Quotes of 2013 - Part II

Some additional quotes from 2013 as a quick follow up to this recent post.

Quotes of 2013

Munger and Buffett: High-Frequency Trading and the Flash Crash
"I think the long term investor is not too much affected by things like the flash crash. That said, I think it is very stupid to allow a system to evolve where half of the trading is a bunch of short term people trying to get information one millionth of a nanosecond ahead of somebody else." - Charlie Munger

"I think it is basically evil and I don't think it should have ever been allowed to reach the size that it did. Why should all of us pay a little group of people to engage in legalized front-running of our orders?" - Charlie Munger

"...it [HFT] is not contributing anything to capitalism." - Warren Buffett

"The flash crash didn't hurt any investor. I mean, you know— you're sitting there with— with a stock. And, you know, and the next day...it's gone past. The frictional cost in...investing for somebody that does it in a real investing manner are really peanuts. I mean, they're far less than the cost in real estate or farms or all kinds of things. So it's— unless you turn it to your disadvantage by trying to do a lot of trading or something of the sort, it's a very, very inexpensive market to operate in...and all that noise should not bother you at all. Forget it." - Warren Buffett

Efficient Markets
"Our current problems are very confusing. If you aren't confused, you don't understand them very well." - Charlie Munger

Market Freezes Up
"Plainly, physics has made a different kind of contribution to human society than economics has. Then, again, physics is an easier nut to crack than economics. Electrons don't have feelings, as they say.

Progress in science is cumulative; we stand on the shoulders of giants. But progress in finance is cyclical; in money and banking, especially, we seem to keep making the same mistakes." - From Page 17-18 in Grant's Interest Rate Observer, Volume 31 Summer Break, August 23rd, 2013

Deadly Sins of Investing
"What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding cost. It's a mathematical fact. There's no getting around it. The fact that we don't look at it, too bad for us." - John Bogle

John Bogle on "The Last Gatekeeper"
In this Morningstar interview, John Bogle points out that if you add together the money managed by the 25 largest firms in the mutual fund business, it represents something like 50% of the equity in America.

"A small handful of corporations, particularly the top five of them, control corporate America. And corporate America needs a lot of cleanup, a sweeping out. Executive compensation is a disgrace. Political contributions made by corporations are a disgrace..."

Bogle then later added...

"So when you look at the whole picture, really we're the last gatekeeper. Think about that for a minute; I have a chapter in the book about gatekeepers. We're the last gatekeeper. We, the mutual fund industry. The courts have failed us in terms of shareholder rights. The regulators have failed. The security analysts have failed. The money managers have failed. Right down, the press has in many respects failed with a few exceptions. The fund and corporate directors have both failed, and we're now down to the last line: the shareholders who own those companies. And if they don't speak, there's nobody left, and corporations should not be left to operate as private fiefdoms of their chief executives."

Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
"Economics is a very soft science but it has delusions of hardness or what has been called physics envy. One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed introduced rigor into economics, it unfortunately also brought mortis. Later in his career he felt that economics had lost sight of its job to be useful to society, having lost its way in a maze of econometric formulas, which placed elegance over accuracy.

At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not fi t the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).

We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the last 25 years at least four of the great investment bubbles in all of investment history." - Jeremy Grantham

"So, economics has been more or less threadbare for 50 years. Pity then the plight of the Bank of Sweden with all that money to give away in honor of Alfred Nobel and in envy, perhaps, of the harder sciences." - Jeremy Grantham

Happy New Year,

Adam

Quotes of 2012

Quotes of 2013

A collection of quotes from 2013. All were said or written at some point during this calendar year.

Grantham: Investing in a Low-Growth World
"All corporate growth has to funnel through return on equity. The problem with growth companies and growth countries is that they so often outrun the capital with which to grow and must raise more capital. Investors grow rich not on earnings growth, but on growth in earnings per share. There is almost no evidence that faster-growing countries have higher margins. In fact, it is slightly the reverse." - Jeremy Grantham

"The fact that growth companies historically have underperformed the market – probably because too much was expected of them and because they were more appealing to clients – was not accepted for decades, but by about the mid-1990s the historical data in favor of 'value' stocks began to overwhelm the earlier logically appealing idea that growth should win out. It was clear that 'value' or low growth stocks had won for the prior 50 years at least. This was unfortunate because the market's faulty intuition had made it very easy for value managers or contrarians to outperform. Ah, the good old days! But now the same faulty intuition applies to fast-growing countries. How appealing an assumption it is that they should beat the slow pokes. But it just ain't so." - Jeremy Grantham

Buffett on Berkshire's "Powerhouse Five" & "Big Four"
"At Berkshire we much prefer owning a non-controlling but substantial portion of a wonderful business to owning 100% of a so-so business. Our flexibility in capital allocation gives us a significant advantage over companies that limit themselves only to acquisitions they can operate." - Warren Buffett

Buffett on Berkshire's Float
"If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it. That's like your taking out a loan and having the bank pay you interest." - Warren Buffett

"...we have now operated at an underwriting profit for ten consecutive years, our pre-tax gain for the period having totaled $18.6 billion. Looking ahead, I believe we will continue to underwrite profitably in most years. If we do, our float will be better than free money." - Warren Buffett

"So how does our attractive float affect the calculations of intrinsic value? When Berkshire's book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and were unable to replenish it. But that's an incorrect way to look at float..." - Warren Buffett

"The value of our float is one reason – a huge reason – why we believe Berkshire's intrinsic business value substantially exceeds its book value." - Warren Buffett

Warren Buffett on "The Key to Investing"
"American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor. (The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions. And don't forget that shareholders received substantial dividends throughout the century as well.)

Since the basic game is so favorable, Charlie and I believe it's a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of 'experts,' or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it." - Warren Buffett

Not Picking Stocks By The Numbers
An exchange between Warren Buffett and Charlie Munger as summarized by the Wall Street Journal's live blog:

"We are looking at businesses exactly like we are looking at them if somebody came in and asked us to buy the whole business," Buffett said. He said they then want to know how it will do in ten years. 

Munger was even more forceful: "We don't know how to buy stocks by metrics ... We know that Burlington Northern will have a competitive advantage in years ... we don't know what the heck Apple will have. ... You really have to understand the company and its competitive positions. ... That's not disclosed by the math.

Buffett: "I don't know how I would manage money if I had to do it just on the numbers."

Munger, interupting, "You'd do it badly."

Buffett on Bonds and Productive Assets
"I bought a piece of real estate in New York in 1992, I have not had a quote on it since. I look to the performance of the assets. Maybe...my piece of real estate have had pull backs, but I don't even know about 'em. People pay way too— way too much attention to the short term. If you're getting your money's worth in a stock, buy it and forget it." - Warren Buffett

"...interest rates have a powerful effect on...all assets. Real estate, farms, oil, everything else...they're the cost of carrying other assets. They're the alternative. They're the yardstick." - Warren Buffett

"...the fact that there are troubles in Europe, and there are plenty of troubles, and they're not going go away fast, does not mean you don't buy stocks. We bought stocks when the United States was in trouble, in 2008 and— and it was in huge trouble and we spent 15 1/2 billion in three weeks in— between September 15th and October 10th. It wasn't because the news was good, it was because the prices were good." - Warren Buffett

"In terms of stocks, you know, stocks are reasonably priced. They were very cheap a few years ago. They're reasonably priced now. But stocks grow in value over time because they retain earnings..." - Warren Buffett
(Stocks prices were, of course, generally much lower when Buffett said this compared to now.)

"There could be conditions under which we...would own bonds. But— they're conditions far different than what exist now." - Warren Buffett

"I would have productive assets. I would favor those enormously over fixed dollars investments now, and I think it's silly — to have some ratio like 30 or 40 or 50% in bonds. They're terrible investments now." - Warren Buffett

"News is better now. Stocks are higher. They're still not— they're not ridiculously high at all, and bonds are priced artificially. You've got some guy buying $85 billion a month. (LAUGH) And— that will change at some point. And when it changes, people could lose a lot of money if they're in long-term bonds." - Warren Buffett

"...I bought a farm in 1985, I haven't had— had a quote on it since. But I know what it's produced every year. And I know it's worth more money now. You know, it— if I'd gotten a quote on it every day and somebody's said, "You know, maybe you oughta sell because there's, you know, there's clouds in the West," or something. (LAUGH) It's — it's crazy." - Warren Buffett

Charlie Munger: What Buying a House and Rabbit Hunting Have in Common
"Partly there was a time you felt foolish you didn't buy a house because you weren't making all the money everybody else was making, so it was a typical crazy boom. Now people have learned house prices can go down as well as up." - Charlie Munger

"It's like a fella who goes rabbit hunting and thoroughly enjoys himself. And then the rabbits haul out guns and start firing back. It would dim your enthusiasm for rabbit hunting, and that's what happened in the housing market." - Charlie Munger

More quotes in a follow up,

Adam

Quotes of 2012

Grantham on Efficient Markets, Bubbles, and Ignoble Prizes

The latest GMO quarterly letter was recently released.*

Below, I've highlighted some of Jeremy Grantham's thoughts on efficient markets, bubbles, and the 2013 Nobel Prize in Economic Sciences from his section of the letter:

"Economics is a very soft science but it has delusions of hardness or what has been called physics envy. One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed introduced rigor into economics, it unfortunately also brought mortis. Later in his career he felt that economics had lost sight of its job to be useful to society, having lost its way in a maze of econometric formulas, which placed elegance over accuracy.

At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not fi t the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).

We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the last 25 years at least four of the great investment bubbles in all of investment history."

To me, this latest letter is Grantham at his best.
(His section begins on page 6.)

Well worth reading in its entirety.

Grantham goes on to describe the four bubbles that, for many, will hardly be unfamiliar:

1) Bubble in Japanese Stocks - By 1989 stocks were selling at 65 times earnings (on what may be not so great accounting). Grantham points out, before that, stocks had never peaked at more than 25 times earnings. Japanese stocks would go on to fall 90%.

2) Japanese Land Bubble - This bubble peaked a couple of years later in 1991. Grantham describes it this way:

"This was probably the biggest bubble in history and was certainly far worse than the Tulip Bubble and the South Sea Bubble. And, yes, the land under the Emperor's Palace, valued at property prices in downtown Tokyo, really was equal to the value of the land in the state of California. Seems efficient to me..."

3) U.S. Equity Bubble in 2000 - This one peaked at 35 times earnings but that doesn't even begin to describe how expensive certain stocks had become. For perspective, earnings peaked at 21 times earnings in 1929.

4) The Housing Bubble - According to Grantham this was the first bubble that was truly global.

Grantham notes that, according to EMH, these annoying real world occurrences should happen something like once every 10,000 years.

He also makes the point that "this efficient market nonsense" certainly didn't hurt value managers like himself.

"...so I should find time to thank all those involved for producing and passionately promoting the idea. During the 1970s and 1980s I am convinced it helped reduce the number of quantitatively-talented individuals entering the money management business."

Warren Buffett has previously made a similar point.

Max Planck understood well the resistance of the human mind, even among those who happen to be very smart, to new ideas. He understood how that tendency impacted scientific advancement.

Buffett has said the same applies to finance.

Well, one of the more disappointing -- even if unfortunately not exactly surprising -- aspects of what has happened over these past decades is this:

"...the proponents of the EMH not only promoted their theory, but via the academic establishment the high priests badgered academic researchers into leaving, resigning themselves to non-tenure, or getting religion, as it were."

Much later in the letter, Grantham talks more specifically about the 2013 Nobel Prize in Economic Sciences:

"So, economics has been more or less threadbare for 50 years. Pity then the plight of the Bank of Sweden with all that money to give away in honor of Alfred Nobel and in envy, perhaps, of the harder sciences. If you had $1.2 million to give away but few worthy recipients, what would you do? I would suggest making it a once-every-three-year event..."

His primary reason?

To make it more likely that only "the Real McCoys" win the prize and to prevent "so many ordinary soldiers" from getting it.

That's unlikely to happen anytime soon, but that doesn't make it any less unfortunate that the Bank of Sweden did the following:

"...to further prove how completely they have lost the plot, they gave two-thirds of the prize to two economists who attempted to prove market inefficiency and one-third to another who claimed it was efficient and seriously efficient at that. What a farce. And to read all these genteel descriptions, or rather rationalizations, as to why this made sense is to realize to what extent the establishment is respected, regardless of its competence level."

The economists he is referring to are Eugene Fama, Robert Shiller, and Lars Peter Hansen.

"Robert Shiller at least served society – Kenneth Boulding would have approved – by loudly warning us of impending doom from the Tech Bubble with his superbly timed book Irrational Exuberance in the spring of 2000. Not bad! He also warned us well in advance of the much more dangerous housing bubble..."

Grantham is, not surprisingly, not quite so complimentary of Fama:

"As for Fama, who conversely provided a rationale for all of us to walk off the cliff with confidence, the less said the better. For believers in market efficiency and all the assumptions that go along with it, the real world really is merely an annoying special case."

Grantham has mentioned this so-called "special case" before.

Now, to get an idea how Eugene Fama looks at bubbles, consider what he said back in 2010 in this interview.

When Fama was presented with the following:

"Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst."

He responded this way:

"I don't even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don't know what a credit bubble means. I don't even know what a bubble means. These words have become popular. I don't think they have any meaning."

That comment from Fama just might help begin to explain how such bad ideas and assumptions have been able to maintain their widespread -- and rather more than a little bit damaging -- influence for so long.

From later in the same interview:

But you are skeptical about the claims about how irrationality affects market prices?

Fama's response: 

"It's a leap. I'm not saying you couldn't do it, but I'm an empiricist. It's got to be shown."

Naturally, there's nothing inherently wrong with needing it "to be shown", but somehow, at least for Fama, insufficient evidence has been supplied by these recent bubbles.

So this means Fama continues to think, more or less, that coldly rational efficient markets exist in the real world.

Shiller, of course, does not.

Fama, in fact, seems to have an almost unflappable confidence that EMH (and related) provides a useful way to understand how financial markets work.

Not long after their Nobel Prize was announced Shiller was interviewed on CNBC. In the interview, Shiller called Fama the "father" of efficient markets as a theory and most responsible for popularizing it over the years.

Shiller also said the following about Fama's rather consistent, if nothing else, view that markets are mostly quite efficient and rational:

"When you hatch a theory, you don't easily let go, that's where he [Fama) is. I think he's a -- he's a brilliant man...but he's rather involved in this theory."

CNBC Video: Robert Shiller on Eugene Fama

Maybe, just maybe, the reason Fama doesn't see the empirical evidence relates, in part, to Shiller's explanation.

In fact, that doesn't really seem a stretch at all.

I happen to be rather convinced that the influence of efficient markets -- and the many related ideas and assumptions that have descended from EMH -- have been anything but a good thing for civilization.

To me, the sooner they lose their influence the better.

Well, in any case, these three empiricists have won a big prize.

It's the Data, Stupid!

No doubt winning it involved lots of hard work by what are well-intentioned and smart people.

Maybe, down the road, it will become more obvious how much at least some of these recently honored contributions will be of benefit to world.

I'd certainly like to see their work prove to be useful but, at least for now, consider me a bit skeptical much of it will end up having a truly significant and favorable impact.

Others might have a more optimistic view.

Adam

Related posts:
Efficient Markets - Part II
Risk and Reward Revisited
Efficient Markets
Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
Buffett on Risk and Reward
Beta, Risk, & the Inconvenient Real World Special Case
Black-Scholes and the Flat Earth Society
Buffett: Indebted to Academics
Superinvestors: Galileo vs The Flat Earth
Max Planck: Resistance of the Human Mind

* Also published in Barron's.

Risk and Reward Revisited

From the Implications and Conclusion section of this paper, co-written by Nardin Baker and Robert A. Haugen:

"As a result of the mounting body of straightforward evidence produced by us and many serious practitioners, the basic pillar of finance, that greater risk can be expected to produce a greater reward, has fallen. It is now clear to a greater and greater number of researchers and practitioners that inside all of the stock (and even some bond) markets of the world the reward for bearing risk is negative."

Paper: Low Risk Stocks Outperform within All Observable Markets of the World

Well, according to the paper, if the "basic pillar of finance" is not necessarily valid then:

"...its invalidation carries critical implications for the theories underlying investment and corporate finance. In our view, existing textbooks on both subjects are dramatically wrong and need to be rewritten."

Buffett explained this negative correlation between risk and reward very well nearly 30 years ago in The Superinvestors of Graham-and-Doddsville.

I highlighted it in this recent post.

Buffett on Risk and Reward

"I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward! 

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is." - Warren Buffett in The Superinvestors of Graham-and-Doddsville

Sometimes risk and reward is positively correlated. Sometimes it is not.

Some act as if they must always be correlated in a positive manner.

Note that, for example, the capital asset pricing model (CAPM) doesn't leave any room for the possibility that risk and reward can be correlated in a negative manner.*

Ra = Rf + β(Rm-Rf)

Ra = Expected Return
Rf = Risk Free Rate
β = Beta of the Security
Rm = Expected Market Return

I think it is fair to say that just because an equation happens to have a greek letter, is elegant in appearance, and is widely taught, it doesn't automatically qualify as some great leap of insight.

"...Berkshire's whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to." - Charlie Munger at UC Santa Barbara back in 2003

Efficient markets and the "descendants" is not just somewhat flawed thinking. It is, to me, worse than useless. Charlie Munger said the following later in the same speech talking about what he calls physics envy:**

"I want economics to pick up the basic ethos of hard science, the full attribution habit, but not the craving for an unattainable precision that comes from physics envy. The sort of precise reliable formula that includes Boltzmann's constant is not going to happen, by and large, in economics." - Charlie Munger at UC Santa Barbara back in 2003

These ideas have -- sometimes quietly and sometimes less so -- influenced real world behavior and system design in far from desirable ways. They continue to do so. The damage done may be subtle but it's real.

Not all flawed ideas deserve to be viewed with contempt (and even a brutal disrespect), but at least some of this stuff just might deserve such treatment.

It's not difficult to show, as Jeremy Grantham points out, that participants do not always behave in the cold, rational manner that the efficient market hypothesis relies upon.***

It's not difficult to show that market prices fluctuate far more than intrinsic business values.

It's not difficult to show that risk and reward are not always positively correlated.

It's not difficult to show that a single greek letter -- in this case β -- cannot possibly be a proxy for risk.

Systems should be designed with these realities in mind. The next generation of business leaders, finance professionals, and economists will be more effective if taught to think about the world the way it is (or, at least, as close as possible to the way it is) instead of an imaginary one built upon certain flawed models and assumptions.

In capital markets, mispricing is the norm and, as we've seen during the past decade and a half or so, sometimes that mispricing goes to extremes.

The paper ends by asking, then attempting to answer, the question "how can it be true that over the course of almost fifty years, millions of unsuspecting students have been trained by thousands of finance professors to believe" in efficient markets?
(Including the many related ideas -- the "descendants" -- that have been spun off from it.)

Well, they say it comes down to the following:

"The answer is that in all but the hardest of sciences, academic research may be influenced by other factors in addition to a pure quest for the truth."

They go on to explain this further. In a nutshell, Baker and Haugen suggest that once ideas like these obtain widespread influence in academia, it is in the interest of those involved to maintain that influence.

In any case, it's usually a good idea to never be surprised by how long it takes for widely adopted, credible sounding, but highly flawed thinking to surrender its costly influence.

Adam

* Some will rightly point out that alpha would pick this up. Well, in my view, all this does is mask the fact that risk and reward are not always positively correlated. To me that makes alpha really just a fudge factor of the worst kind. A solution that's elegant in appearance, less so in fact. For this reason and others I think alpha deserves little attention and likely even warrants loathing despite its popularity as a term of choice. I'm well aware of how much alpha has become the favored way to express risk-adjusted outperformance; its broad acceptance in this way need not logically lead one to conclude it's based upon sound thinking or even that, while somewhat flawed, it is at least incidentally useful. Unfortunately, it's not even of incidental utility. It's worse than useless. That probably seems a bit too harsh but I think, in this case, it's appropriately harsh. It succeeds at concealing instead of revealing what's really going on in terms of risk and reward. I guess greek letters have a way of creating an aura of legitimacy that makes something rather dumb seem like it must have merit. It's not the first time this has happened -- where seriously smart people become stubborn proponents of suspect ideas -- and it's likely not going to be the last time.

If that otherwise intelligent and capable people behave in such ways seems at all surprising, check out Charlie Munger at Harvard-Westlake back in 2010 for more on this subject. Well worth reading. It applies far beyond the world of investing. Psychological factors (various fallacies/biases/illusions both subconscious and conscious) lead to cognitive errors that affect even the very brightest (including those who might be quite admirable in other ways). At Harvard-Westlake, Charlie Munger provided a very useful explanation why this tends to happen (and often at the major institutions no less). It's how aspects of human nature lead to less than reasonable outcomes. Too often, that's just what happens. I'm sure some will -- consciously or not -- underestimate this stuff. I happen to think that's a mistake. An awareness and understanding of these forces at least has the potential to reduce the quantity and scale one's own cognitive errors. It's worth mentioning that CAPM was expanded upon in the Fama and French Three Factor Model. In the less elaborate CAPM, beta alone was supposed to explain portfolio returns. The expanded model adds company size and value factors (finally!) to the single risk factor of beta. So these two additional factors are an attempt to better explain portfolio returns.

Empiricists surely possess the capacity to make useful contributions. No doubt the work that went into developing these models was done by smart individuals, is all very well-intentioned, and not at all simple to do. Those interested in this sort of thing should, of course, study both models as carefully as they feel is necessary. I've unfortunately taken the time to do just that (time I'd like back). To me, as far as the investment decision making goes, neither model offers much real world utility (and I'm being generous here). There's just far more effective ways to spend valuable time. Others may reach a more optimistic conclusion.
** At UC Santa Barbara back in 2003, Charlie Munger talked about nine different categories of weaknesses in economics. According to Munger, the following is the third weakness:

"The third weakness that I find in economics is what I call physics envy. And of course, that term has been borrowed from...one of the world's great idiots, Sigmund Freud. But he was very popular in his time, and the concept got a wide vogue."

*** Efficient market hypothesis depends upon the assumption that agents have rational expectations.

Grantham: Investing in a Low-Growth World

In Jeremy Grantham's latest letter, he asks whether lower GDP growth logically leads to reduced stock returns.

Grantham answers that question this way:

"This is where I break ranks with many pessimists because I believe theory and practice strongly indicate that lower GDP growth does not directly affect stock returns or corporate profitability.

He adds, parenthetically, that their may be some effects of lower GDP growth that will lower equity returns in a minor way. This gets covered in more detail later in the letter. Otherwise, as far as stock returns go, growth is just not as big a factor as some might think.

All corporate growth has to funnel through return on equity. The problem with growth companies and growth countries is that they so often outrun the capital with which to grow and must raise more capital. Investors grow rich not on earnings growth, but on growth in earnings per share. There is almost no evidence that faster-growing countries have higher margins. In fact, it is slightly the reverse."

In fact, growth can be a negative factor. According to Grantham, it turns out that growth companies and countries underperform...

"The fact that growth companies historically have underperformed the market – probably because too much was expected of them and because they were more appealing to clients – was not accepted for decades, but by about the mid-1990s the historical data in favor of 'value' stocks began to overwhelm the earlier logically appealing idea that growth should win out. It was clear that 'value' or low growth stocks had won for the prior 50 years at least. This was unfortunate because the market's faulty intuition had made it very easy for value managers or contrarians to outperform. Ah, the good old days! But now the same faulty intuition applies to fast-growing countries. How appealing an assumption it is that they should beat the slow pokes. But it just ain't so."

While maybe not intuitive, that high growth rates will have a high correlation with investor returns is far from a given.
(Regular readers obviously know that this has been covered more than a few times on this blog.)

High levels of growth should, of course, generally lead to more desirable investment outcomes, right? As it turns out, not necessarily. If interested, here are some of the prior posts that deal with variations of this subject:

Buffett: Stocks, Bonds, and Coupons - January 2013
Maximizing Per-Share Value - October 2012
Death of Equities Greatly Exaggerated - August 2012
Stock Returns & GDP Growth - July 2012
Why Growth Matters Less Than Investors Think - July 2012
Ben Graham: Better Than Average Expected Growth - March 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - June 2010
High Growth Doesn't Equal High Investor Returns - July 2009
The Growth Myth Revisited - July 2009
The Growth Myth - June 2009

Fast-growing countries, industries, and individual businesses have a whole range of possible investor outcomes with above average returns far from being certain.

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - Warren Buffett in the 1992 Berkshire Hathaway (BRKa) Shareholder Letter

Wait, growth can be a negative thing?

Some might choose to treat all this as anomaly. Yet, it's often not a bad idea to explore in some depth what's against conventional wisdom -- what's not intuitive. Occasionally, that's where the more useful insights reside.

Growth, of course, can be a good thing but some seem to think, from an investor point of view, it is always a good thing. What gets in the way? Well, investors often pay too much for attractive future prospects. Also, high growth prospects invite in lots of capital and competition. Lots of well-financed capable competitors can lead to undesirable core economics and a wide range of unpredictable outcomes.*

The real question becomes whether growth will have a favorable impact on the per share value created over a very long time. Sometimes it does. Sometimes it does not.

The primary drivers of long-term returns is the price that's paid relative to well-judged intrinsic value, return on capital**, and whether real durable advantages exist.

A good business needs little capital. It can return the excess capital produced to shareholders. It can use it to finance opportunities at an attractive long-term return. It can do these things while maintaining or even increasing the size and strength of its economic moat (has no trouble defending its core business economics).

This just requires business leaders who do not choose growth for its own sake over per share returns for its shareholders.

Far from a certainty.

Unfortunately, sometimes the fastest growing, most promising, dynamic, and exciting areas of opportunity produce less attractive risk-adjusted returns and a wider range of outcomes.

Adam

* Growth will often have a favorable impact on value. It just happens to be a mistake to think that it always has a favorable impact. In fact, growth can actually reduce value if it requires capital inputs in excess of the discounted value of the cash that will be generated over time. Sometimes, the highest growth opportunities attract lost of capable competition and capital that ruins the long run economics. Sometimes, high growth requires costly yet necessary capital raising (to fund key investments, deal with competitive threats) that dilutes existing shareholders and reduces per share returns.

Finally, even if growth that materializes does have favorable economics, some investors tend to pay a large premium upfront for those growth prospects. That hefty price paid may turn attractive long-term business results into not so attractive investment results.
** The highest possible truly free cash flows relative to the ongoing capital requirements of an enterprise.

Quotes of 2012

A collection of quotes from 2012. All were said or written at some point during this calendar year.

Bogle on Speculation
"The thing that has always bothered me about gold is it has no value-creating unit. Underlying common stocks are earnings and dividends. Underlying bond returns are interest coupons. Underlying gold returns are nothing. There's nothing -- there's no there there. So it's a complete speculation on price." - John Bogle

Buffett: The Long Run Trumps Quick Returns
"If somebody bought Berkshire Hathaway in 1965 and they held it, they made a great investment — and their broker would have starved to death." - Warren Buffett

John Bogle: The Clash of the Cultures
"The issue that concerns me is, simply put, today's ascendance of speculation over investment in our financial markets; or, if you will, the ascen­dance of the culture of science -- of instant measurement and quantification -- over the culture of the humanities of steady reason and rationality." - John Bogle

Tom Russo: First Mover Advantage and the "Capacity to Suffer"
"The three prongs that I look for when investing in a business are: the fifty cent dollar bill, the capacity to reinvest in great brands and the 'capacity to suffer.' The 'capacity to suffer' is key because often the initial spending to build on these great brands in new markets has no initial return." - Tom Russo

Charlie Munger On "Rapid Trading By The Computer Geniuses"
"...take the rapid trading by the computer geniuses with the computer algorithms. Those people have all the social utility of a bunch of rats admitted to a granary. I never would have allowed the rats to get in the granary. I don't want the brilliant young men of America doting their lives at being rats in somebody else's granary. That's not my idea of the right way to run the republic. And if you let me write the laws, it wouldn't happen. But of course, nobody's going to do that." - Charlie Munger

Buffett & Munger on Gold
"...I think civilized people don't buy gold, they invest in productive businesses." - Charlie Munger

Assured Mediocrity
"...if you have patience, a decent pain threshold, an ability to withstand herd mentality, perhaps one credit of college level math, and a reputation for common sense, then go for it. In my opinion, you hold enough cards and will beat most professionals (which is sadly, but realistically, a relatively modest hurdle) and may even do very well indeed." - Jeremy Grantham

Why Buffett Wants IBM's Shares "To Languish"
"If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.

Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus." - Warren Buffett

Buffett on Productive Assets Like Businesses, Farms, & Real Estate
"Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See's peanut brittle." - Warren Buffett

"Berkshire's goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety -- but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three* we've examined. More important, it will be by far the safest." - Warren Buffett

Happy New Year,

Adam

* The three are currency-based investments (i.e. money-market funds, bonds, mortgages, deposits etc.), nonproductive assets (i.e. gold), and productive assets (i.e. businesses or shares of businesses, farms, and real estate).

Quotes of 2011

Jeremy Grantham's 3Q 2012 Letter: The Decline in U.S. Net Capital Formation

From Jeremy Grantham's latest letter:

"Typically I see less significance than others in debt and monetary factors and more in real factors. When someone says that China is building its trains and houses on debt I think, "No, they are built by real people with real bricks, cement, and steel and whatever happens to the debt, these assets will still be there." (They may fall down but that's a separate story; you can build a bad high rise with or without debt). So I take the quality and quantity of capital and people very seriously: they are the keys to growth and a healthy economy. A badly trained, badly educated workforce is a problem...but reduced, abnormally low capital investment, particularly in the U.S., is the current topic."

Grantham sees the emergence of the "Bonus Culture" as a contributor to the problem (check out the letter for Grantham's explanation) of reduced capital investment. He later added:

"When I was a young analyst, companies like International Paper and International Harvester would drive us all crazy, for just as the supply/demand situation was getting tight and fat profits seemed around the corner, they and their competitors would all build new plants and everyone would drown in excess capacity. The CEOs were all obsessed with market share and would throw capital spending at everything. It might not have been the way to maximize an individual company's profit but it was great for jobs and growth. Now, in the bonus culture, new capacity is regarded with great suspicion. It tends to lower profitability in the near term and, occasionally these days, exposes the investing company to a raider. It is far safer to hold tight to the money and, when the stock needs a little push, buy some of your own stock back. This is going on today as I write, and on a big scale (approximately $500 billion this year). Do this enough, though, and we will begin to see disappointing top-line revenues and a slower growing general economy, such as we may be seeing right now."

In my view, the buybacks themselves aren't a problem, they're a symptom. As a shareholder of a good business, I'm enthusiastic about buybacks when the stock is cheap. When done the right way for the right reasons, buybacks are an important part of disciplined capital allocation.
(Unfortunately, they're frequently executed with too little discipline.)

Still, Grantham is very right that buybacks require capital that could be put to work elsewhere. For increased economic activity to occur, healthy capital investment is needed to fund good ideas and build useful things. Why, in the current environment, are buybacks the more attractive alternative for so many companies? It's worth understanding the real reasons. Maybe the "Bonus Culture" is a contributor to the problem, but I doubt it comes down to just one thing.* I'm guessing there are many reasons companies are choosing buybacks over other capital investments that might lead to economic expansion.

Understanding the root cause(s) of this might not be an easy thing to do, but incredibly important. Even if a business is not buying back stock, it may just hunker down, remain conservative with its capital expenditures, and avoid other forms of risk until there's more certainty.

Compared to historical norms, we are no where near a healthy level of capital formation. Exhibit 5 in Grantham's letter (see page 8) shows this. Check it out. The chart in that exhibit reveals capital formation as a percent of GDP at levels compared to U.S. historical norms that should make no one comfortable.**

Of course, it's not just how much but how smart the investments end up being. It's, as Grantham says, both "the quality and quantity of capital" that matters, but going from where capital formation was a bit more than 50 years ago to where it's at now can hardly be seen as a good thing.

You'll have a hard time convincing me this can't be fixed once it's more fully understood with some smart policy moves and changes to the system. I'm guessing that increased certainty and confidence will eventually lead to more healthy levels of capital formation and investment.

One can only hope that the best ideas will be considered carefully and turned into action.

There's plenty of capital sitting on the sidelines that eventually can be put to good use.

Adam

* Though increased certainty/confidence for businesses and consumers might be cheapest form of economic stimulus.
** Though no measure is perfect, Fixed Private Investment (FPI) as a percent of GDP, points to a similar dynamic. The following chart shows how FPI as a percent of GDP has looked in the U.S. since 1947:

Based upon that chart, it sure looks as if FPI/GDP was closer to the historic average, it would materially improve recent U.S. GDP growth.

Jeremy Grantham & Warren Buffett: Career Risk and the Institutional Imperative

Jeremy Grantham had this to say about what he calls "career risk" in his April 2012 Quarterly Letter:

"The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples' money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority 'go with the flow," either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest."

He also talked about "career risk" in part 2 of his January 2011 Quarterly Letter: 

"Career risk drives the institutional world. Basically,everyone behaves as if their job description is 'keep it.' Keynes explains perfectly how to keep your job: never, ever be wrong on your own. You can be wrong in company; that's okay."

Investment professionals certainly had to wrestle with "career risk" head on during the dot-com bubble. At the time, more than a little conviction and willingness to appear very wrong for quite a long time was necessary. Some pros rightly resisted the herd and were promptly rewarded with client redemptions. 

Unceremoniously dumped as investors chased the "new paradigm". 

Supposedly, those that weren't buying the hottest tech stocks just didn't "get it" or at least that's what much of the herd seemed to be thinking. Well, there was no new valuation paradigm. Many transformative companies were created (and plenty less so) but, either way, valuations went to ludicrous extremes. Only after the fact (and, unfortunately for some money managers, after the money had left) is it usually clear who really "gets it".*

This likely helps to explain something Warren Buffett pointed out in the 1978 Berkshire Hathaway (BRKa) Shareholder Letter:

"...in 1971, pension fund managers invested a record 122% of net funds available in equities - at full prices they couldn't buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks."

Jeremy Grantham happens to be describing a specific investment industry dynamic but, even if not precisely the same, it is not unlike something more generalized that Warren Buffett has covered from time to time.

What he calls the "institutional imperative".** 

From the 1989 Berkshire Shareholder Letter:

My most surprising discovery: the overwhelming importance in business of an unseen force that we might call "the institutional imperative."

Basically, in Buffett's view, the imperative is a powerful tendency to imitate peer companies, at times rather foolishly, on things like acquisitions, executive compensation, expansion plans or whatever else.**

He described it in the 1990 Berkshire Shareholder Letter this way:

...the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so.

Buffett makes it clear he considers the power of the "institutional imperative" to be rather substantial. In fact, so much so that Berkshire Hathaway has been deliberately set up to minimize its influence. Also, he prefers to invest in companies that seem to have an awareness of the problem.

Adam

* And it's not like having money drain out of a fund (or funds) doesn't create its own return sapping headaches for a professional money manager. Part of the brilliance of Berkshire Hathaway is how it is designed to prevent this problem and, in fact, benefit from it.
** Check out the Mistakes of the First Twenty-five Years section of the 1989 Berkshire Shareholder Letter (the section is near the end of that letter) for more background on this.

Yacktman: Above Average Businesses, Below Average Prices

Here's a good GuruFocus interview with Donald Yacktman and Russell Wilkins of the Yacktman Funds. Check it out in its entirety. 

Some highlights (all excerpts below are Donald Yacktman quotes):

Above Average Businesses, Below Average Prices
"...one of my children said to me once, after dinner when we were talking about investing, 'Now let me see if I have this right, Dad. Basically what you're saying is if you buy above average businesses at below average prices, then on average it's going to work out?' I said, 'Yes, that's basically it.'"

So much for using complex formulas to boost returns.

On Patience
"So many people in this business think in terms of 10 minutes, or 10 hours, or 10 days, or 10 weeks, or 10 months, not 10 years. Very few people have the inner strength or patience to wait it out."

On Focus
"We are focused on a fairly narrow universe of companies we know well."

On Capital Intensity and Cyclicality
The interview includes a useful chart that Donald Yacktman used to demonstrate the business characteristics he and his team find attractive. On the y-axis is capital intensity and on the x-axis is cyclicality from high to low. It's a simple but useful way to think about businesses. As an example, they have consumer staples shown as low capital intensity and low cyclicality.

I'd add that greater cyclicality and capital intensity means that a strong balance sheet is a must. Too much financial leverage can get any business (anyone) in trouble, but excess financial leverage with highly cyclical and capital intensive businesses is just asking for it.

In Mr. Yacktman's view, businesses with both low capital intensity and low cyclicality (Coca-Cola: KO, Pepsi: PEP, and P&G: PG are the specifics mentioned) are likely to earn the highest returns.*

Jeremy Grantham has previously described the higher quality stocks as the "one free lunch" in investing.
(Coca-Cola, Pepsi, and P&G are all in the top 25 of the GMO Quality portfolio)

I happen to think that sometimes, even if rarely, a simple insight can trump details and complexity. When it occasionally does, use it. A simpler approach can beat the complex and, in fact, often does.**

Back to the Yacktman interview:

On Valuation
The managers at the Yacktman funds have mentioned the following mantra on prior occasions:

"It's almost all about the price." 

Well, the chance to buy a good business cheap is usually when it is experiencing difficulties. During the interview, Russell Wilkins also points out sometimes a stock gets cheap when prospects for a business seem solid but unexciting.

On Growth
Yacktman points out that many businesses, especially the high growth ones, have difficult to project long-term prospects. That high growth doesn't generally last very long, yet valuations of fast-growers often assume growth will continue for an extended time. 

"...the problem is that the market has a central tendency to overprice things, and put very high multiples on companies that are growing quickly, even if it is for a short period."

Well, when high growth selling at a premium price disappoints, watch out below. 

On Hewlett-Packard, Microsoft, and Cisco
Hewlett Packard (HPQ) is cheap but its history of doing dumb things with cash (Yacktman specifically mentions the value destroying event that was the Autonomy purchase) and their relatively high net debt has kept it a smaller position for the Yacktman team.

The Yacktman team is more favorable toward Microsoft (MSFT) and Cisco (CSCO) considering their also cheap valuations but much stronger balance sheets. As a result, both of those stocks are larger technology positions than Hewlett-Packard.

Special situations like Hewlett-Packard have been some of their biggest winners but they recognize that these have a higher probability of not working out. So they tend to keep positions like Hewlett-Packard on the smaller side.

Check out the full interview.

Adam

Long positions in all stocks mentioned

* To me, the shares of many of these businesses are not especially cheap these days even if they have been at times over the past few years. It's worth waiting for a good price then acting decisively when valuation is attractive. Since each is unique, the necessary homework to build some depth of knowledge and understanding can be done while waiting for the right price. These may be lower risk but they're certainly not no risk. Margin of safety still matters. There's no way around the preparation and patience required in investing. After figuring out what's attractive at a certain price lots of waiting is inevitably necessary.
** Some may become bored by the straightforwardness. A few may even choose more complicated, high risk journeys just to enhance the challenge. Long-term Capital Management (LTCM) comes to mind. Charlie Munger said it best in this 1998 speech:

"...the hedge fund known as "Long-Term Capital Management" recently collapsed, through overconfidence in its highly leveraged methods, despite IQ's of its principals that must have averaged 160. Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger's 1998 speech to the Foundation Financial Officers Group

Uncomplicated, understandable, yet effective ways to produce attractive risk-adjusted returns should be embraced. Sophisticated or esoteric methods, especially those involving leverage, should not.

Munger's Speech to Foundation Financial Officers - 1998

Bogle: "The Tyranny of Compounding Costs"

Apparently, hedge funds aren't doing so well this year. From this CNBC article on hedge fund performance:

They are supposed to be the smart money—the best of the best....

The article later adds...

Hedge funds as a group are badly underperforming this year, which could lead to a series of redemptions, closings and rethinking of the lofty fee structures the managers of these alternative vehicles enjoy.

Many know the magic of compound returns, but fewer seem to fully appreciate what John Bogle calls "the tyranny of compounding costs". In the aggregate fees, commissions, and other "frictional" costs can only subtract, too often substantially over the long haul, from total returns. There's no way around it. 

Little or, well, nothing of real use is created and the costs aren't exactly immaterial.

An individual investor or professional manager may be outperform but the industry as a whole, after frictional costs are subtracted, can't be anything but a net drag on returns. Productive assets will produce a certain amount of value over time with or without some money manager acting as the middle man. So the fees charged by professional investment management simply subtract (and certainly cannot add). I know some may challenge this premise but, at a minimum, lots of talent wakes up every day engaged in activities that seem mostly non-productive or of little utility.

There are those that rationalize the benefits of all these frictional costs (improved capital allocation being one of them) but I'm mostly skeptical of the arguments that I've heard.
(My mind remains open to the possibility that there are other benefits I do not fully appreciate.)

I do think that investment professionals who stay with their investments for a long time and try to engage constructively in corporate governance issues can add some real value. 

Higher quality management, better business strategies, improved capital and resource allocation among things can be the result. 

Otherwise, these costs meaningfully subtracts from the long-term returns for investors overall. The fees paid may benefit an individual investor who happens to be investing with someone, through luck or skill (or maybe a little of both), produces above average results. So, for that individual investor, it works at a micro-level. The best professionals can outperform by enough on a consistent basis to even justify their fees. I'm not arguing otherwise. This doesn't alter the arithmetic reality that all the salaries, fees, bonuses paid to money managers subtracts from returns of investors as a whole.

"If we [the investment industry] raise our fees from 0.5 percent to 1 percent, we actually raid the balance sheet. We take 0.5 per cent from what would have been savings and investment and turn it into income and GDP. In other words, you're taking money that would have become capital and chewing it up as bankers' bonuses." - Jeremy Grantham

Jeremy Grantham: 'We Add Nothing But Costs'

So it's the conversion of capital to income. Think of the compensation that's paid to investment management professionals (sometimes what seems an endless parade of these professional managers appear on business news each day). Some (maybe even many) are very capable and work very hard for their clients no doubt, but there's no getting around that their rather substantial compensation is literally savings and investment being converted to income. 

It's simple arithmetic. Allow the "tyranny of compounding costs" to play out for many years and we're talking some real money when it is all said and done.

These flaws are costly even if all the costs aren't necessarily measurable. To improve the system overall, reducing frictional costs and increasing the average holding period ought to be among the top priorities. Of course, if and when that might happen isn't knowable. So, until then, the individual investor can still choose to not participate in the folly (even if society still bears the costs, unfortunately).

More in a follow up post.

Adam

Jeremy Grantham's Latest Quarterly Letter: Tortured Logic of Rational Expectations

From Jeremy Grantham's latest quarterly letter:

"It is simple to see what is necessary, but not easy to be willing or able to do it. To repeat an old story: in 1998 and 1999 I got about 1100 full-time equity professionals to vote on two questions. Each and every one agreed that if the P/E on the S&P were to go back to 17 times earnings from its level then of 28 to 35 times, it would guarantee a major bear market. Much more remarkably, only 7 voted that it would not go back! Thus, more than 99% of the analysts and portfolio managers of the great, and the not so great, investment houses believed that there would indeed be 'a major bear market' even as their spokespeople, with a handful of honorable exceptions, reassured clients that there was no need to worry."

Price action in the short run (and even longer) will almost always be driven by the mood of the herd, not fundamentals. If price of something happens to be near fair value at any time it's likely mere coincidence.

I suppose no one is entirely immune to the influence of crowd behavior. Yet, it seems those who can mostly ignore what others are doing, judge value consistently well, buy what they understand at a discount (margin of safety or price versus value discipline), and have a bias toward owning what they like for a very long time seem to do more than okay.

Simple? Maybe.

Easy?

Not so much.

Check out the quarterly letter in its entirety.

Adam

* ...the efficient-market hypothesis requires that agents have rational expectations; that on average the population is correct (even if no one person is) and whenever new relevant information appears, the agents update their expectations appropriately. - Wikipedia