He also added that they have been buying net $ 4 billion of some other common stocks in the 3rd quarter.
CNBC article: Warren Buffett Buying Stock Bargains
Buffett says he still hopes to make some big acquisitions. Not exactly bearish.
Adam
Friday, September 30, 2011
Buffett: The Berkshire Hathaway Buybacks Have Begun
In a live interview with CNBC on the New York Stock Exchange, Warren Buffett told CNBC that the buying back of Berkshire Hathaway's (BRKa) stock has now started.
He also added that they have been buying net $ 4 billion of some other common stocks in the 3rd quarter.
CNBC article: Warren Buffett Buying Stock Bargains
Buffett says he still hopes to make some big acquisitions. Not exactly bearish.
Adam
He also added that they have been buying net $ 4 billion of some other common stocks in the 3rd quarter.
CNBC article: Warren Buffett Buying Stock Bargains
Buffett says he still hopes to make some big acquisitions. Not exactly bearish.
Adam
Buffett on Wells Fargo - Part II: Berkskhire Shareholder Letter Highlights
A follow up to this post.
More from what Buffett said in the 1990 Berkshire Hathaway (BRKa) Shareholder Letter about Wells Fargo (WFC):
Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.
None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.
A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.
When the above was written the extensive use of derivatives was not in vogue yet. Their current prevalent use create systemic risks and risks unique to each institution that is difficult to gauge.
From the 2002 Berkshire Hathaway Shareholder Letter:
...derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is running.
The shares of Wells Fargo have increased in value well over 1,800% including dividends since Buffett wrote about the bank in the 1990 letter (though Buffett has bought many shares since with lesser gains). I doubt many banks will produce those kind of returns over the next twenty years or so but some of the better ones will certainly do quite well.
It's an example of what high return on equity (or preferably high return on capital for a non-financial) bought at 5x earnings, what Buffett paid for Wells back then, can produce in value when compounded over 20 years.
Yesterday's post covered this. Pay a lot less than what a business is worth now and make sure it is capable of producing a high return on tangible capital in the future. The cheap price provides a margin of safety in the near term. The high return on capital drives value long-term.
Joel Greenblatt on Stocks
Still, as I said in the earlier post, with so many inexpensive non-financial businesses available I'm not certain any bank is worth the trouble (considering the unique risks involved with owning shares of a bank) for most investors.
Adam
Long WFC
More from what Buffett said in the 1990 Berkshire Hathaway (BRKa) Shareholder Letter about Wells Fargo (WFC):
Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.
None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.
A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.
When the above was written the extensive use of derivatives was not in vogue yet. Their current prevalent use create systemic risks and risks unique to each institution that is difficult to gauge.
From the 2002 Berkshire Hathaway Shareholder Letter:
...derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is running.
The shares of Wells Fargo have increased in value well over 1,800% including dividends since Buffett wrote about the bank in the 1990 letter (though Buffett has bought many shares since with lesser gains). I doubt many banks will produce those kind of returns over the next twenty years or so but some of the better ones will certainly do quite well.
It's an example of what high return on equity (or preferably high return on capital for a non-financial) bought at 5x earnings, what Buffett paid for Wells back then, can produce in value when compounded over 20 years.
Yesterday's post covered this. Pay a lot less than what a business is worth now and make sure it is capable of producing a high return on tangible capital in the future. The cheap price provides a margin of safety in the near term. The high return on capital drives value long-term.
Joel Greenblatt on Stocks
Still, as I said in the earlier post, with so many inexpensive non-financial businesses available I'm not certain any bank is worth the trouble (considering the unique risks involved with owning shares of a bank) for most investors.
Adam
Long WFC
Thursday, September 29, 2011
Joel Greenblatt on Stocks
From this CNBC interview with Joel Greenblatt:
"It's a very scary time to invest, and that's when you get your best bargains," he told CNBC Tuesday.
Greenblatt, known for his "magic formula" investing approach, places emphasis on buying companies with a high free cash flow yield and high return on tangible capital.
Basically, a decent quality business that is cheap.
Greenblatt uses free cash flow yield* to measure whether a company is cheap and uses return on tangible capital as the measure of choice to indicate higher quality.
In the interview, Greenblatt acknowledged his formula isn't perfect and doesn't always work (nothing always works, of course). So it's far from comprehensive. Clearly, other factors must also be considered (threats to the sustainability of the company's economic moat among other things), some of them intangible, but high free cash flow yield in combination with high return on tangible capital is not a bad place to start.
I think it is a very useful way of looking at things.
Using this approach Greenblatt says the stocks he now likes include:
Gamestop (GME)
American Eagle (AEO)
Best Buy (BBY)
Microsoft (MSFT)
Wells Fargo (WFC)
Hewlett-Packard (HPQ)
More from Greenblatt on CNBC:
What they have in common is "each one of those companies is hated brutally by most people."
In the interview he added that at HP's current multiple "you're going to get your money back in the next 4-5 years and own the company for free at these kind of prices."
I happen to think HP's earnings and free cash flow will probably be less than $ 5/share but what he is saying is still chiefly valid.
Once something sells at or near 5x free cash flow (a 20% free cash flow yield) very little has to go right. Well, that is true as long as management doesn't do the equivalent of throwing the cash into a furnace (consistently overpaying for acquisitions, buying back the stock when expensive etc.) and there is not a serious threat to the economic moat.
In other words, just believing that a business is stagnating or even shrinking a bit isn't compatible with a 5x multiple. The economic situation of a business has to be much worse to justify a multiple that low.
Consider a durable high return on capital business bought at a 20% free cash flow yield that happens to shrink a bit over the next five years. I know I can still live with those kinds of returns as a co-owner. I mean, a 20% return getting reduced to something like 15% is not exactly a disaster as long as it stabilizes at a somewhat lower level of profitability**.
There is often an obsession with growth that can be misplaced. A low price combined with durability trumps growth.
At very low prices a little growth is not a necessity but a bonus if it happens (by the way extremely high growth often attracts competition that can adversely change the economics of a business).
The story of a very low multiple stock will rarely sound like a great one (so usually not a great subject at a cocktail party) but that doesn't matter. You can't spend a story. What does matter is whether the future stream of cash flows provides satisfactory returns considering the risks.
The key thing will always be that the stream of cash flows remains durable, even if a bit variable, and is either returned to shareholders or put to high return use by management.
Adam
Long position in WFC established at lower than recent prices in addition to much smaller long positions in MSFT and HPQ.
* Use earnings yield (inverse price to earnings) as a measure instead is often sufficient but free cash flow is more economically reliable and helps in avoiding lower quality earnings via accounting gimmickry. It's easier to dress up the income statement than the statement of cash flows.
** At an extremely low valuation the business doesn't even need to stabilize. Berkshire's Blue Chip Stamps is an example that comes to mind.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational and educational use and the opinions found here should not be treated as specific individualized investment advice. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions.
"It's a very scary time to invest, and that's when you get your best bargains," he told CNBC Tuesday.
Greenblatt, known for his "magic formula" investing approach, places emphasis on buying companies with a high free cash flow yield and high return on tangible capital.
Basically, a decent quality business that is cheap.
Greenblatt uses free cash flow yield* to measure whether a company is cheap and uses return on tangible capital as the measure of choice to indicate higher quality.
In the interview, Greenblatt acknowledged his formula isn't perfect and doesn't always work (nothing always works, of course). So it's far from comprehensive. Clearly, other factors must also be considered (threats to the sustainability of the company's economic moat among other things), some of them intangible, but high free cash flow yield in combination with high return on tangible capital is not a bad place to start.
I think it is a very useful way of looking at things.
Using this approach Greenblatt says the stocks he now likes include:
Gamestop (GME)
American Eagle (AEO)
Best Buy (BBY)
Microsoft (MSFT)
Wells Fargo (WFC)
Hewlett-Packard (HPQ)
More from Greenblatt on CNBC:
What they have in common is "each one of those companies is hated brutally by most people."
In the interview he added that at HP's current multiple "you're going to get your money back in the next 4-5 years and own the company for free at these kind of prices."
I happen to think HP's earnings and free cash flow will probably be less than $ 5/share but what he is saying is still chiefly valid.
Once something sells at or near 5x free cash flow (a 20% free cash flow yield) very little has to go right. Well, that is true as long as management doesn't do the equivalent of throwing the cash into a furnace (consistently overpaying for acquisitions, buying back the stock when expensive etc.) and there is not a serious threat to the economic moat.
In other words, just believing that a business is stagnating or even shrinking a bit isn't compatible with a 5x multiple. The economic situation of a business has to be much worse to justify a multiple that low.
Consider a durable high return on capital business bought at a 20% free cash flow yield that happens to shrink a bit over the next five years. I know I can still live with those kinds of returns as a co-owner. I mean, a 20% return getting reduced to something like 15% is not exactly a disaster as long as it stabilizes at a somewhat lower level of profitability**.
There is often an obsession with growth that can be misplaced. A low price combined with durability trumps growth.
At very low prices a little growth is not a necessity but a bonus if it happens (by the way extremely high growth often attracts competition that can adversely change the economics of a business).
The story of a very low multiple stock will rarely sound like a great one (so usually not a great subject at a cocktail party) but that doesn't matter. You can't spend a story. What does matter is whether the future stream of cash flows provides satisfactory returns considering the risks.
The key thing will always be that the stream of cash flows remains durable, even if a bit variable, and is either returned to shareholders or put to high return use by management.
Adam
Long position in WFC established at lower than recent prices in addition to much smaller long positions in MSFT and HPQ.
* Use earnings yield (inverse price to earnings) as a measure instead is often sufficient but free cash flow is more economically reliable and helps in avoiding lower quality earnings via accounting gimmickry. It's easier to dress up the income statement than the statement of cash flows.
** At an extremely low valuation the business doesn't even need to stabilize. Berkshire's Blue Chip Stamps is an example that comes to mind.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational and educational use and the opinions found here should not be treated as specific individualized investment advice. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions.
Wednesday, September 28, 2011
Coca-Cola's Muhtar Kent on China, Brazil, and the U.S. (KO)
Muhtar Kent, the CEO of Coca-Cola (KO), said some things of note about doing business in the U.S. compared to China and Brazil in this article:
..."in many respects" it was easier doing business in China, comparing the country with a well-managed company. "You have a one-stop shop in terms of the Chinese foreign investment agency and local governments are fighting for investment with each other," he told the Financial Times.
He later added...
"They're learning very fast, these countries," he said. "In the west, we're forgetting what really worked 20 years ago. In China and other markets around the world, you see the kind of attention to detail about how business works and how business creates employment."
The above comments remind me of what Professor Michael Porter said in an interview earlier this year on U.S. competitiveness. In the interview, he offers up some thoughts on how to make doing business in the United States more competitive with other countries.
How the U.S. Can Compete Better
Separately, in this 2010 interview, Professor Porter said that the U.S. needs to do more to encourage domestic investment.
According to Porter, data shows U.S. domestic investment is, somewhat amazingly, the lowest among OECD countries. He says that individual U.S. companies are competitive globally but they hold back investment on home soil because the cost and complexity (healthcare, litigation, taxes, other regulations etc.) of doing business in the U.S. has piled up over the years.
Michael Porter: U.S. Needs Increased Domestic Investment
In the interview, Professor Porter also said that according to the Global Competitiveness Report, the US now ranks like a developing country in terms of cost and complexity of doing business.
Finally, in this The Globe and Mail article from a couple years back, he added the following thoughts:
Michael Porter on Business and Investing
With so much focus on the immediate value of stocks, and the resulting costs from short-term trading in and out of individual company shares, "the stock market now is a tax on the real economy."
"The financial sector is extracting value from the rest of the economy [through] fees, costs and expenses."
Mr. Porter, considered one of the world's foremost experts on business strategy, noted that 30 years ago many people owned stocks for the long term – 20 years or more. In that environment, corporate executives could focus on long-term growth rather than quarterly results, and investors' interests were aligned with those goals.
We can't address some of these weaknesses soon enough as far as I'm concerned.
Adam
..."in many respects" it was easier doing business in China, comparing the country with a well-managed company. "You have a one-stop shop in terms of the Chinese foreign investment agency and local governments are fighting for investment with each other," he told the Financial Times.
He later added...
"They're learning very fast, these countries," he said. "In the west, we're forgetting what really worked 20 years ago. In China and other markets around the world, you see the kind of attention to detail about how business works and how business creates employment."
The above comments remind me of what Professor Michael Porter said in an interview earlier this year on U.S. competitiveness. In the interview, he offers up some thoughts on how to make doing business in the United States more competitive with other countries.
How the U.S. Can Compete Better
Separately, in this 2010 interview, Professor Porter said that the U.S. needs to do more to encourage domestic investment.
According to Porter, data shows U.S. domestic investment is, somewhat amazingly, the lowest among OECD countries. He says that individual U.S. companies are competitive globally but they hold back investment on home soil because the cost and complexity (healthcare, litigation, taxes, other regulations etc.) of doing business in the U.S. has piled up over the years.
Michael Porter: U.S. Needs Increased Domestic Investment
In the interview, Professor Porter also said that according to the Global Competitiveness Report, the US now ranks like a developing country in terms of cost and complexity of doing business.
Finally, in this The Globe and Mail article from a couple years back, he added the following thoughts:
Michael Porter on Business and Investing
With so much focus on the immediate value of stocks, and the resulting costs from short-term trading in and out of individual company shares, "the stock market now is a tax on the real economy."
"The financial sector is extracting value from the rest of the economy [through] fees, costs and expenses."
Mr. Porter, considered one of the world's foremost experts on business strategy, noted that 30 years ago many people owned stocks for the long term – 20 years or more. In that environment, corporate executives could focus on long-term growth rather than quarterly results, and investors' interests were aligned with those goals.
We can't address some of these weaknesses soon enough as far as I'm concerned.
Adam
Tuesday, September 27, 2011
Buffett on Wells Fargo: Berkshire Shareholder Letter Highlights
Below is an excerpt from the 1990 Berkshire Hathaway (BRKa) Shareholder Letter.
Starting in 1989 and continuing into 1990, Buffett was buying lots of Wells Fargo (WFC) shares for the first time. Here is what he had to say about Wells back then:
Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings. The exception was Wells Fargo, a superbly-managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board. About one-sixth of our position was bought in 1989, the rest in 1990.
The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.
This next excerpt from the letter sounds like something that would just as aptly describe banks during the more recent financial crisis...
Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.
As always, the price paid is the best way to regulate the specific risks of an investment. Future outcomes are always uncertain and unknowable despite what those in the business of forecasting say.
Most forecasters are, if nothing else, reliably unreliable.
"We have two classes of forecasters: those who don't know, and those who don't know they don't know." - John Kenneth Galbraith in the Wall Street Journal (January 1993)
Making a judgment on the known strengths and weaknesses of a business and whether the price is low enough to provide an acceptable margin of safety seems, by comparison, more doable on a regular basis.
The good news is effective macro forecasting is not a prerequisite of successful investing.
"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen." - Warren Buffett in the 1994 Berkshire Hathaway Shareholder Letter
"A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results." - Warren Buffett in the 1994 Berkshire Hathaway Shareholder Letter
Now Back to Wells Fargo.
Normally, at 5x after-tax earnings, if the investor has a long-term investing horizon, an awful lot has to go extraordinarily wrong for even a decent business (for a lousy business like an airline no multiple is cheap enough...all bets are off).
At that kind of multiple, the problem can't just be something like ugly headlines or a dysfunctional board. It has to be along the lines of a collapse in the core economics of a business (economic moat wrecked) or an event that causes massive shareholder dilution at prices well below intrinsic value (often the result of extreme leverage).
Most times, not much has to go right with an equity investment that cheap. A multiple that low implies the business will stagnate or maybe even shrink a bit. If a business shrinks yet maintains most of its favorable economic advantages, with patience very solid long run returns can still be had at that kind of multiple.
So a 5x multiple (a 20% earnings yield) compensates the investor for quite a lot of risks and uncertainties.
Now, a bank always has a unique set of risks mostly related to the inherent leverage used but also the systemic variety. In the context of today's investing environment and, considering other available very inexpensive non-financial investment alternatives, I'm not sure those kinds of risks are worth the trouble.
Buffett made the judgment back in 1990 that Wells Fargo still had an excellent franchise and terrific economics and once the noise of the moment passed its value would become clear. Berkshire Hathaway shareholders were compensated handsomely for Buffett getting that judgment right.
He seems to be making the same call this time around with Wells Fargo and U.S. Bancorp (USB). If the worst kinds of systemic failures do not occur some of the better banks like Wells and U.S. Bancorp will likely end up with, if not the same as what has happened since 1990, a solid long run outcome (Buffett's Bank of America: BAC investment is a little different since he went the preferred shares route and the terms are uniquely favorable).
Once again, it's just that considering the number of attractive alternatives available, I'm not convinced banks need to be anything more than a small portion of an equity portfolio.
The risks unique to investing in banks have always been significant. The better banks right now would be more interesting if there were not so many other 5-7x multiple non-financial stocks.
Adam
Long USB and WFC
Starting in 1989 and continuing into 1990, Buffett was buying lots of Wells Fargo (WFC) shares for the first time. Here is what he had to say about Wells back then:
Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings. The exception was Wells Fargo, a superbly-managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board. About one-sixth of our position was bought in 1989, the rest in 1990.
The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.
This next excerpt from the letter sounds like something that would just as aptly describe banks during the more recent financial crisis...
Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.
As always, the price paid is the best way to regulate the specific risks of an investment. Future outcomes are always uncertain and unknowable despite what those in the business of forecasting say.
Most forecasters are, if nothing else, reliably unreliable.
"We have two classes of forecasters: those who don't know, and those who don't know they don't know." - John Kenneth Galbraith in the Wall Street Journal (January 1993)
Making a judgment on the known strengths and weaknesses of a business and whether the price is low enough to provide an acceptable margin of safety seems, by comparison, more doable on a regular basis.
The good news is effective macro forecasting is not a prerequisite of successful investing.
"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen." - Warren Buffett in the 1994 Berkshire Hathaway Shareholder Letter
"A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results." - Warren Buffett in the 1994 Berkshire Hathaway Shareholder Letter
Now Back to Wells Fargo.
Normally, at 5x after-tax earnings, if the investor has a long-term investing horizon, an awful lot has to go extraordinarily wrong for even a decent business (for a lousy business like an airline no multiple is cheap enough...all bets are off).
At that kind of multiple, the problem can't just be something like ugly headlines or a dysfunctional board. It has to be along the lines of a collapse in the core economics of a business (economic moat wrecked) or an event that causes massive shareholder dilution at prices well below intrinsic value (often the result of extreme leverage).
Most times, not much has to go right with an equity investment that cheap. A multiple that low implies the business will stagnate or maybe even shrink a bit. If a business shrinks yet maintains most of its favorable economic advantages, with patience very solid long run returns can still be had at that kind of multiple.
So a 5x multiple (a 20% earnings yield) compensates the investor for quite a lot of risks and uncertainties.
Now, a bank always has a unique set of risks mostly related to the inherent leverage used but also the systemic variety. In the context of today's investing environment and, considering other available very inexpensive non-financial investment alternatives, I'm not sure those kinds of risks are worth the trouble.
Buffett made the judgment back in 1990 that Wells Fargo still had an excellent franchise and terrific economics and once the noise of the moment passed its value would become clear. Berkshire Hathaway shareholders were compensated handsomely for Buffett getting that judgment right.
He seems to be making the same call this time around with Wells Fargo and U.S. Bancorp (USB). If the worst kinds of systemic failures do not occur some of the better banks like Wells and U.S. Bancorp will likely end up with, if not the same as what has happened since 1990, a solid long run outcome (Buffett's Bank of America: BAC investment is a little different since he went the preferred shares route and the terms are uniquely favorable).
Once again, it's just that considering the number of attractive alternatives available, I'm not convinced banks need to be anything more than a small portion of an equity portfolio.
The risks unique to investing in banks have always been significant. The better banks right now would be more interesting if there were not so many other 5-7x multiple non-financial stocks.
Adam
Long USB and WFC
Monday, September 26, 2011
Berkshire Hathaway Authorizes Share Repurchase
Well, it turns out we are going to get what is a rare share buyback by Berkshire Hathaway (BRKa).
Last Tuesday, I happened to explore the following question in this post:
Should Berkshire Hathaway Repurchase Its Own Stock?
To me, the answer was a firm yes. Berkshire Hathaway's recent stock price seemed an odd undervaluation when considering its combination of assets. A share repurchase made a lot of sense if you compare recent market prices to a conservative estimate of intrinsic value.
It all came down to whether other available investing alternatives were available for Berkshire Hathaway.
Otherwise, to me it was a no-brainer.
Well, we got explicit confirmation of Buffett, Munger, and the Board of Directors view six days after that post in the form of this morning's Berkshire share repurchase announcement.
Berkshire Hathaway Authorizes Repurchase Program
An excerpt from the announcement:
Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares. In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest.
Lately, he and Charlie Munger have been more than hinting that they think the stock is cheap. Something they've said infrequently.
Buffet & Munger on Berkshire's Stock
At recent prices, the market value implied that the non-insurance operating businesses have little to no value.
That's nonsense, of course.
It also implied that Berkshire's exceptional ability to allocate capital funded in large part by low cost insurance float was of little future value.
That also makes no sense.
The long run value of exceptional capital allocation abilities is harder to quantify but no less real.
Adam
Last Tuesday, I happened to explore the following question in this post:
Should Berkshire Hathaway Repurchase Its Own Stock?
To me, the answer was a firm yes. Berkshire Hathaway's recent stock price seemed an odd undervaluation when considering its combination of assets. A share repurchase made a lot of sense if you compare recent market prices to a conservative estimate of intrinsic value.
It all came down to whether other available investing alternatives were available for Berkshire Hathaway.
Otherwise, to me it was a no-brainer.
Well, we got explicit confirmation of Buffett, Munger, and the Board of Directors view six days after that post in the form of this morning's Berkshire share repurchase announcement.
Berkshire Hathaway Authorizes Repurchase Program
An excerpt from the announcement:
Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares. In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest.
Lately, he and Charlie Munger have been more than hinting that they think the stock is cheap. Something they've said infrequently.
Buffet & Munger on Berkshire's Stock
At recent prices, the market value implied that the non-insurance operating businesses have little to no value.
That's nonsense, of course.
It also implied that Berkshire's exceptional ability to allocate capital funded in large part by low cost insurance float was of little future value.
That also makes no sense.
The long run value of exceptional capital allocation abilities is harder to quantify but no less real.
Adam
Friday, September 23, 2011
Inefficient Market Theory
"If obfuscation clouds public debate and sidelines reform, many confidences that bona fide investors have in the capital markets may be irreparably harmed." - Mason Hawkins
The economy isn't operating at full strength but, as the excerpt below points out, it's sure not because of the consumer.
In the U.S., consumer spending makes up the bulk of gross domestic product. This Barron's article points out real consumer spending already exceeds its 2007 highs but...
The sick man of the economy—and the original cause of the bust—is that broad category called "gross private domestic investment," meaning investment in plants, equipment, software, housing and inventories. Despite some gains, real gross private domestic investment is still more than 16% below its peak of fourth-quarter '07.
It turns out consumer spending is alive and well. What makes up 70% of gross domestic product has been surprisingly stable.
As the article points out, the problem is that job creation depends to a great extent on the remaining 30%. In fact, something like more than than half the jobs are created there.
So increasing the amount and effectiveness of "gross private domestic investment" is key. For a variety of reasons that's where the trouble lies.
Corporate cash balances have grown to rather high levels as have excess reserves at banks. Fixing this so-called capital strike will likely come down to changing a bunch of factors over time, both systemic and psychological, that currently dominate the investing environment.
Creating certainty when it comes to putting capital at risk would certainly help. Policies that investors and businesses see as unfriendly is a part of the problem.
The memory of the recent crisis also contributes to the reduction in "animal spirits" no doubt.
To an extent, when it comes to an apparent capital strike, it seems fair to point to the uncertainties created by things like an aggressive regulatory environment and other government policies. Those are easy targets but definitely real factors when it comes to getting businesses to invest.
Yet, whether a direct contributor to the capital strike or not, we also need capital markets to get back to basics.
What seem like (or, in fact, are) less stable capital markets can hinder confidence. When that happens businesses and individuals, at least at the margin, naturally hunker down. The numbers above, of course, suggest it is investment by businesses that is taking the biggest hit right now.
One question worth asking: Have the substantial changes to capital market structure in recent years amplified some of what has always been inherently manic tendencies?
Capital markets exist to foster capital formation and allocation. That is their primary purpose or reason for being. I'd argue that role has become weakened in recent years.
I happen to think, when it comes to the essential role of transferring capital from investors to businesses, the evolution of capital markets to their current form has got to be a net negative and not a small one
These days, we have something that better resembles a casino where people, and increasingly computers, make rapid fire bets all day long with the main purpose seemingly an afterthought. This CNBC article points out:
- High frequency trading now accounts for something like 70 percent of volume
- The average holding period for U.S. stocks now: 2.8 months
- The average holding period for U.S. stocks in the 1980s: 2 years
Stock Market Morphs into Casino
Not good. Keep in mind that the average holding period was even higher, more like 4-8 years, from the 1930s to the 1970s.
In the past twenty years or so, a disproportionate amount of the emphasis in markets has become gambling and speculation in lieu of investment. The excessive and frenetic activity means frictional costs are unnecessarily high. It also means, with a disproportionate amount of "stock-renters" involved, the system operates more like a capital misallocation machine.
Inefficient and ineffective with mispricing the norm.
I think it is fair to say that renters*, at least compared to long-term owners of an asset, do not think nearly as much or as carefully about what something is worth, could be worth, and whether its potential being nurtured properly by those in charge.
We have too many rental oriented market participants involved these days.
It's, unfortunately, the triumph of gambling and speculation over investment.
First and foremost, capital markets should facilitate the allocation of capital from investors to businesses. As Mason Hawkins and his colleagues said in this letter, "markets do not exist as an end in and of themselves", their purpose is "transferring capital from investors to productive businesses that can provide a return on that capital".
Capital Markets: An Overshadowed Servant to Traders?
It seems we've become, in many ways, somewhere between neglecting the importance of high quality capital formation and allocation to downright being hostile toward it.
Adam
* How carefully did you drive your last rental car? It's a completely different context but did you worry much about the underlying asset? Short-term renting changes behavior whether it's a car or a stock (part ownership of a business). If most participants are only willing to commit capital for days, minutes, and these days even seconds or less, what's the chance they are going to pay attention to whether the board of some company is doing its job? Equities aren't trading cards. They're partial ownership of some mostly rather useful assets. I've said before that those who think this situation doesn't impact the real economy and ultimately reduce wealth creation I have a nice, well-maintained, rental car to sell them.
The economy isn't operating at full strength but, as the excerpt below points out, it's sure not because of the consumer.
In the U.S., consumer spending makes up the bulk of gross domestic product. This Barron's article points out real consumer spending already exceeds its 2007 highs but...
The sick man of the economy—and the original cause of the bust—is that broad category called "gross private domestic investment," meaning investment in plants, equipment, software, housing and inventories. Despite some gains, real gross private domestic investment is still more than 16% below its peak of fourth-quarter '07.
It turns out consumer spending is alive and well. What makes up 70% of gross domestic product has been surprisingly stable.
As the article points out, the problem is that job creation depends to a great extent on the remaining 30%. In fact, something like more than than half the jobs are created there.
So increasing the amount and effectiveness of "gross private domestic investment" is key. For a variety of reasons that's where the trouble lies.
Corporate cash balances have grown to rather high levels as have excess reserves at banks. Fixing this so-called capital strike will likely come down to changing a bunch of factors over time, both systemic and psychological, that currently dominate the investing environment.
Creating certainty when it comes to putting capital at risk would certainly help. Policies that investors and businesses see as unfriendly is a part of the problem.
The memory of the recent crisis also contributes to the reduction in "animal spirits" no doubt.
To an extent, when it comes to an apparent capital strike, it seems fair to point to the uncertainties created by things like an aggressive regulatory environment and other government policies. Those are easy targets but definitely real factors when it comes to getting businesses to invest.
Yet, whether a direct contributor to the capital strike or not, we also need capital markets to get back to basics.
What seem like (or, in fact, are) less stable capital markets can hinder confidence. When that happens businesses and individuals, at least at the margin, naturally hunker down. The numbers above, of course, suggest it is investment by businesses that is taking the biggest hit right now.
One question worth asking: Have the substantial changes to capital market structure in recent years amplified some of what has always been inherently manic tendencies?
Capital markets exist to foster capital formation and allocation. That is their primary purpose or reason for being. I'd argue that role has become weakened in recent years.
I happen to think, when it comes to the essential role of transferring capital from investors to businesses, the evolution of capital markets to their current form has got to be a net negative and not a small one
These days, we have something that better resembles a casino where people, and increasingly computers, make rapid fire bets all day long with the main purpose seemingly an afterthought. This CNBC article points out:
- High frequency trading now accounts for something like 70 percent of volume
- The average holding period for U.S. stocks now: 2.8 months
- The average holding period for U.S. stocks in the 1980s: 2 years
Stock Market Morphs into Casino
Not good. Keep in mind that the average holding period was even higher, more like 4-8 years, from the 1930s to the 1970s.
In the past twenty years or so, a disproportionate amount of the emphasis in markets has become gambling and speculation in lieu of investment. The excessive and frenetic activity means frictional costs are unnecessarily high. It also means, with a disproportionate amount of "stock-renters" involved, the system operates more like a capital misallocation machine.
Inefficient and ineffective with mispricing the norm.
I think it is fair to say that renters*, at least compared to long-term owners of an asset, do not think nearly as much or as carefully about what something is worth, could be worth, and whether its potential being nurtured properly by those in charge.
We have too many rental oriented market participants involved these days.
It's, unfortunately, the triumph of gambling and speculation over investment.
First and foremost, capital markets should facilitate the allocation of capital from investors to businesses. As Mason Hawkins and his colleagues said in this letter, "markets do not exist as an end in and of themselves", their purpose is "transferring capital from investors to productive businesses that can provide a return on that capital".
Capital Markets: An Overshadowed Servant to Traders?
It seems we've become, in many ways, somewhere between neglecting the importance of high quality capital formation and allocation to downright being hostile toward it.
Adam
* How carefully did you drive your last rental car? It's a completely different context but did you worry much about the underlying asset? Short-term renting changes behavior whether it's a car or a stock (part ownership of a business). If most participants are only willing to commit capital for days, minutes, and these days even seconds or less, what's the chance they are going to pay attention to whether the board of some company is doing its job? Equities aren't trading cards. They're partial ownership of some mostly rather useful assets. I've said before that those who think this situation doesn't impact the real economy and ultimately reduce wealth creation I have a nice, well-maintained, rental car to sell them.
Wednesday, September 21, 2011
Buffett: When it's Advisable for a Company to Repurchase Shares
More from the 1999 Berkshire Hathaway (BRKa) Shareholder Letter on when it makes sense for a company to repurchase its own shares.
In the 1970s, stocks were extremely cheap (selling well below intrinsic value) yet, as Buffett points out below, few management teams acted upon it.
By the late 1990s, when stocks were extremely expensive, buybacks became all the rage.
Buffett has covered the subject of share repurchases many times but this excerpt from the 1999 letter is about as good as any of them in my view:
There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down.
The business "needs" that I speak of are of two kinds: First, expenditures that a company must make to maintain its competitive position (e.g., the remodeling of stores at Helzberg's) and, second, optional outlays, aimed at business growth, that management expects will produce more than a dollar of value for each dollar spent (R. C. Willey's expansion into Idaho).*
When available funds exceed needs of those kinds, a company with a growth-oriented shareholder population can buy new businesses or repurchase shares. If a company's stock is selling well below intrinsic value, repurchases usually make the most sense. In the mid-1970s, the wisdom of making these was virtually screaming at managements, but few responded. In most cases, those that did made their owners much wealthier than if alternative courses of action had been pursued. Indeed, during the 1970s (and, spasmodically, for some years thereafter) we searched for companies that were large repurchasers of their shares. This often was a tipoff that the company was both undervalued and run by a shareholder-oriented management.
That day is past. Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.
Charlie and I admit that we feel confident in estimating intrinsic value for only a portion of traded equities and then only when we employ a range of values, rather than some pseudo-precise figure. Nevertheless, it appears to us that many companies now making repurchases are overpaying departing shareholders at the expense of those who stay. In defense of those companies, I would say that it is natural for CEOs to be optimistic about their own businesses. They also know a whole lot more about them than I do. However, I can't help but feel that too often today's repurchases are dictated by management's desire to "show confidence" or be in fashion rather than by a desire to enhance per-share value.
Sometimes, too, companies say they are repurchasing shares to offset the shares issued when stock options granted at much lower prices are exercised. This "buy high, sell low" strategy is one many unfortunate investors have employed -- but never intentionally! Managements, however, seem to follow this perverse activity very cheerfully.
Of course, both option grants and repurchases may make sense -- but if that's the case, it's not because the two activities are logically related. Rationally, a company's decision to repurchase shares or to issue them should stand on its own feet. Just because stock has been issued to satisfy options -- or for any other reason -- does not mean that stock should be repurchased at a price above intrinsic value. Correspondingly, a stock that sells well below intrinsic value should be repurchased whether or not stock has previously been issued (or may be because of outstanding options).
You should be aware that, at certain times in the past, I have erred in not making repurchases. My appraisal of Berkshire's value was then too conservative or I was too enthused about some alternative use of funds. We have therefore missed some opportunities -- though Berkshire's trading volume at these points was too light for us to have done much buying, which means that the gain in our per-share value would have been minimal. (A repurchase of, say, 2% of a company's shares at a 25% discount from per-share intrinsic value produces only a ½% gain in that value at most -- and even less if the funds could alternatively have been deployed in value-building moves.)
Some of the letters we've received clearly imply that the writer is unconcerned about intrinsic value considerations but instead wants us to trumpet an intention to repurchase so that the stock will rise (or quit going down). If the writer wants to sell tomorrow, his thinking makes sense -- for him! -- but if he intends to hold, he should instead hope the stock falls and trades in enough volume for us to buy a lot of it. That's the only way a repurchase program can have any real benefit for a continuing shareholder.
We will not repurchase shares unless we believe Berkshire stock is selling well below intrinsic value, conservatively calculated. Nor will we attempt to talk the stock up or down. (Neither publicly or privately have I ever told anyone to buy or sell Berkshire shares.) Instead we will give all shareholders -- and potential shareholders -- the same valuation-related information we would wish to have if our positions were reversed.
One of the more complete explanations of the circumstances when management should and should not consider repurchasing stock.
Adam
* The expenditures at Helzberg and R.C. Willey are explained in more detail earlier in the 1999 letter.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
In the 1970s, stocks were extremely cheap (selling well below intrinsic value) yet, as Buffett points out below, few management teams acted upon it.
By the late 1990s, when stocks were extremely expensive, buybacks became all the rage.
Buffett has covered the subject of share repurchases many times but this excerpt from the 1999 letter is about as good as any of them in my view:
There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down.
The business "needs" that I speak of are of two kinds: First, expenditures that a company must make to maintain its competitive position (e.g., the remodeling of stores at Helzberg's) and, second, optional outlays, aimed at business growth, that management expects will produce more than a dollar of value for each dollar spent (R. C. Willey's expansion into Idaho).*
When available funds exceed needs of those kinds, a company with a growth-oriented shareholder population can buy new businesses or repurchase shares. If a company's stock is selling well below intrinsic value, repurchases usually make the most sense. In the mid-1970s, the wisdom of making these was virtually screaming at managements, but few responded. In most cases, those that did made their owners much wealthier than if alternative courses of action had been pursued. Indeed, during the 1970s (and, spasmodically, for some years thereafter) we searched for companies that were large repurchasers of their shares. This often was a tipoff that the company was both undervalued and run by a shareholder-oriented management.
That day is past. Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.
Charlie and I admit that we feel confident in estimating intrinsic value for only a portion of traded equities and then only when we employ a range of values, rather than some pseudo-precise figure. Nevertheless, it appears to us that many companies now making repurchases are overpaying departing shareholders at the expense of those who stay. In defense of those companies, I would say that it is natural for CEOs to be optimistic about their own businesses. They also know a whole lot more about them than I do. However, I can't help but feel that too often today's repurchases are dictated by management's desire to "show confidence" or be in fashion rather than by a desire to enhance per-share value.
Sometimes, too, companies say they are repurchasing shares to offset the shares issued when stock options granted at much lower prices are exercised. This "buy high, sell low" strategy is one many unfortunate investors have employed -- but never intentionally! Managements, however, seem to follow this perverse activity very cheerfully.
Of course, both option grants and repurchases may make sense -- but if that's the case, it's not because the two activities are logically related. Rationally, a company's decision to repurchase shares or to issue them should stand on its own feet. Just because stock has been issued to satisfy options -- or for any other reason -- does not mean that stock should be repurchased at a price above intrinsic value. Correspondingly, a stock that sells well below intrinsic value should be repurchased whether or not stock has previously been issued (or may be because of outstanding options).
You should be aware that, at certain times in the past, I have erred in not making repurchases. My appraisal of Berkshire's value was then too conservative or I was too enthused about some alternative use of funds. We have therefore missed some opportunities -- though Berkshire's trading volume at these points was too light for us to have done much buying, which means that the gain in our per-share value would have been minimal. (A repurchase of, say, 2% of a company's shares at a 25% discount from per-share intrinsic value produces only a ½% gain in that value at most -- and even less if the funds could alternatively have been deployed in value-building moves.)
Some of the letters we've received clearly imply that the writer is unconcerned about intrinsic value considerations but instead wants us to trumpet an intention to repurchase so that the stock will rise (or quit going down). If the writer wants to sell tomorrow, his thinking makes sense -- for him! -- but if he intends to hold, he should instead hope the stock falls and trades in enough volume for us to buy a lot of it. That's the only way a repurchase program can have any real benefit for a continuing shareholder.
We will not repurchase shares unless we believe Berkshire stock is selling well below intrinsic value, conservatively calculated. Nor will we attempt to talk the stock up or down. (Neither publicly or privately have I ever told anyone to buy or sell Berkshire shares.) Instead we will give all shareholders -- and potential shareholders -- the same valuation-related information we would wish to have if our positions were reversed.
One of the more complete explanations of the circumstances when management should and should not consider repurchasing stock.
Adam
* The expenditures at Helzberg and R.C. Willey are explained in more detail earlier in the 1999 letter.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
Tuesday, September 20, 2011
Should Berkshire Hathaway Repurchase Its Own Stock?
*** Update - Well, less than a week after this post on the merits of a buyback for Berkshire, the following news release came out announcing: Berkshire Hathaway Authorizes Share Repurchase***
-----
In 1999, Warren Buffett considered making some share repurchases of Berkshire Hathaway's (BRKa) stock.
Lately, he and Charlie Munger have more than hinted that they think the stock is cheap. Something they've said infrequently.
So, if Buffett was considering a buyback of the stock in 1999, it seems worthwhile to compare how valuation now compares to back then.
Let's first look at what Buffett said about repurchasing the stock in the 1999 Berkshire Hathaway Shareholder Letter:
"Recently, when the A shares fell below $45,000, we considered making repurchases. We decided, however, to delay buying, if indeed we elect to do any, until shareholders have had the chance to review this report. If we do find that repurchases make sense, we will only rarely place bids on the New York Stock Exchange ("NYSE"). Instead, we will respond to offers made directly to us at or below the NYSE bid. If you wish to offer stock, have your broker call Mark Millard at 402-346-1400. When a trade occurs, the broker can either record it in the "third market" or on the NYSE. We will favor purchase of the B shares if they are selling at more than a 2% discount to the A. We will not engage in transactions involving fewer than 10 shares of A or 50 shares of B.
Please be clear about one point: We will never make purchases with the intention of stemming a decline in Berkshire's price. Rather we will make them if and when we believe that they represent an attractive use of the Company's money."
Back then the dominant driver of Berkshire's intrinsic value* was investments per share funded to a great extent by insurance float.
Since the letter was written, investments per share have increased from roughly $ 47k to $ 95k. Not bad but also hardly explosive.
On the surface, the fact that the A shares have gone from the $ 45k/share Buffett refers to above to $ 105k/share it now sells at may makes it seem, even if still cheap, not much more of a bargain now.
Here's what's wrong with that.
A bit over a decade ago, by far the biggest driver of Berkshire's intrinsic value was investments funded, in part, by cheap and stable float (along with Buffett's future ability to deploy capital). Now it is increasingly the earnings from non-insurance businesses that Berkshire owns outright. In other words, businesses like Burlington Northern increasingly drive intrinsic value.
To quantify how this has changed, look at what has happened to pre-tax operating earnings from the non-insurance businesses:
In 2000, Berkshire's per share pre-tax earnings was $ 919k.
In 2010, Berkshire per share pre-tax earnings was $ 5,926k.
Source: 2010 Berkshire Hathaway Shareholder Letter
So it has grown more than 6-fold in a decade, a compounded annual increase in earnings of 20.5%.
Not bad, and, it's not like earnings should be shrinking in the coming years (even if there will certainly be year to year fluctuations considering some of the cyclically oriented businesses owned by Berkshire).
Now, Berkshire does often earn money in the insurance businesses but I'm excluding that to be conservative.
I'm assuming they break even on average going forward in insurance underwriting (even though that has not typically been the case). Of course, if they do make some underwriting profits that will be additional intrinsic value creation.
Also, I'd point out that many of the securities in the Berkshire equity portfolio (Coca-Cola; KO comes to mind) were selling at market values that were optimistic relative to intrinsic value a decade or so ago. The net effect being to inflate the book value of Berkshire's investments per share just a bit.
That's not the case these days. The multiples of many Berkshire equity holdings is anywhere from single digits to mid-teens. Back then, Coca-Cola sold for more like 50x earnings while others like American Express (AXP) were selling for 25-30x.
If Buffett thought Berkshire's stock was cheap back then it is easy to see why he (and Munger) have hinted or explicitly said lately that they think Berkshire shares are, once again, cheap right now.
Buffett and Munger on Berkshire's Stock
So should they buyback stock? It makes a lot of sense to me.
Whether it happens is a different story and comes down to what other investing alternatives are available for Berkshire Hathaway.
Adam
Related posts:
Buffett: When It's Advisable for a Company to Repurchase Shares
Berkshire Hathaway Authorizes Share Repurchase
Long BRKb
* The two main components of Berkshire's intrinsic value come from investments, funded in part by insurance float, and the earnings from non-insurance businesses that are owned outright. Another component of Berkshire's intrinsic value -- much more difficult to quantify but very real -- is explained in the Intrinsic Value - Today and Tomorrow section of the 2010 Shareholder Letter: "There is a third, more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills."
-----
In 1999, Warren Buffett considered making some share repurchases of Berkshire Hathaway's (BRKa) stock.
Lately, he and Charlie Munger have more than hinted that they think the stock is cheap. Something they've said infrequently.
So, if Buffett was considering a buyback of the stock in 1999, it seems worthwhile to compare how valuation now compares to back then.
Let's first look at what Buffett said about repurchasing the stock in the 1999 Berkshire Hathaway Shareholder Letter:
"Recently, when the A shares fell below $45,000, we considered making repurchases. We decided, however, to delay buying, if indeed we elect to do any, until shareholders have had the chance to review this report. If we do find that repurchases make sense, we will only rarely place bids on the New York Stock Exchange ("NYSE"). Instead, we will respond to offers made directly to us at or below the NYSE bid. If you wish to offer stock, have your broker call Mark Millard at 402-346-1400. When a trade occurs, the broker can either record it in the "third market" or on the NYSE. We will favor purchase of the B shares if they are selling at more than a 2% discount to the A. We will not engage in transactions involving fewer than 10 shares of A or 50 shares of B.
Please be clear about one point: We will never make purchases with the intention of stemming a decline in Berkshire's price. Rather we will make them if and when we believe that they represent an attractive use of the Company's money."
Back then the dominant driver of Berkshire's intrinsic value* was investments per share funded to a great extent by insurance float.
Since the letter was written, investments per share have increased from roughly $ 47k to $ 95k. Not bad but also hardly explosive.
On the surface, the fact that the A shares have gone from the $ 45k/share Buffett refers to above to $ 105k/share it now sells at may makes it seem, even if still cheap, not much more of a bargain now.
Here's what's wrong with that.
A bit over a decade ago, by far the biggest driver of Berkshire's intrinsic value was investments funded, in part, by cheap and stable float (along with Buffett's future ability to deploy capital). Now it is increasingly the earnings from non-insurance businesses that Berkshire owns outright. In other words, businesses like Burlington Northern increasingly drive intrinsic value.
To quantify how this has changed, look at what has happened to pre-tax operating earnings from the non-insurance businesses:
In 2000, Berkshire's per share pre-tax earnings was $ 919k.
In 2010, Berkshire per share pre-tax earnings was $ 5,926k.
Source: 2010 Berkshire Hathaway Shareholder Letter
So it has grown more than 6-fold in a decade, a compounded annual increase in earnings of 20.5%.
Not bad, and, it's not like earnings should be shrinking in the coming years (even if there will certainly be year to year fluctuations considering some of the cyclically oriented businesses owned by Berkshire).
Now, Berkshire does often earn money in the insurance businesses but I'm excluding that to be conservative.
I'm assuming they break even on average going forward in insurance underwriting (even though that has not typically been the case). Of course, if they do make some underwriting profits that will be additional intrinsic value creation.
Also, I'd point out that many of the securities in the Berkshire equity portfolio (Coca-Cola; KO comes to mind) were selling at market values that were optimistic relative to intrinsic value a decade or so ago. The net effect being to inflate the book value of Berkshire's investments per share just a bit.
That's not the case these days. The multiples of many Berkshire equity holdings is anywhere from single digits to mid-teens. Back then, Coca-Cola sold for more like 50x earnings while others like American Express (AXP) were selling for 25-30x.
If Buffett thought Berkshire's stock was cheap back then it is easy to see why he (and Munger) have hinted or explicitly said lately that they think Berkshire shares are, once again, cheap right now.
Buffett and Munger on Berkshire's Stock
So should they buyback stock? It makes a lot of sense to me.
Whether it happens is a different story and comes down to what other investing alternatives are available for Berkshire Hathaway.
Adam
Related posts:
Buffett: When It's Advisable for a Company to Repurchase Shares
Berkshire Hathaway Authorizes Share Repurchase
Long BRKb
* The two main components of Berkshire's intrinsic value come from investments, funded in part by insurance float, and the earnings from non-insurance businesses that are owned outright. Another component of Berkshire's intrinsic value -- much more difficult to quantify but very real -- is explained in the Intrinsic Value - Today and Tomorrow section of the 2010 Shareholder Letter: "There is a third, more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills."
Monday, September 19, 2011
Large Cap Stocks: High Earnings Yield, Low Borrowing Costs
From this recent Barron's article on cheap European stocks. According to the article, the Euro Stoxx 50 trades at roughly 8x earnings and has a dividend yields above 5%. The S&P 500 is more like 12x earnings with a 2.2% yield.
Here are some of the stocks* mentioned in the article.
-Telefonica (TEF)
P/E: 8.4, Dividend: 8.1%
-Total S.A. (TOT)
P/E: 6.2, Div: 6.9%
-Vodafone (VOD)
P/E: 9.6. Div: 5.4%
-Royal Dutch Shell (RDS.A)
P/E: 8.0, Div: 4.3%
-Sanofi (SNY)
P/E: 7.0, Div: 3.9%
-Novartis (NVS)
P/E: 10.1, Div: 3.6%
-Unilever (UN)
P/E: 13.4, Div: 3.3%
-Siemens (SI)
P/E: 8.9, Div: 2.8%
With the exception of Unilever, all the above have earnings yield (inverse P/E) exceeding 10% and, in the case of Total S.A., more than 15%.
Many large companies (whether in Europe or elsewhere) are tapping the bond market, raising low cost money, to make acquisitions or return cash to shareholders in the form of dividends and share repurchases.
In the month of September alone, there has been $ 40 billion of investment-grade debt offered so far.
The combination of low-cost borrowing and, at least in some cases, oddly undervalued shares of large capitalization businesses makes what is happening pretty inevitable.
It creates an excellent environment for the long-term investor.
Now, this past decade brought to the forefront how extremely overvalued assets produced in bubbles cause serious economic problems. Widespread mispricing and misallocation of capital leads to recession or worse.
What may be less obvious is that extremely undervalued equities can, at least in the short run, also hinder near term economic potential.
How?
Consider that in some cases the above is done in lieu of building plants or buying equipment...things that tend to lead to economic expansion and job creation. So at least the short run, these expansion opportunities becomes a relatively less attractive alternative when extremely low cost borrowing is available to a strong business with a cheap stock.
(Building factories, launching new businesses is not exactly easy. Plenty can go wrong. Buying back stock to generate something like a low risk 15% return for shareholders is a lot easier than building factories, launching new businesses, etc.).
In addition, a company in that situation will frequently be acting wisely if it uses a good chunk of its free cash flows for buybacks. This process should continue until the market adjusts price to something that more closely approximates intrinsic value (well, at least if management is tending to their capital allocation responsibilities).
Buying a company's own cheap stock is the right thing to do for corporate managers but, at least in the short or intermediate run, it produces at the margin somewhat less economic activity. Some might be tempted to "fix" this to somehow encourage growth.
That'd be a mistake. Capital allocators need to focus on deploying dollars based on their judgment of return potential relative to the risk being taken (especially when the opportunity happens to be something that management should understand best...the business they are running).
For the economy at large, clearly expansion by these businesses would be the more desirable outcome. So consider the following:
In a perfect situation capital markets** serve the world best when, more often than not, the prices of individual securities spend most of their time fluctuating around some reasonable estimate of intrinsic value.
Realistically, capital markets will always be sometimes manic other times depressed and prices inevitably will reflect emotions as much as logic and insight (things like efficient markets might suggest otherwise but that thinking is flawed at its core).
That is the nature of markets.
Knowing this, it seems clear they shouldn't be structured in a way that amplifies this nature.
In its current short-term hyperactive construct I'd say the markets do tend to amplify.
Extremely low valuations can, at least at the margin in the near term, delay or suppress an economic recovery (though I am far from suggesting this alone is at the root of our current weak economy). Still, there's no reason to change what amounts to rational corporate behavior.
Instead, it'd probably be better to get at the root of why our capital markets are going to extremes so frequently.
Maybe it is, at least in part, as Mason Hawkins and his colleagues suggest:
"Unintended, yet permitted advantages within market structure have come to dominate and overshadow the true intent of the capital markets - to facilitate the allocation of capital from investors to businesses. The market has become a servant to short-term professional traders..."
Capital Markets: An Overshadowed Servant to Traders?
So I doubt it comes down to any one thing but odds are good that what Hawkins is saying is a part of the problem. Developing a market structure (along with other incentives) that better supports a longer-term investing ethos in place of the existing hyperactive casino-oriented system would surely be a win.
So until an opportunity to expand becomes the best risk-adjusted use of capital for a good business, buybacks make sense if the stock is cheap, debt can be had at low cost, and the balance sheet is healthy. A recent example:
Intel's Debt Issuance
Intel (INTC) recently announced it was issuing debt to finance a buyback.
Intel's $ 5 billion Bond Sale
Last week Intel issued 5, 10, and 30 year debt at an average rate of 3.35% (the after tax cost is even less when you consider the deductibility of interest). They can use those low cost funds (and their ample free cash flow) to buy back a stock with an after tax earnings yield north of 10%.
In this statement, the company said the proceeds will mainly be used to fund stock buybacks.
As it stands now, there's the potential for more situations like this.
A good thing for the long-term shareholder as long as the core business franchise has a reliable moat combined with a healthy balance sheet and the stock is, in fact, cheap.
Adam
Long positions in TOT, SNY, INTC
* Cheap valuation is just a starting point, of course. More research and due diligence is naturally always required.
** The market as a whole is not particularly inexpensive in my view. I'm talking about the mispricing of individual securities. Keep in mind, mispriced securities is a great thing for an individual long-term investor. While true at the individual level, a market system designed in a way that produces frequently mispriced assets doesn't serve its broader role for society very well. That broader role being, of course, the transfer of capital from investors to productive businesses that can provide a return on that capital long-term. How much in the current investing culture do you hear of about that role? I think it is pretty clear the answer is not much.
Here are some of the stocks* mentioned in the article.
-Telefonica (TEF)
P/E: 8.4, Dividend: 8.1%
-Total S.A. (TOT)
P/E: 6.2, Div: 6.9%
-Vodafone (VOD)
P/E: 9.6. Div: 5.4%
-Royal Dutch Shell (RDS.A)
P/E: 8.0, Div: 4.3%
-Sanofi (SNY)
P/E: 7.0, Div: 3.9%
-Novartis (NVS)
P/E: 10.1, Div: 3.6%
-Unilever (UN)
P/E: 13.4, Div: 3.3%
-Siemens (SI)
P/E: 8.9, Div: 2.8%
With the exception of Unilever, all the above have earnings yield (inverse P/E) exceeding 10% and, in the case of Total S.A., more than 15%.
Many large companies (whether in Europe or elsewhere) are tapping the bond market, raising low cost money, to make acquisitions or return cash to shareholders in the form of dividends and share repurchases.
In the month of September alone, there has been $ 40 billion of investment-grade debt offered so far.
The combination of low-cost borrowing and, at least in some cases, oddly undervalued shares of large capitalization businesses makes what is happening pretty inevitable.
It creates an excellent environment for the long-term investor.
Now, this past decade brought to the forefront how extremely overvalued assets produced in bubbles cause serious economic problems. Widespread mispricing and misallocation of capital leads to recession or worse.
What may be less obvious is that extremely undervalued equities can, at least in the short run, also hinder near term economic potential.
How?
Consider that in some cases the above is done in lieu of building plants or buying equipment...things that tend to lead to economic expansion and job creation. So at least the short run, these expansion opportunities becomes a relatively less attractive alternative when extremely low cost borrowing is available to a strong business with a cheap stock.
(Building factories, launching new businesses is not exactly easy. Plenty can go wrong. Buying back stock to generate something like a low risk 15% return for shareholders is a lot easier than building factories, launching new businesses, etc.).
In addition, a company in that situation will frequently be acting wisely if it uses a good chunk of its free cash flows for buybacks. This process should continue until the market adjusts price to something that more closely approximates intrinsic value (well, at least if management is tending to their capital allocation responsibilities).
Buying a company's own cheap stock is the right thing to do for corporate managers but, at least in the short or intermediate run, it produces at the margin somewhat less economic activity. Some might be tempted to "fix" this to somehow encourage growth.
That'd be a mistake. Capital allocators need to focus on deploying dollars based on their judgment of return potential relative to the risk being taken (especially when the opportunity happens to be something that management should understand best...the business they are running).
For the economy at large, clearly expansion by these businesses would be the more desirable outcome. So consider the following:
In a perfect situation capital markets** serve the world best when, more often than not, the prices of individual securities spend most of their time fluctuating around some reasonable estimate of intrinsic value.
Realistically, capital markets will always be sometimes manic other times depressed and prices inevitably will reflect emotions as much as logic and insight (things like efficient markets might suggest otherwise but that thinking is flawed at its core).
That is the nature of markets.
Knowing this, it seems clear they shouldn't be structured in a way that amplifies this nature.
In its current short-term hyperactive construct I'd say the markets do tend to amplify.
Extremely low valuations can, at least at the margin in the near term, delay or suppress an economic recovery (though I am far from suggesting this alone is at the root of our current weak economy). Still, there's no reason to change what amounts to rational corporate behavior.
Instead, it'd probably be better to get at the root of why our capital markets are going to extremes so frequently.
Maybe it is, at least in part, as Mason Hawkins and his colleagues suggest:
"Unintended, yet permitted advantages within market structure have come to dominate and overshadow the true intent of the capital markets - to facilitate the allocation of capital from investors to businesses. The market has become a servant to short-term professional traders..."
Capital Markets: An Overshadowed Servant to Traders?
So I doubt it comes down to any one thing but odds are good that what Hawkins is saying is a part of the problem. Developing a market structure (along with other incentives) that better supports a longer-term investing ethos in place of the existing hyperactive casino-oriented system would surely be a win.
So until an opportunity to expand becomes the best risk-adjusted use of capital for a good business, buybacks make sense if the stock is cheap, debt can be had at low cost, and the balance sheet is healthy. A recent example:
Intel's Debt Issuance
Intel (INTC) recently announced it was issuing debt to finance a buyback.
Intel's $ 5 billion Bond Sale
Last week Intel issued 5, 10, and 30 year debt at an average rate of 3.35% (the after tax cost is even less when you consider the deductibility of interest). They can use those low cost funds (and their ample free cash flow) to buy back a stock with an after tax earnings yield north of 10%.
In this statement, the company said the proceeds will mainly be used to fund stock buybacks.
As it stands now, there's the potential for more situations like this.
A good thing for the long-term shareholder as long as the core business franchise has a reliable moat combined with a healthy balance sheet and the stock is, in fact, cheap.
Adam
Long positions in TOT, SNY, INTC
* Cheap valuation is just a starting point, of course. More research and due diligence is naturally always required.
** The market as a whole is not particularly inexpensive in my view. I'm talking about the mispricing of individual securities. Keep in mind, mispriced securities is a great thing for an individual long-term investor. While true at the individual level, a market system designed in a way that produces frequently mispriced assets doesn't serve its broader role for society very well. That broader role being, of course, the transfer of capital from investors to productive businesses that can provide a return on that capital long-term. How much in the current investing culture do you hear of about that role? I think it is pretty clear the answer is not much.
Friday, September 16, 2011
Capital Markets: An Overshadowed Servant to Traders?
Unintended, yet permitted advantages within market structure have come to dominate and overshadow the true intent of the capital markets - to facilitate the allocation of capital from investors to businesses. The market has become a servant to short-term professional traders, in particular high-frequency traders ("HFT"). - Mason Hawkins of Southeastern Asset Management
With those thoughts as context, consider what John Bogle had to say in this The Motley Fool interview. In it, he explains why buying and holding is the winner's game and trading the loser's game.
Traders by definition bear the costs that goes to the intermediaries (croupiers) and achieve less collectively than the market return. Participants who buy and hold largely do not bear those costs and therefore capture the market return.
Now, check out this new survey on the impact of high frequency trading on the equities market:
Liquidnet's Institutional Voice Survey polled traders worldwide from Liquidnet's community of 630 institutional asset management firms. These firms collectively manage equity assets of more than $13 trillion.
Seth Merrin, Liquidnet's CEO said that:
"The survey reveals that there is strong conviction among the vast majority of long-only traders that HFT is a negative for institutional investors trading in large size..."
Merrin also said:
"Investors are clearly concerned that their long-term investment styles are at odds with the speculative, nano-second profit taking approach utilized by high frequency traders."
According to independent industry research analysts Aite Group and Tabb Group something like 75 percent of daily trading in equities comes from high frequency.
So we've got the machines trading back and forth all day. Even if most HFT practices are legit the question remains how is any of this useful? The SEC is, in fact, currently reviewing some of the high frequency trading practices that...
...if executed in slower motion by conventional traders, would look a lot like front running, bid fishing or other practices that have long been banned by leading stock exchanges. - from the latest Davis Funds Semi-Annual Review
Below is a continuation of the excerpt I opened this post with from a letter to the SEC written by Mason Hawkins and colleagues regarding HFT (a letter well worth a full read for background):
The market has become a servant to short-term professional traders, in particular high-frequency traders ("HFT"). As a result, the long-term investor - whether an individual, mutual fund, or hedge fund - incurs unnecessary execution and opportunity costs when allocating capital to businesses. Unfair competition and structurally advantaged short-term professional traders ultimately prevent the markets from reaching their end goal. If obfuscation clouds public debate and sidelines reform, many confidences that bona fide investors have in the capital markets may be irreparably harmed.
The argument for change is predicated upon several fundamental premises:
1. The markets do not exist as an end in and of themselves;
2. The markets exist to facilitate capital allocation, transferring capital from investors to productive businesses that can provide a return on that capital;
3. "Trading efficiency" as defined by HFTs (e.g. increased speed, increased "liquidity", price "improvement") is not straightforward, nor is it an end, and has merit only if it improves the capital allocation process;
4. Practices that implicitly "tax" the allocation of capital or result in investing
inefficiencies must be eliminated; and
5. Markets should be fair, open, and accessible to all with the first obligation being to
uphold the interests of long-term investor.
How all this activity benefits anyone beyond high frequency traders and the exchanges is beyond me.
Charlie Munger says it best...
Fancy computers are engaging in legalized front-running. The profits are clearly coming from the rest of us -- our college endowments and our pensions. Why is this legal? What the hell is the government thinking? It's like letting rats into a restaurant. - Charlie Munger
Charlie Munger's Thoughts on the World: Part 1
It's not exactly just some academic problem. These weaknesses are costly and will become even more so over the longer haul. It makes no sense to allow HFT and other short-term oriented behaviors to continue to tax and infect the capital allocation process.
Allocating capital has historically been a strength of the United States. It's a role fundamental to wealth creation and ultimately raising standards of living that's too important to not reform.
Adam
With those thoughts as context, consider what John Bogle had to say in this The Motley Fool interview. In it, he explains why buying and holding is the winner's game and trading the loser's game.
Traders by definition bear the costs that goes to the intermediaries (croupiers) and achieve less collectively than the market return. Participants who buy and hold largely do not bear those costs and therefore capture the market return.
Now, check out this new survey on the impact of high frequency trading on the equities market:
Liquidnet's Institutional Voice Survey polled traders worldwide from Liquidnet's community of 630 institutional asset management firms. These firms collectively manage equity assets of more than $13 trillion.
Seth Merrin, Liquidnet's CEO said that:
"The survey reveals that there is strong conviction among the vast majority of long-only traders that HFT is a negative for institutional investors trading in large size..."
Merrin also said:
"Investors are clearly concerned that their long-term investment styles are at odds with the speculative, nano-second profit taking approach utilized by high frequency traders."
According to independent industry research analysts Aite Group and Tabb Group something like 75 percent of daily trading in equities comes from high frequency.
So we've got the machines trading back and forth all day. Even if most HFT practices are legit the question remains how is any of this useful? The SEC is, in fact, currently reviewing some of the high frequency trading practices that...
...if executed in slower motion by conventional traders, would look a lot like front running, bid fishing or other practices that have long been banned by leading stock exchanges. - from the latest Davis Funds Semi-Annual Review
Below is a continuation of the excerpt I opened this post with from a letter to the SEC written by Mason Hawkins and colleagues regarding HFT (a letter well worth a full read for background):
The market has become a servant to short-term professional traders, in particular high-frequency traders ("HFT"). As a result, the long-term investor - whether an individual, mutual fund, or hedge fund - incurs unnecessary execution and opportunity costs when allocating capital to businesses. Unfair competition and structurally advantaged short-term professional traders ultimately prevent the markets from reaching their end goal. If obfuscation clouds public debate and sidelines reform, many confidences that bona fide investors have in the capital markets may be irreparably harmed.
The argument for change is predicated upon several fundamental premises:
1. The markets do not exist as an end in and of themselves;
2. The markets exist to facilitate capital allocation, transferring capital from investors to productive businesses that can provide a return on that capital;
3. "Trading efficiency" as defined by HFTs (e.g. increased speed, increased "liquidity", price "improvement") is not straightforward, nor is it an end, and has merit only if it improves the capital allocation process;
4. Practices that implicitly "tax" the allocation of capital or result in investing
inefficiencies must be eliminated; and
5. Markets should be fair, open, and accessible to all with the first obligation being to
uphold the interests of long-term investor.
How all this activity benefits anyone beyond high frequency traders and the exchanges is beyond me.
Charlie Munger says it best...
Fancy computers are engaging in legalized front-running. The profits are clearly coming from the rest of us -- our college endowments and our pensions. Why is this legal? What the hell is the government thinking? It's like letting rats into a restaurant. - Charlie Munger
Charlie Munger's Thoughts on the World: Part 1
It's not exactly just some academic problem. These weaknesses are costly and will become even more so over the longer haul. It makes no sense to allow HFT and other short-term oriented behaviors to continue to tax and infect the capital allocation process.
Allocating capital has historically been a strength of the United States. It's a role fundamental to wealth creation and ultimately raising standards of living that's too important to not reform.
Adam
Thursday, September 15, 2011
Davis New York Venture Fund Update: Financial Innovation, Fishing Tackle, Destructive Investor Tendencies, Equities, & Bonds
Some excerpts from the latest Davis Funds Semi-Annual Review:
Davis New York Venture Fund Top Five Holdings: American Express (AXP), Costco (COST), Bank of New York Mellon (BK), Occidental Petroleum (OXY), and Wells Fargo (WFC).
Financial Innovation
...the fact that successful investors are constantly adapting to new information does not mean that the underlying principles of economics and investing are called into question or that common sense has been repealed. While we have our biases, it seems to us that many of today's "innovations" are simply ways for promoters of one type or another to generate more transactions, charge higher fees or simply make more money at the expense of the investing public.
Well, it's usually either a way to generate fees or a new form of leverage in some new form. From John Kenneth Galbraith's book, A Short History of Financial Euphoria:
"The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets." - John Kenneth Galbraith
More from the Semi-Annual Review...
Fishing Tackle
..hucksters market so-called "tools" and "strategies" for trading stocks, options, ETFs, commodities, and more. What these tools and strategies have in common is that the people selling them will get paid whether the buyer makes or loses money. Get-rich-quick schemes and day trading strategies in which promoters capitalize on hopes, dreams and greed are nothing new. Investors would do well to remember Charlie Munger's wonderful story in which he says "I think the reason that there is such idiocy is best illustrated by a story I tell about the guy who sold fishing tackle. I asked him, 'My God, they're purple and green. Do fish really take these lures?' And he said, 'Mister, I don't sell to fish.'"
A study* was published this year by professors at Harvard and Emory. It concluded that the "timing and selection penalty" cost hedge fund investors 3% to 7% per year from 1980 to 2008. These destructive investor tendencies come from chasing performance:
Timing and Selection Penalty
According to the study, "We find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns [earned by hedge-fund investors] are reliably lower than the return of the S&P 500® Index and are only marginally higher than the risk-free rate…
On Equities
...we think long-term investing in a carefully constructed portfolio of high quality equities is still the best way to build and protect wealth over decades. We would even argue that the very fact that it has become unfashionable increases the likelihood of a satisfactory outcome given that investment fads are a notoriously reliable contrary indicator.
Bonds = "Return-free Risk"
...it seems certain that a significant amount of optimism and euphoria is incorporated in bond prices, presaging the likely demise of the long bull market in bonds. My grandfather Shelby Cullom Davis referred to bonds as "certificates of confiscation."
His dislike of bonds stemmed from the fact that for almost three decades ending in 1982, investors in bonds lost money on an inflation adjusted basis. While it is impossible to predict the short-term direction of interest rates, the fact that they are close to their historic lows at a time when deficits and commodity prices are soaring makes it almost certain the long-term direction will be up. To use Jim Grant's phrase, at today's prices, bonds represent "return-free risk."
I've always liked Paul Volcker's quip late in 2009 that automatic telling machines were the "single most important contribution" in the past 25 years because, unlike most financial innovation, at least they're "useful".
ATMs the Peak of Financial Innovation
Now, these new innovative tools and strategies peddled on the business news networks seemingly all day long no doubt benefit those who are selling them.
Whether they actually benefit the individual investor remains to be seen. I'm skeptical to say the least.
The "timing and selection penalty" noted above must be one of the costliest behavioral patterns in investing.
It continues to amaze that, often en masse, investors have this reliable pattern of buying large amounts of an asset class when it becomes popular (usually near the top) while avoiding buying the unpopular ones (near the bottom).
It's worth mentioning that Isaac Newton fell prey to this very pattern during the South Sea Bubble. So it's certainly not a lack of IQ that gets investors in trouble.
Isaac Newton's Nightmare
Here's essentially what happened:
- Newton invests a small amount prior to the bubble
- Newton exits happy in the early stages before the bubble really gets going having made some money
- Newton sees his friends getting rich as the bubble does really get going
- So Newton re-enters near the peak of the bubble with a lot of money
Then, of course...
- Newton exits broke after the stock then falls roughly back to where he had initially invested just a small amount of money
Previous post: Isaac Newton, The Investor
Assets not in vogue are more likely to have prices that provide an investor the crucial margin of safety or discount to value that is needed to manage risk.
So it would seem to be pretty straightforward then that investors would not generally get adequate compensation for the risks being taken when something is all the rage.
These days, things like bonds and gold most certainly seem very popular.
Equities, at least some of them, not so much.
That, of course, does not mean equity prices won't go down even further in the short or even intermediate run.
In fact, Jeremy Grantham points out that sensible value investors tend to "...buy too early in busts" and this post (Buffett Buys "Too Early", Again) covers how historically Buffett has, at times, done just that.
Still, buying a sound asset that you understand at a discount when out of favor improves the probability of attractive long run returns relative to the risks involved.
Adam
* Dichev, Ilia D. and Yu, Gwen, Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn (July 1, 2009). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN:http://ssrn.com/abstract=1354070
Davis New York Venture Fund Top Five Holdings: American Express (AXP), Costco (COST), Bank of New York Mellon (BK), Occidental Petroleum (OXY), and Wells Fargo (WFC).
Financial Innovation
...the fact that successful investors are constantly adapting to new information does not mean that the underlying principles of economics and investing are called into question or that common sense has been repealed. While we have our biases, it seems to us that many of today's "innovations" are simply ways for promoters of one type or another to generate more transactions, charge higher fees or simply make more money at the expense of the investing public.
Well, it's usually either a way to generate fees or a new form of leverage in some new form. From John Kenneth Galbraith's book, A Short History of Financial Euphoria:
"The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets." - John Kenneth Galbraith
More from the Semi-Annual Review...
Fishing Tackle
..hucksters market so-called "tools" and "strategies" for trading stocks, options, ETFs, commodities, and more. What these tools and strategies have in common is that the people selling them will get paid whether the buyer makes or loses money. Get-rich-quick schemes and day trading strategies in which promoters capitalize on hopes, dreams and greed are nothing new. Investors would do well to remember Charlie Munger's wonderful story in which he says "I think the reason that there is such idiocy is best illustrated by a story I tell about the guy who sold fishing tackle. I asked him, 'My God, they're purple and green. Do fish really take these lures?' And he said, 'Mister, I don't sell to fish.'"
A study* was published this year by professors at Harvard and Emory. It concluded that the "timing and selection penalty" cost hedge fund investors 3% to 7% per year from 1980 to 2008. These destructive investor tendencies come from chasing performance:
Timing and Selection Penalty
According to the study, "We find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns [earned by hedge-fund investors] are reliably lower than the return of the S&P 500® Index and are only marginally higher than the risk-free rate…
On Equities
...we think long-term investing in a carefully constructed portfolio of high quality equities is still the best way to build and protect wealth over decades. We would even argue that the very fact that it has become unfashionable increases the likelihood of a satisfactory outcome given that investment fads are a notoriously reliable contrary indicator.
Bonds = "Return-free Risk"
...it seems certain that a significant amount of optimism and euphoria is incorporated in bond prices, presaging the likely demise of the long bull market in bonds. My grandfather Shelby Cullom Davis referred to bonds as "certificates of confiscation."
His dislike of bonds stemmed from the fact that for almost three decades ending in 1982, investors in bonds lost money on an inflation adjusted basis. While it is impossible to predict the short-term direction of interest rates, the fact that they are close to their historic lows at a time when deficits and commodity prices are soaring makes it almost certain the long-term direction will be up. To use Jim Grant's phrase, at today's prices, bonds represent "return-free risk."
I've always liked Paul Volcker's quip late in 2009 that automatic telling machines were the "single most important contribution" in the past 25 years because, unlike most financial innovation, at least they're "useful".
ATMs the Peak of Financial Innovation
Now, these new innovative tools and strategies peddled on the business news networks seemingly all day long no doubt benefit those who are selling them.
Whether they actually benefit the individual investor remains to be seen. I'm skeptical to say the least.
The "timing and selection penalty" noted above must be one of the costliest behavioral patterns in investing.
It continues to amaze that, often en masse, investors have this reliable pattern of buying large amounts of an asset class when it becomes popular (usually near the top) while avoiding buying the unpopular ones (near the bottom).
It's worth mentioning that Isaac Newton fell prey to this very pattern during the South Sea Bubble. So it's certainly not a lack of IQ that gets investors in trouble.
Isaac Newton's Nightmare
Here's essentially what happened:
- Newton invests a small amount prior to the bubble
- Newton exits happy in the early stages before the bubble really gets going having made some money
- Newton sees his friends getting rich as the bubble does really get going
- So Newton re-enters near the peak of the bubble with a lot of money
Then, of course...
- Newton exits broke after the stock then falls roughly back to where he had initially invested just a small amount of money
Previous post: Isaac Newton, The Investor
Assets not in vogue are more likely to have prices that provide an investor the crucial margin of safety or discount to value that is needed to manage risk.
So it would seem to be pretty straightforward then that investors would not generally get adequate compensation for the risks being taken when something is all the rage.
These days, things like bonds and gold most certainly seem very popular.
Equities, at least some of them, not so much.
That, of course, does not mean equity prices won't go down even further in the short or even intermediate run.
In fact, Jeremy Grantham points out that sensible value investors tend to "...buy too early in busts" and this post (Buffett Buys "Too Early", Again) covers how historically Buffett has, at times, done just that.
Still, buying a sound asset that you understand at a discount when out of favor improves the probability of attractive long run returns relative to the risks involved.
Adam
* Dichev, Ilia D. and Yu, Gwen, Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn (July 1, 2009). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN:http://ssrn.com/abstract=1354070
Wednesday, September 14, 2011
Buffett & Munger on Berkshire's Stock
From this Bloomberg article:
Buffett can't get analysts to say buy Berkshire
Warren Buffett's Berkshire Hathaway Inc. (BRK/A) can't get a buy recommendation from equity analysts, even as it trades in New York at the cheapest price relative to book value since March 2009.
I think the best quote award goes to the analyst in the article who said the following:
"It's the cheapest that I've seen it in a while," said Tom Lewandowski, an analyst with Edward Jones & Co., who has a "hold" rating on Berkshire shares. "It's hard for me to get really positive on that."
Geez. What would it take to get positive? For it to be more expensive than it has been in a while?
From the 1988 Berkshire Hathaway Shareholder Letter:
...we do not want to maximize the price at which Berkshire shares trade. We wish instead for them to trade in a narrow range centered at intrinsic business value (which we hope increases at a reasonable - or, better yet, unreasonable - rate).
The article goes on to point out that Berkshire is of little interest to brokerages and research firms because its trading volume is low then references this comment by Buffett from the 1988 letter (I've included a slightly longer excerpt from the letter than the one used in the article):
...we wish for very little trading activity. If we ran a private business with a few passive partners, we would be disappointed if those partners, and their replacements, frequently wanted to leave the partnership. Running a public company, we feel the same way.
Our goal is to attract long-term owners who, at the time of purchase, have no timetable or price target for sale but plan instead to stay with us indefinitely. We don't understand the CEO who wants lots of stock activity, for that can be achieved only if many of his owners are constantly exiting. At what other organization - school, club, church, etc. - do leaders cheer when members leave?
It also mentions Munger's comment at the final Wesco Financial annual meeting in July that "Berkshire stock went to a price we never thought..."
At that same meeting Munger also said the following:
Investors owning Berkshire at current prices will do quite all right just sitting on their rear ends.
The Class A shares traded between $115,230 and $117,250 on that day. The Bloomberg article also points out:
Buffett said on Jan. 20, 2010, that Berkshire was "undervalued" in the market. That day, Class A shares traded between $100,000 and $105,001.
As I write this, the Class A shares currently trades at $ 102,300/share.
It's at least notable that Munger and Buffett would even comment on Berkshire's stock (never mind say or imply that it is cheap). They are not exactly known for pumping Berkshire's stock in the past.
Actually they have historically done very much the opposite.
Adam
Long BRKb
Buffett can't get analysts to say buy Berkshire
Warren Buffett's Berkshire Hathaway Inc. (BRK/A) can't get a buy recommendation from equity analysts, even as it trades in New York at the cheapest price relative to book value since March 2009.
I think the best quote award goes to the analyst in the article who said the following:
"It's the cheapest that I've seen it in a while," said Tom Lewandowski, an analyst with Edward Jones & Co., who has a "hold" rating on Berkshire shares. "It's hard for me to get really positive on that."
Geez. What would it take to get positive? For it to be more expensive than it has been in a while?
From the 1988 Berkshire Hathaway Shareholder Letter:
...we do not want to maximize the price at which Berkshire shares trade. We wish instead for them to trade in a narrow range centered at intrinsic business value (which we hope increases at a reasonable - or, better yet, unreasonable - rate).
The article goes on to point out that Berkshire is of little interest to brokerages and research firms because its trading volume is low then references this comment by Buffett from the 1988 letter (I've included a slightly longer excerpt from the letter than the one used in the article):
...we wish for very little trading activity. If we ran a private business with a few passive partners, we would be disappointed if those partners, and their replacements, frequently wanted to leave the partnership. Running a public company, we feel the same way.
Our goal is to attract long-term owners who, at the time of purchase, have no timetable or price target for sale but plan instead to stay with us indefinitely. We don't understand the CEO who wants lots of stock activity, for that can be achieved only if many of his owners are constantly exiting. At what other organization - school, club, church, etc. - do leaders cheer when members leave?
It also mentions Munger's comment at the final Wesco Financial annual meeting in July that "Berkshire stock went to a price we never thought..."
At that same meeting Munger also said the following:
Investors owning Berkshire at current prices will do quite all right just sitting on their rear ends.
The Class A shares traded between $115,230 and $117,250 on that day. The Bloomberg article also points out:
Buffett said on Jan. 20, 2010, that Berkshire was "undervalued" in the market. That day, Class A shares traded between $100,000 and $105,001.
As I write this, the Class A shares currently trades at $ 102,300/share.
It's at least notable that Munger and Buffett would even comment on Berkshire's stock (never mind say or imply that it is cheap). They are not exactly known for pumping Berkshire's stock in the past.
Actually they have historically done very much the opposite.
Adam
Long BRKb
Tuesday, September 13, 2011
Buffett Buys "Too Early", Again
It's worth noting that Berkshire Hathaway (BRKa) bought more common stocks in the most recent reported quarter than any quarter since the 3rd quarter of 2008.
Berkshire bought $ 3.6 billion of stock in the most recent quarter. The last time he bought more was in the third quarter of 2008.
Bloomberg:
Buffett Bet on Stocks Before Rout by Spending Most Since 2008
For the first time since 2009, equities exceeded fixed-income purchases. Back in 2008, it turns out Buffett was buying "too early" as stocks would go on to drop even more.
Well, Berkshire's most recent 2nd quarter 2011 buying spree was completed before many stocks recently took a further beating.
If you look closely at Buffett's history you'll see this buying "too early" (and selling "too early" at times for that matter) behavior is far from unusual.
Some seem to think otherwise.
Here's one example. It is an excerpt from this 2001 Fortune article by Buffett:
Previous post: Buffett: The Disguised Bond
In 1979, when I felt stocks were a screaming buy, I wrote in an article, "Pension fund managers continue to make investment decisions with their eyes firmly fixed on the rear-view mirror. This generals-fighting-the-last-war approach has proved costly in the past and will likely prove equally costly this time around." That's true, I said, because "stocks now sell at levels that should produce long-term returns far superior to bonds."
Later in that article Buffett continued with...
Now, if you had read that article in 1979, you would have suffered--oh, how you would have suffered!--for about three years. I was no good then at forecasting the near-term movements of stock prices, and I'm no good now. I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.
But I think it is very easy to see what is likely to happen over the long term.
In his 1965 Partnership Letter, Buffett explains that in a well-selected concentrated portfolio "the chance of serious permanent loss of capital is minimal", but makes the point that "anything can happen on a short-term quotational basis".
So, in the long run, a concentrated portfolio has a better chance to produce above average results if shares are bought at a sufficient discount to value and intrinsic value* is estimated reasonably well. That doesn't mean that on a "quotational basis" things won't look ugly for quite a while. Things that get cheap tend to get more cheap (just as overvalued businesses in the late 1990s got even more overvalued).
The key is conviction. If an investor lacks conviction in the price paid relative to value it will likely become impossible to handle the sometimes not all that temporary (especially by the hyperactive trading standards these days) paper losses.
Portfolio concentration and sometimes buying "too early" means short-to-intermediate-term results will bounce around more. Some would say that makes the portfolio more risky.
The tendency toward what may seem extreme concentration is the Buffett way.
"The strategy we've adopted precludes our following standard diversification dogma...We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett
1993 Berkshire Hathaway Shareholder Letter
Superior performance at lower risk from: 1) intrinsic value being judged consistently well, 2) shares bought at the largest possible discount to that value (conservatively estimated), and 3) a concentration on one's best ideas.
Doing these things in combination is a simple idea that, in the real world, is just not that easy to do. It's less to do with intellect and more about having the right temperament and discipline.
These days the size of Berkshire prevents the same kind of portfolio concentration that Buffett used to employ. Still, consider that two stocks, Coca-Cola (KO) and Wells Fargo (WFC), typically still make up roughly 30-35% of the current equity portfolio.
Adam
* There is no such thing as a precise intrinsic value. It's really an approximation or estimated range of value.
Berkshire bought $ 3.6 billion of stock in the most recent quarter. The last time he bought more was in the third quarter of 2008.
Bloomberg:
Buffett Bet on Stocks Before Rout by Spending Most Since 2008
For the first time since 2009, equities exceeded fixed-income purchases. Back in 2008, it turns out Buffett was buying "too early" as stocks would go on to drop even more.
Well, Berkshire's most recent 2nd quarter 2011 buying spree was completed before many stocks recently took a further beating.
If you look closely at Buffett's history you'll see this buying "too early" (and selling "too early" at times for that matter) behavior is far from unusual.
Some seem to think otherwise.
Here's one example. It is an excerpt from this 2001 Fortune article by Buffett:
Previous post: Buffett: The Disguised Bond
In 1979, when I felt stocks were a screaming buy, I wrote in an article, "Pension fund managers continue to make investment decisions with their eyes firmly fixed on the rear-view mirror. This generals-fighting-the-last-war approach has proved costly in the past and will likely prove equally costly this time around." That's true, I said, because "stocks now sell at levels that should produce long-term returns far superior to bonds."
Later in that article Buffett continued with...
Now, if you had read that article in 1979, you would have suffered--oh, how you would have suffered!--for about three years. I was no good then at forecasting the near-term movements of stock prices, and I'm no good now. I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.
But I think it is very easy to see what is likely to happen over the long term.
In his 1965 Partnership Letter, Buffett explains that in a well-selected concentrated portfolio "the chance of serious permanent loss of capital is minimal", but makes the point that "anything can happen on a short-term quotational basis".
So, in the long run, a concentrated portfolio has a better chance to produce above average results if shares are bought at a sufficient discount to value and intrinsic value* is estimated reasonably well. That doesn't mean that on a "quotational basis" things won't look ugly for quite a while. Things that get cheap tend to get more cheap (just as overvalued businesses in the late 1990s got even more overvalued).
The key is conviction. If an investor lacks conviction in the price paid relative to value it will likely become impossible to handle the sometimes not all that temporary (especially by the hyperactive trading standards these days) paper losses.
Portfolio concentration and sometimes buying "too early" means short-to-intermediate-term results will bounce around more. Some would say that makes the portfolio more risky.
The tendency toward what may seem extreme concentration is the Buffett way.
"The strategy we've adopted precludes our following standard diversification dogma...We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett
1993 Berkshire Hathaway Shareholder Letter
Superior performance at lower risk from: 1) intrinsic value being judged consistently well, 2) shares bought at the largest possible discount to that value (conservatively estimated), and 3) a concentration on one's best ideas.
Doing these things in combination is a simple idea that, in the real world, is just not that easy to do. It's less to do with intellect and more about having the right temperament and discipline.
These days the size of Berkshire prevents the same kind of portfolio concentration that Buffett used to employ. Still, consider that two stocks, Coca-Cola (KO) and Wells Fargo (WFC), typically still make up roughly 30-35% of the current equity portfolio.
Adam
* There is no such thing as a precise intrinsic value. It's really an approximation or estimated range of value.
Monday, September 12, 2011
Diageo's Global Franchise
David Herro, Morningstar's International Stock Fund Manager of the Decade, said the following about Diageo (DEO) in this interview:
"There is one nice, stable, well-managed company that at this stage does not appear very expensive, and it's a stock you could hold for a long, long time, unless it spikes way up. Again, you cannot forget price. That stock is Diageo (DEO). It is the world's largest drinks company."
Then later he added...
"...the profit dynamics of this business are great. It's extremely well managed. Remember my two criteria of a quality business: the return structure, and are they good at allocating capital. This company strongly ticks both of those boxes, and at the same time today you could buy at a relatively low valuation somewhere around ten times gross cash flow. So if you get a good quality company that has moderate long-term growth prospects, low financial risk, unless you believe we're going to have global prohibition, this is going to be a very good stock to own."
In the 1991 Berkshire Hathaway(BRKa) Shareholder Letter, Guinness was revealed as a holding for the first time.
These days, Guinness is one of the many leading global brands of Diageo.
From the 1991 Berkshire Hathaway (BRKa) Shareholder Letter:
Our Guinness holding represents Berkshire's first significant investment in a company domiciled outside the United States. Guinness, however, earns its money in much the same fashion as Coca-Cola and Gillette, U.S.-based companies that garner most of their profits from international operations. Indeed, in the sense of where they earn their profits - continent-by-continent - Coca- Cola and Guinness display strong similarities. (But you'll never get their drinks confused - and your Chairman remains unmovably in the Cherry Coke camp.)
We continually search for large businesses with understandable, enduring and mouth-watering economics that are run by able and shareholder-oriented managements. This focus doesn't guarantee results: We both have to buy at a sensible price and get business performance from our companies that validates our assessment. But this investment approach - searching for the superstars - offers us our only chance for real success. Charlie and I are simply not smart enough, considering the large sums we work with, to get great results by adroitly buying and selling portions of far-from-great businesses. Nor do we think many others can achieve long-term investment success by flitting from flower to flower.
Diageo's strategic brands include the likes of: Johnnie Walker, Smirnoff, Ketel One, Baileys, Captain Morgan, Jose Cuervo, Tanguerey, Guinness, Crown Royal, and J&B.
Diageo was first mentioned on this blog, as part of the six stock portfolio*, as a business with an attractive share price when it was selling at around $ 45/share. At that price it sported a dividend of around 5%. The current price is more like $ 76.
It's still a terrific franchise with intrinsic value that should grow nicely over time but the stock is a lot less interesting at current prices.
More from Buffett's 1991 letter:
If my universe of business possibilities was limited, say, to private companies in Omaha, I would, first, try to assess the long- term economic characteristics of each business; second, assess the quality of the people in charge of running it; and, third, try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town. Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies? And since finding great businesses and outstanding managers is so difficult, why should we discard proven products? (I was tempted to say "the real thing.") Our motto is: "If at first you do succeed, quit trying."
John Maynard Keynes, whose brilliance as a practicing investor matched his brilliance in thought, wrote a letter to a business associate, F. C. Scott, on August 15, 1934 that says it all: "As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. . . .One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence."
Diageo has many great qualities but, unlike Herro, I think it is a bit expensive now.
Recently, Diageo participated in the Barclays Back To School Consumer Conference.
Here's an article with some notes from that conference.
Adam
*The six stock portfolio is up 67% compared to 37% for the S&P 500 over the same time period (including dividends for both the portfolio and the benchmark). There was no trading over that time frame. The portfolio is simply six good businesses bought at discounts to value with the intention of very long-term ownership. The economics of these businesses (bought with a margin of safety to account for unknowables) will generally drive returns over time...not trading skills. It's intentionally concentrated. Will rarely sell one of these if something materially damages one of these franchises long run viability or if opportunity cost becomes very high.
"There is one nice, stable, well-managed company that at this stage does not appear very expensive, and it's a stock you could hold for a long, long time, unless it spikes way up. Again, you cannot forget price. That stock is Diageo (DEO). It is the world's largest drinks company."
Then later he added...
"...the profit dynamics of this business are great. It's extremely well managed. Remember my two criteria of a quality business: the return structure, and are they good at allocating capital. This company strongly ticks both of those boxes, and at the same time today you could buy at a relatively low valuation somewhere around ten times gross cash flow. So if you get a good quality company that has moderate long-term growth prospects, low financial risk, unless you believe we're going to have global prohibition, this is going to be a very good stock to own."
In the 1991 Berkshire Hathaway(BRKa) Shareholder Letter, Guinness was revealed as a holding for the first time.
These days, Guinness is one of the many leading global brands of Diageo.
From the 1991 Berkshire Hathaway (BRKa) Shareholder Letter:
Our Guinness holding represents Berkshire's first significant investment in a company domiciled outside the United States. Guinness, however, earns its money in much the same fashion as Coca-Cola and Gillette, U.S.-based companies that garner most of their profits from international operations. Indeed, in the sense of where they earn their profits - continent-by-continent - Coca- Cola and Guinness display strong similarities. (But you'll never get their drinks confused - and your Chairman remains unmovably in the Cherry Coke camp.)
We continually search for large businesses with understandable, enduring and mouth-watering economics that are run by able and shareholder-oriented managements. This focus doesn't guarantee results: We both have to buy at a sensible price and get business performance from our companies that validates our assessment. But this investment approach - searching for the superstars - offers us our only chance for real success. Charlie and I are simply not smart enough, considering the large sums we work with, to get great results by adroitly buying and selling portions of far-from-great businesses. Nor do we think many others can achieve long-term investment success by flitting from flower to flower.
Diageo's strategic brands include the likes of: Johnnie Walker, Smirnoff, Ketel One, Baileys, Captain Morgan, Jose Cuervo, Tanguerey, Guinness, Crown Royal, and J&B.
Diageo was first mentioned on this blog, as part of the six stock portfolio*, as a business with an attractive share price when it was selling at around $ 45/share. At that price it sported a dividend of around 5%. The current price is more like $ 76.
It's still a terrific franchise with intrinsic value that should grow nicely over time but the stock is a lot less interesting at current prices.
More from Buffett's 1991 letter:
If my universe of business possibilities was limited, say, to private companies in Omaha, I would, first, try to assess the long- term economic characteristics of each business; second, assess the quality of the people in charge of running it; and, third, try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town. Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies? And since finding great businesses and outstanding managers is so difficult, why should we discard proven products? (I was tempted to say "the real thing.") Our motto is: "If at first you do succeed, quit trying."
John Maynard Keynes, whose brilliance as a practicing investor matched his brilliance in thought, wrote a letter to a business associate, F. C. Scott, on August 15, 1934 that says it all: "As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. . . .One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence."
Diageo has many great qualities but, unlike Herro, I think it is a bit expensive now.
Recently, Diageo participated in the Barclays Back To School Consumer Conference.
Here's an article with some notes from that conference.
Adam
*The six stock portfolio is up 67% compared to 37% for the S&P 500 over the same time period (including dividends for both the portfolio and the benchmark). There was no trading over that time frame. The portfolio is simply six good businesses bought at discounts to value with the intention of very long-term ownership. The economics of these businesses (bought with a margin of safety to account for unknowables) will generally drive returns over time...not trading skills. It's intentionally concentrated. Will rarely sell one of these if something materially damages one of these franchises long run viability or if opportunity cost becomes very high.
Friday, September 9, 2011
Skeptical Bogle
From a Fox Business interview with Jack Bogle back in May. He makes the following points:
- Odds are good stocks will beat bonds.
- Wall Street has changed...not for the better.
- It's a speculative culture.
- Investments are no longer the star of the show... they're now in a cameo role.
...we've changed from a financial industry that was about stewardship for the small investor to it being all about marketing, selling and speculating. And that leads the average investor down the wrong path.
What's important to note is that the stock market doesn't create value -- companies create value.
He says Mutual Funds, unfortunately, have joined the speculative game and, as a result, care a lot less about the corporate governance of the companies they own. Why care if you're just going to sell in days or weeks? That hurts the long-term business performance and, of course, ultimately stock performance.
...investors don't have to play this game of speculation. That's why we have the index fund, which is an obvious idea, the idea of owning the entire stock market. Your investment is the intrinsic value of U.S. corporations -- that is where returns really get created.
Check out the full interview here.
Adam
- Odds are good stocks will beat bonds.
- Wall Street has changed...not for the better.
- It's a speculative culture.
- Investments are no longer the star of the show... they're now in a cameo role.
...we've changed from a financial industry that was about stewardship for the small investor to it being all about marketing, selling and speculating. And that leads the average investor down the wrong path.
What's important to note is that the stock market doesn't create value -- companies create value.
He says Mutual Funds, unfortunately, have joined the speculative game and, as a result, care a lot less about the corporate governance of the companies they own. Why care if you're just going to sell in days or weeks? That hurts the long-term business performance and, of course, ultimately stock performance.
...investors don't have to play this game of speculation. That's why we have the index fund, which is an obvious idea, the idea of owning the entire stock market. Your investment is the intrinsic value of U.S. corporations -- that is where returns really get created.
Check out the full interview here.
Adam
Thursday, September 8, 2011
Facebook's 1st Half Revenue Doubles to $ 1.6 Billion (GOOG, DELL, CSCO, MSFT, AAPL)
This Reuters article says Facebook's revenue doubled to $ 1.6 billion in the 1st half of 2011.
Net income was almost $ 500 million over the same period.
Estimates of the previous year's earnings have ranged from $ 400-600 million so it appears that Facebook has roughly doubled its earning power year over year.
Some expect when Facebook goes public early next year its valuation will approach $ 100 billion.
From this previous post:
Is Facebook Worth $ 100 billion?
To put that $ 100 billion valuation of Facebook in perspective, the combined enterprise value* of Dell (DELL) and Cisco (CSCO) is ~$ 80 billion.
Combined current earnings of Dell and Cisco: ~$ 12 billion
So a 6.7x multiple of earnings.
Facebook's estimated earnings: ~$ 1 billion
A 100x multiple.
Clearly, Facebook's growth rate may ultimately cause that expected $ 100 billion to make sense but investors early next year will initially be paying a lot for promise.
I realize that comparing two mature tech companies to something as glossy, new, and full of potential like Facebook probably seems like apples to oranges. The type of investor who will buy a Facebook is no doubt very different from the one who'll buy some low multiple old tech company.
The same would be true for something like Microsoft (MSFT).
What's more difficult to explain is Apple (AAPL). Much like Facebook, that company is also growing extremely quickly, has tremendous economics (extremely high return on capital), $ 76 billion of cash, yet sells for just 11-12x** the $ 25 billion or so it will earn this year.
Why pay 100x for a fast growing leader in its space when another is selling for just 11-12x?
Adam
* Enterprise Value = Market Capitalization - Net Cash.
**Apple's market capitalization is $ 356 billion. Subtract the $ 76 billion of cash and investments and you get an enterprise value of $ 280 billion. Enterprise Value/Earnings = $ 280 billion/$ 25 billion = 11.2x
Net income was almost $ 500 million over the same period.
Estimates of the previous year's earnings have ranged from $ 400-600 million so it appears that Facebook has roughly doubled its earning power year over year.
Some expect when Facebook goes public early next year its valuation will approach $ 100 billion.
From this previous post:
Is Facebook Worth $ 100 billion?
To put that $ 100 billion valuation of Facebook in perspective, the combined enterprise value* of Dell (DELL) and Cisco (CSCO) is ~$ 80 billion.
Combined current earnings of Dell and Cisco: ~$ 12 billion
So a 6.7x multiple of earnings.
Facebook's estimated earnings: ~$ 1 billion
A 100x multiple.
Clearly, Facebook's growth rate may ultimately cause that expected $ 100 billion to make sense but investors early next year will initially be paying a lot for promise.
I realize that comparing two mature tech companies to something as glossy, new, and full of potential like Facebook probably seems like apples to oranges. The type of investor who will buy a Facebook is no doubt very different from the one who'll buy some low multiple old tech company.
The same would be true for something like Microsoft (MSFT).
What's more difficult to explain is Apple (AAPL). Much like Facebook, that company is also growing extremely quickly, has tremendous economics (extremely high return on capital), $ 76 billion of cash, yet sells for just 11-12x** the $ 25 billion or so it will earn this year.
Why pay 100x for a fast growing leader in its space when another is selling for just 11-12x?
Adam
* Enterprise Value = Market Capitalization - Net Cash.
**Apple's market capitalization is $ 356 billion. Subtract the $ 76 billion of cash and investments and you get an enterprise value of $ 280 billion. Enterprise Value/Earnings = $ 280 billion/$ 25 billion = 11.2x
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