the right tool for the job.
MUNGER: But isn’t reality multidisciplinary, so that you have to use the tools of all the disciplines to solve the complex problems?
STOUT: Yes, and be willing to pick and choose depending on which seem to work best.
MUNGER: But you can’t have a whole area where you say, “I don’t carry that tool kit and just do the best with what I’ve got.” That isn’t too rational a way to handle it is it?
STOUT: I’m guilty.
MUNGER: We all are.
GORDON: But Charlie, at the end of the day, you don’t expect your shareholders to ask whether they are happy. You ask them to look at the bottom line. The Buffett Essays are all about essentially focusing on ways to bring economic reality to bear on the running of a business. Insofar as psychology enters the picture it is something to be avoided, driven out and hopefully patiently waded through.
MUNGER: Driven out of supervising a bunch of subordinate managers? Psychology driven out? How?
GORDON: You’re dealing with people to be sure, but in making investments don’t you try to weight out the psychology before you buy?
MUNGER: Yes, we don’t go to auctions. I’m like Lynn, I’m afraid of my own idiocy.