From the Coca-Cola (KO) Full-Year and 4th Quarter 2011 Results released earlier this morning:
The Coca-Cola Company reported worldwide volume growth of 5% for the full year and 3% during the quarter. Excluding new cross-licensed brands in North America, primarily Dr Pepper brands (which the Company began distributing Oct. 2, 2010), worldwide volume grew 4% for the full year, at the high end of our long-term growth target. Volume growth for the full year was well-balanced across the globe, with solid growth in key developed markets like North America, Japan and Germany and double-digit growth in key emerging markets like India and China. In addition, solid growth continued in countries with per capita consumption of Company brands less than 150 eight-ounce servings per year, with volume up 6% for the full year and 4% in the quarter.
The press release also added the following:
We continued to see growth in sparkling beverages, with gains in global volume and value share for the full year and in the quarter. This growth was driven by our continued focus on and investment in our brands, starting with brand Coca-Cola. Brand Coca-Cola volume grew 3% in both the full year and the quarter, with strong growth in the fourth quarter in a number of markets around the world, including 33% in Thailand, 15% in India, 13% in China, 12% in Argentina, 9% in Germany, 8% in Russia, 4% in both Mexico and France, and 3% in Japan.
Perspective can sometimes be lost comparing earnings year over year or quarter over quarter. Occasionally, it is worth stepping back a bit instead of making such short-term comparisons. For an investor, understanding a company's long run capacity to earn is what matters. Sometimes the near-term noise gets in the way of understanding that sort of thing.
Let's see how Coca-Cola's business has progressed since prior to the beginning of the financial crisis. One test of a good business is how it performs during times of stress.
I think it's fair to say that 2006 to 2011 saw more than its share of economic challenges.
Coca-Cola's earnings in 2006, the year before the market peaked and the financial crisis started unfolding, was just over $ 5 billion.
During 2008, when the financial crisis was really gaining some momentum earnings came in at $ 5.8 billion (slightly lower than 2007). So while many other businesses experienced dramatic reductions in profitability, Coca-Cola continued to do just fine. The economic stresses merely ended up delaying some earnings growth.
From the most recent earnings report, we just learned that Coca-Cola earned $ 8.6 billion for the full year of 2011.
So, with $ 8.6 billion in 2011 earnings, the company appears to have been able to improve earnings nearly 70% compared to the just over $ 5 billion it earned in 2006 (on a per share basis it's slightly better as share count has been reduced slightly via buybacks). I think that counts as a pretty solid performance considering much of that time contained an extended tough economic environment.
It's not just that Coca-Cola's earnings have fully recovered to pre-crisis levels and then some (some lesser businesses have still not even returned to pre-crisis profitability), it's that earnings didn't drop off much during the worst of the crisis.
A sign of resilience.
A good way to understand the earnings power of most businesses is to see what happens over a full business cycle and be sure the earnings doesn't come from events that result in one time gains.*
For some, a full business cycle isn't even long enough.
One easy mistake to make is to value certain cyclical businesses (something Coca-Cola certainly is not) with higher operating leverage (and, in some cases, financial leverage) using peak or near peak earnings. Cyclical businesses typically look cheapest when they are actually quite expensive. So an investor needs to normalize earnings over many years to get a meaningful economic picture and avoid misjudgment.**
Coca-Cola's stock now sells for around $ 68/share. At that price, the stock is no longer a bargain as it sells for ~18 times 2011 earnings.
On a forward basis it looks a bit cheaper, of course, but as is usually the case the opportunity to buy the stock with a large margin of safety was a couple years back when the economic storm clouds were front and center.
Adam
Long position in KO established at much lower than recent market prices
* In 2010, Coca-Cola bought the North American bottling business from Coca-Cola Enterprises (CCE), its largest bottler: MarketWatch - Coca-Cola buying CCE North American bottling business. Excluding that type of gain is the best way to understand Coca-Cola (or any business) on an operating basis.
So Coca-Cola's earnings in 2010 including a large one time gain from the purchase of those bottling operations. Reporting the one time gain this way is required by Generally Accepted Accounting Principles (GAAP) as it should be. Yet, it ends up making net income appear larger than it really is on an operating basis. Though correct from an accounting point of view, it may make Coca-Cola seem cheaper than it is if just a simple ratio is used without backing out the one time gain. The non-recurring gain should be backed out to get a more meaningful picture of Coca-Cola's true current operating economics. (As it turns out, this one time gain did actually make Coca-Cola's price to earnings (P/E) ratio appear lower on some of the popular finance sites. The "E" in "P/E" can't be relied upon unless it has been checked for non-recurring gains and losses.)
** This is especially true for highly cyclical businesses that are capital intensive (think airlines and auto manufacturers). Those with less predictable revenue and high operating leverage (high fixed costs) are usually more vulnerable to financial strain during a serious economic crisis especially if financial leverage is also involved. Adding financial leverage is usually a bad idea in any business with inherently less predictable revenue, a lack of pricing power, and high operating leverage. So sometimes avoiding certain so-called "cheap" cyclical businesses altogether makes sense. In other words, no price is low enough to account for the potential risks during an economic downturn. In other cases, a perfectly good business with durable competitive advantages just happens to have inherently more variable earnings. So highly variable earnings is not, in itself, a problem if the business is built to handle economic busts. Being built to last likely means having a sustainable position as low cost producer (or possibly some other advantage unique among competitors), a fortress balance sheet, and capable management. Businesses with predictable revenue and a little pricing power can usually safely handle a bit more financial leverage. Both operating leverage and financial leverage magnifies gains and losses (reward and risk). The businesses that had profitability drop the most during the recent financial crisis likely had one or both types of leverage working against them (and if they survive...working for them).
---
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.
Tuesday, February 7, 2012
Monday, February 6, 2012
Buffett: The Test of a Good Business
Some excerpts from a lecture* given by Warren Buffett to Notre Dame faculty, MBA students, and undergraduates in 1991.
In the lecture, Buffett says that one way to test the quality of a business is by asking the following question:
"How long does the management have to think before they decide to raise prices?"
If the answer is "not long" then you've probably got a pretty good business. More from the lecture:
You're looking at marvelous business when you look in the mirror and say "mirror, mirror on the wall, how much should I charge for Coke this fall?" [And the mirror replies, "More."] That's a great business. When you say, like we used to in the textile business, when you get down on your knees... [and say] "just another half cent a yard." Then you get up and they say "We won't pay it." It's just night and day. I mean, if you walk into a drugstore, and you say "I'd like a Hershey bar" and the man says "I don't have any Hershey bars, but I've got this unmarked chocolate bar, and it's a nickel cheaper than a Hershey bar" you just go across the street and buy a Hershey bar. That is a good business.
The ability to raise prices – the ability to differentiate yourself in a real way, and a real way means you can charge a different price – that makes a great business.
Buffett also mentioned this very different example of a good business:
The highest priced daily newspaper in the United States, with any circulation at all, is the Daily Racing Form...You can charge $2.00 for The Form, you can charge $1.50, you can charge $2.50 and people are going to buy it. It's like selling needles to addicts, basically. It's an essential business. It will be an essential business 5 or 10 years from now. You have to decide whether horse racing will be around 5 or 10 years from now, and you have to decide whether there’s any way people will get their information about past performances of different horses from different sources. But you've only got about two questions to answer, and if you answer them, you know the business will make a lot of money. The Form has huge profit margins, incidentally. Wider than any other newspaper. They charge what they want to basically. It's an easy to understand business...
Finally, later in the same lecture Buffett added the following:
You really want something where, if they don't have it in stock, you want to go across the street to get it. Nobody cares what kind of steel goes into a car. Have you ever gone into a car dealership to buy a Cadillac and said "I'd like a Cadillac with steel that came from the South Works of US Steel." It just doesn't work that way, so that when General Motors buys they call in all the steel companies and say "here's the best price we've got so far, and you've got to decide if you want to beat their price, or have your plant sit idle."
Buffett made the above comments about the Daily Racing Form over 20 years ago. Knowing how much the newspaper business has changed over the past decades, it certainly seems worth challenging the idea that it remains such a good business. Buffett himself, in the 1987 Shareholder Letter, made the point that "severe change and exceptional returns usually don't mix."
Good businesses often reside in industries experiencing little change.
Well, I think "experiencing little change" hardly describes what's been happening to most newspaper business models over the past decade plus. Yet, as it turns out, the Daily Racing Form may still be doing just fine despite all the change that has occurred in the industry.
Arlington Capital Partners bought the Daily Racing Form for $ 200 million back in 2007. Since it is a private company, verifying how the business might be doing these days isn't easy but I did find some things of note. According to this article from back in 2010, the Daily Racing Form can now charge more like $ 5 to $ 6 a copy (compared to the $ 2 they were charging 20 years ago).
So, at the very least, there is still plenty of pricing power.
Many newspapers may be struggling the article points out the following:
...at least one daily is thriving, even though its price—$5 to $6 a copy—makes it one of the most expensive papers in the world. In a way, that high price is the Daily Racing Form's strength: 95 percent of its revenue comes from circulation, only 5 percent from advertising. Furthermore, the DRF, which is to horseplayers what the Wall Street Journal is to investors, also prospers online: about 20 percent of its revenue comes from downloading fees for its racetrack data.
That sounds fine but the number of copies sold daily has fallen off dramatically since the early 1990s. According to this New York Times article, 33,000 copies were sold daily or roughly 12 million/year.
Buffett mentions it being more like 150,000 daily in the 1991 Notre Dame lecture.
So that's certainly a steep decline.
Clearly, understanding how circulation is likely to progress over time from here is key. Will the decline continue or stabilize? There's no way to know if it is up to date, but the Arlington Capital Partners website currently says 12.4 million print copies are still being sold each year. That is similar to the numbers from the New York Times article above written back in 2009 and a press release from 2008.
If it is still roughly at the same level 2 or 3 years later, maybe the decline in circulation is stabilizing.
Hard to know.
Still, considering its pricing power, and what I'd expect to be just modest capital needs, the Daily Racing Form seems likely to remain a sound business even as print circulation shrinks.**
Of course, any rapid decline in print copies sold would be more troublesome but it sure seems that their audience is willing to pay for the kind of specialized information they offer.
(Note: It's tough to judge, with available information, what the economics of their internet site is or how it is likely to evolve but, at 20% of revenue already, it obviously seems a big factor long-term.)
Apparently, its status as "the bible" for those who bet at the track remains in tact. From the New York Times article:
"Oh, The Racing Form is the bible," said William Nack, the former Sports Illustrated horse-racing writer and a biographer of Ruffian and Secretariat who grew up admiring The Form's top columnist, Charlie Hatton. "You can't be without it at the track."
Steven Crist, Chairman and publisher of the Daily Racing Form added:
"Absolutely, we're profitable," Crist said. "It's not even close. We turn over a lot of cash." The Form is privately owned by a venture-capital firm, Arlington Capital Partners of Chevy Chase, Md., so there is no independent verification of Crist's profitability claims.
While that's certainly not definitive proof of how well the business is doing, it seems newspapers with content that is specialized, like the Daily Racing Form or even legal newspapers like the Daily Journal (DJCO), have held up much better economically than others.
Most in the newspaper business, of course, have watched their core economics become badly wounded as the internet disrupted their traditional business models.
There will be exceptions, of course, but I doubt many newspapers are entirely immune from the long-term trends and forces at work here.
The ones that thrive in a niche of some kind should continue to do quite well. Yet, I still don't think it's easy to judge how robust the economic moat of most newspaper businesses will be over the very long haul. The more specialized ones could do just fine but picking long-term winners still ought to be a bit tricky.
In general, most businesses with sustainable pricing power that aren't particularly capital intensive will be more attractive investments. To me, those that sell trusted small-ticket consumer brands (or FMCG) with broad-based distribution capabilities are tough to beat on a risk-adjusted basis. Snacks, candies, beverages, and tobacco aren't a bad place to start if you can find shares of those kind of businesses selling at fair (or better than fair) prices.
Adam
* Lightly edited by Whitney Tilson
** A shrinking market dominated competitor doesn't necessarily invite capable competitors so the pricing power on less circulation may work longer and more profitably than otherwise. If return on capital remains above average and the capital will be wisely allocated it may still be a fine business to own. The intrinsic value of a business is driven by expected future cash flows discounted back to present value whether it happens to be growing or shrinking. It's not any more difficult to calculate intrinsic value for a business if it happens to have a shrinking but profitable base of customers. Like anything else, pay a discount to that value and it can be a sound investment. Fast growing businesses in dynamic industries grab the attention but ultimately investing is about paying a nice discount to value that can be (and has been) judged reasonably well.
In contrast, a capital intensive business (especially one with some financial leverage), with high fixed costs (operating leverage), and little pricing power will often have trouble remaining profitable with a shrinking base of customers. As a result, the intrinsic value suffers (if there ends up being any at all). Businesses with predictable revenue and pricing power can usually handle a bit more financial leverage even if its model inherently still requires having lots of operating leverage. Economically sensitive businesses with less predictable revenue streams and high operating leverage should keep financial leverage to a minimum.
In the lecture, Buffett says that one way to test the quality of a business is by asking the following question:
"How long does the management have to think before they decide to raise prices?"
If the answer is "not long" then you've probably got a pretty good business. More from the lecture:
You're looking at marvelous business when you look in the mirror and say "mirror, mirror on the wall, how much should I charge for Coke this fall?" [And the mirror replies, "More."] That's a great business. When you say, like we used to in the textile business, when you get down on your knees... [and say] "just another half cent a yard." Then you get up and they say "We won't pay it." It's just night and day. I mean, if you walk into a drugstore, and you say "I'd like a Hershey bar" and the man says "I don't have any Hershey bars, but I've got this unmarked chocolate bar, and it's a nickel cheaper than a Hershey bar" you just go across the street and buy a Hershey bar. That is a good business.
The ability to raise prices – the ability to differentiate yourself in a real way, and a real way means you can charge a different price – that makes a great business.
Buffett also mentioned this very different example of a good business:
The highest priced daily newspaper in the United States, with any circulation at all, is the Daily Racing Form...You can charge $2.00 for The Form, you can charge $1.50, you can charge $2.50 and people are going to buy it. It's like selling needles to addicts, basically. It's an essential business. It will be an essential business 5 or 10 years from now. You have to decide whether horse racing will be around 5 or 10 years from now, and you have to decide whether there’s any way people will get their information about past performances of different horses from different sources. But you've only got about two questions to answer, and if you answer them, you know the business will make a lot of money. The Form has huge profit margins, incidentally. Wider than any other newspaper. They charge what they want to basically. It's an easy to understand business...
Finally, later in the same lecture Buffett added the following:
You really want something where, if they don't have it in stock, you want to go across the street to get it. Nobody cares what kind of steel goes into a car. Have you ever gone into a car dealership to buy a Cadillac and said "I'd like a Cadillac with steel that came from the South Works of US Steel." It just doesn't work that way, so that when General Motors buys they call in all the steel companies and say "here's the best price we've got so far, and you've got to decide if you want to beat their price, or have your plant sit idle."
Buffett made the above comments about the Daily Racing Form over 20 years ago. Knowing how much the newspaper business has changed over the past decades, it certainly seems worth challenging the idea that it remains such a good business. Buffett himself, in the 1987 Shareholder Letter, made the point that "severe change and exceptional returns usually don't mix."
Good businesses often reside in industries experiencing little change.
Well, I think "experiencing little change" hardly describes what's been happening to most newspaper business models over the past decade plus. Yet, as it turns out, the Daily Racing Form may still be doing just fine despite all the change that has occurred in the industry.
Arlington Capital Partners bought the Daily Racing Form for $ 200 million back in 2007. Since it is a private company, verifying how the business might be doing these days isn't easy but I did find some things of note. According to this article from back in 2010, the Daily Racing Form can now charge more like $ 5 to $ 6 a copy (compared to the $ 2 they were charging 20 years ago).
So, at the very least, there is still plenty of pricing power.
Many newspapers may be struggling the article points out the following:
...at least one daily is thriving, even though its price—$5 to $6 a copy—makes it one of the most expensive papers in the world. In a way, that high price is the Daily Racing Form's strength: 95 percent of its revenue comes from circulation, only 5 percent from advertising. Furthermore, the DRF, which is to horseplayers what the Wall Street Journal is to investors, also prospers online: about 20 percent of its revenue comes from downloading fees for its racetrack data.
That sounds fine but the number of copies sold daily has fallen off dramatically since the early 1990s. According to this New York Times article, 33,000 copies were sold daily or roughly 12 million/year.
Buffett mentions it being more like 150,000 daily in the 1991 Notre Dame lecture.
So that's certainly a steep decline.
Clearly, understanding how circulation is likely to progress over time from here is key. Will the decline continue or stabilize? There's no way to know if it is up to date, but the Arlington Capital Partners website currently says 12.4 million print copies are still being sold each year. That is similar to the numbers from the New York Times article above written back in 2009 and a press release from 2008.
If it is still roughly at the same level 2 or 3 years later, maybe the decline in circulation is stabilizing.
Hard to know.
Still, considering its pricing power, and what I'd expect to be just modest capital needs, the Daily Racing Form seems likely to remain a sound business even as print circulation shrinks.**
Of course, any rapid decline in print copies sold would be more troublesome but it sure seems that their audience is willing to pay for the kind of specialized information they offer.
(Note: It's tough to judge, with available information, what the economics of their internet site is or how it is likely to evolve but, at 20% of revenue already, it obviously seems a big factor long-term.)
Apparently, its status as "the bible" for those who bet at the track remains in tact. From the New York Times article:
"Oh, The Racing Form is the bible," said William Nack, the former Sports Illustrated horse-racing writer and a biographer of Ruffian and Secretariat who grew up admiring The Form's top columnist, Charlie Hatton. "You can't be without it at the track."
Steven Crist, Chairman and publisher of the Daily Racing Form added:
"Absolutely, we're profitable," Crist said. "It's not even close. We turn over a lot of cash." The Form is privately owned by a venture-capital firm, Arlington Capital Partners of Chevy Chase, Md., so there is no independent verification of Crist's profitability claims.
While that's certainly not definitive proof of how well the business is doing, it seems newspapers with content that is specialized, like the Daily Racing Form or even legal newspapers like the Daily Journal (DJCO), have held up much better economically than others.
Most in the newspaper business, of course, have watched their core economics become badly wounded as the internet disrupted their traditional business models.
There will be exceptions, of course, but I doubt many newspapers are entirely immune from the long-term trends and forces at work here.
The ones that thrive in a niche of some kind should continue to do quite well. Yet, I still don't think it's easy to judge how robust the economic moat of most newspaper businesses will be over the very long haul. The more specialized ones could do just fine but picking long-term winners still ought to be a bit tricky.
In general, most businesses with sustainable pricing power that aren't particularly capital intensive will be more attractive investments. To me, those that sell trusted small-ticket consumer brands (or FMCG) with broad-based distribution capabilities are tough to beat on a risk-adjusted basis. Snacks, candies, beverages, and tobacco aren't a bad place to start if you can find shares of those kind of businesses selling at fair (or better than fair) prices.
Adam
* Lightly edited by Whitney Tilson
** A shrinking market dominated competitor doesn't necessarily invite capable competitors so the pricing power on less circulation may work longer and more profitably than otherwise. If return on capital remains above average and the capital will be wisely allocated it may still be a fine business to own. The intrinsic value of a business is driven by expected future cash flows discounted back to present value whether it happens to be growing or shrinking. It's not any more difficult to calculate intrinsic value for a business if it happens to have a shrinking but profitable base of customers. Like anything else, pay a discount to that value and it can be a sound investment. Fast growing businesses in dynamic industries grab the attention but ultimately investing is about paying a nice discount to value that can be (and has been) judged reasonably well.
In contrast, a capital intensive business (especially one with some financial leverage), with high fixed costs (operating leverage), and little pricing power will often have trouble remaining profitable with a shrinking base of customers. As a result, the intrinsic value suffers (if there ends up being any at all). Businesses with predictable revenue and pricing power can usually handle a bit more financial leverage even if its model inherently still requires having lots of operating leverage. Economically sensitive businesses with less predictable revenue streams and high operating leverage should keep financial leverage to a minimum.
Friday, February 3, 2012
Yacktman Funds 4Q 2011 Update
Here's an update from Donald Yacktman and his team on the funds they manage:*
The Yacktman Fund (YACKX) returned 10.63% per year over the past ten years.
The Yacktman Focused Fund (YAFFX) returned 11.39% per year over the past ten years.
For a comparison, the S&P 500 is up 2.92% per year over the same time frame.
Approximately 40% of the Yacktman Focused Fund portfolio is in the top 5 stocks.
Approximately 35% of the Yacktman Fund portfolio is in the top 5 stocks.
The annual turnover of these portfolios is typically less than 10%. That low turnover rate is impressive and, as far as I'm concerned, something not seen often enough.
Yacktman continues to have minimal exposure to financials (~5%) though some small new positions in banks were added last quarter (Goldman Sachs GS, State Street: STT, Northern Trust: NTRS and Bank Of America: BAC).
None of the recent bank purchases are large enough positions to be in the top 25.
Donald Yacktman was asked, in this recent interview with Consuelo Mack, about having added positions in financials after mostly avoiding them in recent years:
...in all cases, you'll notice they're very small positions, and we spread the risk. Sometimes, when things are less predictable, the way to deal with that is to have a smaller position and allow for a greater spread over what your normal hurdle rate would be, to allow for that uncertainty. - Donald Yacktman
The only bank that is a top 10 position is U.S. Bancorp (USB).
The following stocks purchased in the 4th quarter had a greater than 1% portfolio impact.
Stocks purchased
C.R. Bard
Avon Products (AVP)
Pepsi
Microsoft
There were no top 25 positions sold last quarter.
The two funds that Yacktman and his team manage have performed very well but what's even more notable, at least to me, is how they go about producing those returns.
One of the common phrases we use at our firm is, "It's almost all about the price". Often, the most important variable in having a successful investment and managing risk is the price paid for a security. - Donald Yacktman in the 3Q 2011 letter:
They've been able to outperform by generally buying shares of quality businesses with the best risk-adjusted returns and having the discipline to buy when selling at a nice discount.
Adam
* From the letter: The performance data quoted for The Yacktman Fund and The Yacktman Focused Fund represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that the investor's shares, when redeemed, may be worth more or less than their original cost. The current performance may be higher or lower than the performance data quoted.
Established long positions in PEP, PG, MSFT, CSCO, USB at lower than recent prices
---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.
The Yacktman Fund (YACKX) returned 10.63% per year over the past ten years.
The Yacktman Focused Fund (YAFFX) returned 11.39% per year over the past ten years.
For a comparison, the S&P 500 is up 2.92% per year over the same time frame.
At the end of the most recent quarter, both funds continued to hold substantial positions in large capitalization stocks with many being household names.
These funds are very similar but the more concentrated of the two funds, as the name suggests, is the Yacktman Focused Fund.
These funds are very similar but the more concentrated of the two funds, as the name suggests, is the Yacktman Focused Fund.
Top 5 Holdings of The Yacktman Focused Fund
1 Pepsi (PEP)
4 Microsoft (MSFT)
5 C.R. Bard (BCR)
Approximately 40% of the Yacktman Focused Fund portfolio is in the top 5 stocks.
Top 5 Holdings of The Yacktman Fund
1 Pepsi (PEP)
4 Microsoft (MSFT)
5 Cisco (CSCO)
Approximately 35% of the Yacktman Fund portfolio is in the top 5 stocks.
The annual turnover of these portfolios is typically less than 10%. That low turnover rate is impressive and, as far as I'm concerned, something not seen often enough.
Yacktman continues to have minimal exposure to financials (~5%) though some small new positions in banks were added last quarter (Goldman Sachs GS, State Street: STT, Northern Trust: NTRS and Bank Of America: BAC).
None of the recent bank purchases are large enough positions to be in the top 25.
Donald Yacktman was asked, in this recent interview with Consuelo Mack, about having added positions in financials after mostly avoiding them in recent years:
...in all cases, you'll notice they're very small positions, and we spread the risk. Sometimes, when things are less predictable, the way to deal with that is to have a smaller position and allow for a greater spread over what your normal hurdle rate would be, to allow for that uncertainty. - Donald Yacktman
The only bank that is a top 10 position is U.S. Bancorp (USB).
The following stocks purchased in the 4th quarter had a greater than 1% portfolio impact.
Stocks purchased
C.R. Bard
Avon Products (AVP)
Pepsi
Microsoft
There were no top 25 positions sold last quarter.
The two funds that Yacktman and his team manage have performed very well but what's even more notable, at least to me, is how they go about producing those returns.
One of the common phrases we use at our firm is, "It's almost all about the price". Often, the most important variable in having a successful investment and managing risk is the price paid for a security. - Donald Yacktman in the 3Q 2011 letter:
They've been able to outperform by generally buying shares of quality businesses with the best risk-adjusted returns and having the discipline to buy when selling at a nice discount.
Adam
* From the letter: The performance data quoted for The Yacktman Fund and The Yacktman Focused Fund represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that the investor's shares, when redeemed, may be worth more or less than their original cost. The current performance may be higher or lower than the performance data quoted.
Established long positions in PEP, PG, MSFT, CSCO, USB at lower than recent prices
---
Thursday, February 2, 2012
Facebook Files For IPO: What the S-1 Reveals
Some things of interest from yesterday's Facebook S-1 filing:
- Facebook's 2011 revenue was $ 3.7 billion. Revenue grew 88% year over year and is up nearly five fold since 2009.
- Facebook has $ 3.9 billion in cash.
- Net profit was $ 1 billion, a 27% net margin. However, free cash flow was less than half that amount at $ 470 million.
- 845 million active users, up nearly 40% from the previous year.
- In 2009, 98% of its revenue came from advertising.
- In 2011, revenue from advertising was down to 85%. The other 15% is, for the most part, driven by in-app purchases from games like Farmville (12% of revenue comes from Zynga).
- Facebook's revenue last year is slightly higher than Google's was the year it went public ($ 3.7 billion compared to $ 3.2 billion). Facebook's $ 1 billion of net income is more than the $ 400 million Google earned in 2004.
- Mark Zuckerberg owns a little more than 28% of the company. That means his stake is likely to be worth $ 25 billion or so. He'll be fine.
According to this article, revenue growth is expected to slow substantially over the next couple of years:
...Facebook ad sales worldwide are slackening. They grew 104% in 2011 but are expected to climb just 52% to $5.8 billion this year and only 21% to $7 billion next year, according to eMarketer.
The same article goes on to point out that the value of Facebook's ad inventory fares poorly when compared to the industry average and especially to Google:
"Facebook is not as effective as paid search (on Google, Yahoo and Microsoft)," says Dave Beltramini, director of online strategy for G5, a marketing services firm. "The intent of consumers on Google is more about shopping. On Facebook, people are more social, looking at photos of their friends' kids."
The article points out that on CPM (cost per thousand impressions), a key pricing metric when it comes to valuing ad inventory, Facebook's is at just 22 cents compared to Google's several dollars. We'll have to see how that evolves over time.
Facebook is looking to raise around $ 5 billion in this offering but, of course, that number could change between now and when the IPO happens. From the S-1:
We intend to use the net proceeds to us from our initial public offering for working capital and other general corporate purposes; however we do not have any specific uses of the net proceeds planned.
So whatever they do end up raising should be a nice addition to the $ 3.9 billion of cash they already have on their balance sheet.
Most companies aren't a large cap stock the day it goes public but, at a $ 75-100 billion expected valuation (and, of course, a 75 to 100x P/E), it looks like Facebook's going to be an exception. Facebook will have nearly 3-4x the market valuation that Google had when it went public in 2004.
Now, I don't doubt the company could become worth that kind of money or even much more some day.
Whether Facebook is actually worth that much YET is another question.
Profitability will need to grow substantially and prove durable to even justify the expected initial valuation (never mind actually make some money for an investor).
My point is this. Paying a substantial premium to the current valuation with the hope that an investment may actually be intrinsically worth it someday isn't exactly the road to riches. I mean, who puts capital at risk for the privilege of eventually getting it back? So, even though Facebook may someday justify its lofty valuation (and even then some) over time, it won't necessarily provide great risk-adjusted returns compared to alternatives.
It's not that returns will necessarily end up being negative.
It's that returns relative to the risk taken will be inadequate. The direct result of paying an excessively high initial price.
In other words, getting something "right" yet being compensated little for it. Now, Facebook could sure end up being, once again, an exception. It is quite a franchise. Yet, most of the time, pay a price that represents a possible future value instead of a discount to current value and odds are long-term results will be subpar or worse.*
Facebook is clearly worth a lot of money. It's already a sound business that has a good probability of increasing in value over time. Considering the high profile of the company, it's not hard to imagine it starting out as an expensive stock and proceeding to become even more so in a speculative frenzy.
That may make it an interesting trade for those who do that sort of thing but, unless the valuation drops far below what is expected, it's going to be a tough thing to truly invest in. There's nothing wrong with not owning shares of even a very good business if a chance to buy with an appropriate margin of safety isn't available.
Adam
* Near its current valuation, the risk of negative returns is uncomfortably high if things go a bit less well than expected. Having said that, sustained high return on capital over 2 or 3 decades eventually does make an initially expensive looking investment make sense. In the very long run, results tend to be drawn like a magnet toward the return on capital earned by the business. I don't think I have any capacity to even roughly estimate Facebook's return on capital or its sustainability over such a long time horizon. Others may be able to or, at least, think that they can.
- Facebook's 2011 revenue was $ 3.7 billion. Revenue grew 88% year over year and is up nearly five fold since 2009.
- Facebook has $ 3.9 billion in cash.
- Net profit was $ 1 billion, a 27% net margin. However, free cash flow was less than half that amount at $ 470 million.
- 845 million active users, up nearly 40% from the previous year.
- In 2009, 98% of its revenue came from advertising.
- In 2011, revenue from advertising was down to 85%. The other 15% is, for the most part, driven by in-app purchases from games like Farmville (12% of revenue comes from Zynga).
- Facebook's revenue last year is slightly higher than Google's was the year it went public ($ 3.7 billion compared to $ 3.2 billion). Facebook's $ 1 billion of net income is more than the $ 400 million Google earned in 2004.
- Mark Zuckerberg owns a little more than 28% of the company. That means his stake is likely to be worth $ 25 billion or so. He'll be fine.
According to this article, revenue growth is expected to slow substantially over the next couple of years:
...Facebook ad sales worldwide are slackening. They grew 104% in 2011 but are expected to climb just 52% to $5.8 billion this year and only 21% to $7 billion next year, according to eMarketer.
The same article goes on to point out that the value of Facebook's ad inventory fares poorly when compared to the industry average and especially to Google:
"Facebook is not as effective as paid search (on Google, Yahoo and Microsoft)," says Dave Beltramini, director of online strategy for G5, a marketing services firm. "The intent of consumers on Google is more about shopping. On Facebook, people are more social, looking at photos of their friends' kids."
The article points out that on CPM (cost per thousand impressions), a key pricing metric when it comes to valuing ad inventory, Facebook's is at just 22 cents compared to Google's several dollars. We'll have to see how that evolves over time.
Facebook is looking to raise around $ 5 billion in this offering but, of course, that number could change between now and when the IPO happens. From the S-1:
We intend to use the net proceeds to us from our initial public offering for working capital and other general corporate purposes; however we do not have any specific uses of the net proceeds planned.
So whatever they do end up raising should be a nice addition to the $ 3.9 billion of cash they already have on their balance sheet.
Most companies aren't a large cap stock the day it goes public but, at a $ 75-100 billion expected valuation (and, of course, a 75 to 100x P/E), it looks like Facebook's going to be an exception. Facebook will have nearly 3-4x the market valuation that Google had when it went public in 2004.
Now, I don't doubt the company could become worth that kind of money or even much more some day.
Whether Facebook is actually worth that much YET is another question.
Profitability will need to grow substantially and prove durable to even justify the expected initial valuation (never mind actually make some money for an investor).
My point is this. Paying a substantial premium to the current valuation with the hope that an investment may actually be intrinsically worth it someday isn't exactly the road to riches. I mean, who puts capital at risk for the privilege of eventually getting it back? So, even though Facebook may someday justify its lofty valuation (and even then some) over time, it won't necessarily provide great risk-adjusted returns compared to alternatives.
It's not that returns will necessarily end up being negative.
It's that returns relative to the risk taken will be inadequate. The direct result of paying an excessively high initial price.
In other words, getting something "right" yet being compensated little for it. Now, Facebook could sure end up being, once again, an exception. It is quite a franchise. Yet, most of the time, pay a price that represents a possible future value instead of a discount to current value and odds are long-term results will be subpar or worse.*
Facebook is clearly worth a lot of money. It's already a sound business that has a good probability of increasing in value over time. Considering the high profile of the company, it's not hard to imagine it starting out as an expensive stock and proceeding to become even more so in a speculative frenzy.
That may make it an interesting trade for those who do that sort of thing but, unless the valuation drops far below what is expected, it's going to be a tough thing to truly invest in. There's nothing wrong with not owning shares of even a very good business if a chance to buy with an appropriate margin of safety isn't available.
Adam
* Near its current valuation, the risk of negative returns is uncomfortably high if things go a bit less well than expected. Having said that, sustained high return on capital over 2 or 3 decades eventually does make an initially expensive looking investment make sense. In the very long run, results tend to be drawn like a magnet toward the return on capital earned by the business. I don't think I have any capacity to even roughly estimate Facebook's return on capital or its sustainability over such a long time horizon. Others may be able to or, at least, think that they can.
Wednesday, February 1, 2012
The Fracking Revolution: End of the Peak-Oil Hypothesis?
Fracking* is a method of extracting natural gas (and increasingly oil) that seems to be transforming the energy industry.
This Bloomberg article says that the U.S. oil market may be about to have a fracking revolution not unlike what has happened with natural gas.
Fracking Boom Could Finally Cap Myth of Peak Oil
In the U.S., the primary controversy when it comes to fracking has been and continues to be concerns over the adverse environmental effects.
Still, what seems amazing, no matter how the environmental issues play out, is how quickly these advances have changed the oil and gas landscape.
In the article, CEO Jim Mulva of ConocoPhillips said the following:
"The revolution has spread to domestic oil production. And it may track the path it followed with natural gas."
Experts refer to oil that comes from shale formations as "tight oil".
The federal Energy Information Administration estimates that production of crude oil in the U.S. will rise to 6.7 million barrels per day by 2020 (much coming from tight oil and development of offshore resources), a level not achieved since 1994.
As a comparison, domestic crude oil in the U.S. was produced at a rate of 5.5 million barrels per day in 2010.
Some think the future estimates are still conservative since projections of "tight oil" continue to be revised higher. Energy analyst Seth Kleinman added this in the Bloomberg article:
The year ahead, he [Kleinman] says, "could really see the death of the peak-oil hypothesis..."
This Reuters article from late last year also explains some of the implications of horizontal drilling and fracking. Some excerpts from the article:
Transformed in Less Than Half a Decade
The combination of horizontal drilling and hydraulic fracturing has already transformed North America's natural gas market in less than half a decade. It is now starting to do the same for U.S. oil production...
Worldwide Transformation & Major Constraints
Fracking and horizontal drilling have the potential to transform the industry worldwide.
Inside North America and Western Europe, the major constraint on the roll-out of the technology is political and environmental opposition. Outside the United States, the main constraints are lack of specialised equipment, know-how and skilled personnel.
The lack of specialised equipment and skills outside the U.S. would seem to sort itself out over time. Knowing how some of the environmental controversies end up impacting the potential of all this seems harder to gauge.
Adam
* The term fracking (or hydrofracking) is short for hydraulic fracturing.
This Bloomberg article says that the U.S. oil market may be about to have a fracking revolution not unlike what has happened with natural gas.
Fracking Boom Could Finally Cap Myth of Peak Oil
In the U.S., the primary controversy when it comes to fracking has been and continues to be concerns over the adverse environmental effects.
Still, what seems amazing, no matter how the environmental issues play out, is how quickly these advances have changed the oil and gas landscape.
In the article, CEO Jim Mulva of ConocoPhillips said the following:
"The revolution has spread to domestic oil production. And it may track the path it followed with natural gas."
Experts refer to oil that comes from shale formations as "tight oil".
The federal Energy Information Administration estimates that production of crude oil in the U.S. will rise to 6.7 million barrels per day by 2020 (much coming from tight oil and development of offshore resources), a level not achieved since 1994.
As a comparison, domestic crude oil in the U.S. was produced at a rate of 5.5 million barrels per day in 2010.
Some think the future estimates are still conservative since projections of "tight oil" continue to be revised higher. Energy analyst Seth Kleinman added this in the Bloomberg article:
The year ahead, he [Kleinman] says, "could really see the death of the peak-oil hypothesis..."
This Reuters article from late last year also explains some of the implications of horizontal drilling and fracking. Some excerpts from the article:
Transformed in Less Than Half a Decade
The combination of horizontal drilling and hydraulic fracturing has already transformed North America's natural gas market in less than half a decade. It is now starting to do the same for U.S. oil production...
Worldwide Transformation & Major Constraints
Fracking and horizontal drilling have the potential to transform the industry worldwide.
Inside North America and Western Europe, the major constraint on the roll-out of the technology is political and environmental opposition. Outside the United States, the main constraints are lack of specialised equipment, know-how and skilled personnel.
The lack of specialised equipment and skills outside the U.S. would seem to sort itself out over time. Knowing how some of the environmental controversies end up impacting the potential of all this seems harder to gauge.
Adam
* The term fracking (or hydrofracking) is short for hydraulic fracturing.
Tuesday, January 31, 2012
Edward Owens: Vanguard Healthcare Fund Update
Edward Owens has been manager of the Vanguard Healthcare Fund (VGHCX) since 1984. The fund has returned more than 12%/year for the past 15 years and more than 16%/year since inception.
Historically, Vanguard Healthcare has had very low turnover (9% annual turnover) so the investments by the fund tend to have a longer term horizon. Nearly 40% of the fund's holdings are represented by the top ten.
Top Ten Holdings
Merck (MRK)
United Health (UNH)
Forest Labs (FRX)
Abbott Labs (ABT)
McKesson (MCK)
Roche Holdings (RHHBY)
Pfizer (PFE)
Amgen (AMGN)
AstraZeneca (AZN)
Eli Lilly (LLY)
Owens added no new stocks to the portfolio this past quarter and there were no additional shares bought among the top ten positions.
Slight reductions in two top ten positions were made:
Abbott (ABT) was reduced by ~10% while Eli Lilly (LLY) was reduced by ~5%.
Several meaningful increases to much smaller positions were made. Yet, even after the increases, none of these positions individually make up even 1% of the portfolio.
Position
Boston Scientific (BSX)
Hospira (HSP)
Zimmer Holdings (ZMH)
CVS Caremark (CVS)
The turnover by investment managers at a number of other mutual funds is so high that what is owned at any given moment doesn't often tell you much.
Edward Owens certainly isn't one of those investment managers.
Lack of activity in a fund like this may make it seem less exciting, but the approach leads to lower frictional costs (taxes, commissions). The main driver of long-term returns is generally achieved by owning businesses that themselves compound at a high rate and not paying too much for the privilege of ownership.
To me, the approach is an admirable one. Success will always comes down to the quality of the businesses owned and the price that was paid. Things like superior trading skills, well-timed sector rotation, or technical analysis not required.
Adam
Historically, Vanguard Healthcare has had very low turnover (9% annual turnover) so the investments by the fund tend to have a longer term horizon. Nearly 40% of the fund's holdings are represented by the top ten.
Top Ten Holdings
Merck (MRK)
United Health (UNH)
Forest Labs (FRX)
Abbott Labs (ABT)
McKesson (MCK)
Roche Holdings (RHHBY)
Pfizer (PFE)
Amgen (AMGN)
AstraZeneca (AZN)
Eli Lilly (LLY)
Owens added no new stocks to the portfolio this past quarter and there were no additional shares bought among the top ten positions.
Slight reductions in two top ten positions were made:
Abbott (ABT) was reduced by ~10% while Eli Lilly (LLY) was reduced by ~5%.
Several meaningful increases to much smaller positions were made. Yet, even after the increases, none of these positions individually make up even 1% of the portfolio.
Position
Boston Scientific (BSX)
Hospira (HSP)
Zimmer Holdings (ZMH)
CVS Caremark (CVS)
The turnover by investment managers at a number of other mutual funds is so high that what is owned at any given moment doesn't often tell you much.
Edward Owens certainly isn't one of those investment managers.
Lack of activity in a fund like this may make it seem less exciting, but the approach leads to lower frictional costs (taxes, commissions). The main driver of long-term returns is generally achieved by owning businesses that themselves compound at a high rate and not paying too much for the privilege of ownership.
To me, the approach is an admirable one. Success will always comes down to the quality of the businesses owned and the price that was paid. Things like superior trading skills, well-timed sector rotation, or technical analysis not required.
Adam
Monday, January 30, 2012
Buffett: High Current Yield, Long-term Capital Growth, and Stock Market Pyrotechnics
From the 1979 Berkshire Hathaway (BRKa) Shareholder Letter:
Phil Fisher, a respected investor and author, once likened the policies of the corporation in attracting shareholders to those of a restaurant attracting potential customers. A restaurant could seek a given clientele - patrons of fast foods, elegant dining, Oriental food, etc. - and eventually obtain an appropriate group of devotees. If the job were expertly done, that clientele, pleased with the service, menu, and price level offered, would return consistently. But the restaurant could not change its character constantly and end up with a happy and stable clientele. If the business vacillated between French cuisine and take-out chicken, the result would be a revolving door of confused and dissatisfied customers.
So it is with corporations and the shareholder constituency they seek. You can't be all things to all men, simultaneously seeking different owners whose primary interests run from high current yield to long-term capital growth to stock market pyrotechnics, etc.
The reasoning of managements that seek large trading activity in their shares puzzles us. In effect, such managements are saying that they want a good many of the existing clientele continually to desert them in favor of new ones - because you can't add lots of new owners (with new expectations) without losing lots of former owners.
We much prefer owners who like our service and menu and who return year after year. It would be hard to find a better group to sit in the Berkshire Hathaway shareholder "seats" than those already occupying them. So we hope to continue to have a very low turnover among our owners, reflecting a constituency that understands our operation, approves of our policies, and shares our expectations.
What Buffett describes above would seem nearly impossible to find in today's short-term oriented capital markets culture (with many participants now buying/selling via ETFs & employing other short-term trading strategies).
Yet, wherever possible, I'll take investing alongside an investor constituency of informed long-term owners that don't head for the exits at the first sign of trouble in a business (or the macro environment).
These days, quite a few market participants seem to have no shortage of an attention deficit, employing strategies that often make business fundamentals an afterthought (if at all).
Among those that do actually happen to look at fundamental business values from time to time, more than a few seem to embrace the if you don't like near term prospects just sell the stock school of investing. This includes small investor and large institutions alike.* At some level, there's nothing wrong with that, I suppose. Investors and other market participants are free to invest any way they want, of course.
Yet, I'd prefer investing next to a high percentage of co-owners and executives that can be trusted to stick around during the inevitable rough patches (macro or otherwise). Even the best businesses will, at times, experience real but fixable difficulties (I'm not talking about truly broken businesses here). When change intended to improve long-term returns are needed, long-term committed owners, especially those that control a large % of stock, are more apt to use their influence to work with and put pressure on the board and management to fix real problems.**
In the real world, things rarely work anywhere near this ideal but investing with other long-term oriented owners and managers when possible at least improves the odds of shareholder-friendly actions. It also has the advantage of allowing an investor to gain in-depth knowledge and insight into the unique risks/potential of a specific business. It's not possible to know a lot about every business so it helps to concentrate on what one truly can understand. In this approach, returns are generated by the compounded wealth creation of a good business over time, bought at reasonable or better prices, not well-timed trades (something that has been emphasized more than a few times on this blog).
A good business, even one with occasional short-term problems, is a franchise capable of high and sustainable return on capital (superior economics). Long-term portfolio returns can only be above average if the businesses in the portfolio generally produce above average return on capital. A business with below average economics will produce subpar long-term returns even if it is bought at what seems like a substantial discount (though it is possible to make money over a shorter horizon this way).
Now, clearly sometimes having a few co-owners that lack long-term conviction is a benefit. It allows the long-term owners to accumulate more shares from the weak holders. It also may allow the company to buyback shares on the cheap. That's fine up to a point. Yet, there's another less optimal (if more subtle) side to this. Let's say a large block of shareholders (lacking in long-term conviction) are susceptible to selling temporarily depressed shares during times of market stress. This sets up a situation where a smart outside buyer could come along and pay a nice premium to the market price but still well below what remaining committed long-term owners consider anywhere near fair intrinsic value. If enough low-in-conviction co-owners are willing to sell the temporarily depressed shares to this buyer, then the judgment of the business intrinsically being worth more, even if correct, won't matter.
(Of course, it's possible to be a long-term committed owner that is overly optimistic about value and better off with that buyout.)
This may seem improbable but it certainly can happen. So that's just another reason why the more informed and long-term oriented the other owners are the better.
None of this, of course, is particularly easy to judge for a smaller investor, but I still think it's still worth putting any long-term investment through this kind of mostly subjective filter. At some level, the way the market is structured today (speculative activity of various kinds in favor of investing) makes this way of thinking difficult to put into practice.
Difficult yet not irrelevant.
It may be at odds with much of today's investing culture but, at least at the margin, finding businesses where an informed shareholder constituency is generally on board for the long haul is worth it.
Capital put at risk by informed, patient long-term shareholders increases the probability of (though hardly guarantees) improved results. Owners and agents concerned with price action measured in months (or even just a few years) will likely make different decisions than those concerned with the creation of enduring value over, say, 20 years. Most good businesses have the chance to compound at a rate closer to full potential with shareholders, the board, and management all focused upon long-term effects.
Investors as a whole should, on average, end up better off. More importantly, if the main participants were focused upon long-term effects, capital markets would likely function more effectively when it comes to the crucial role of facilitating capital allocation.
Wise capital and other resource allocation is more likely to happen when more owners are in it for the long run (informed about/engaged in what the board and key executives are doing with the resources of the business they own).
Instead, it seems an increasingly extreme amount of mental energy is expended by market participants speculating on near-term stock price action. I think it is safe to say that there are real costs (some hidden, some explicit and obvious) when the proportion of speculative versus investing activities goes to an extreme.***
Well, in a typical recent year, ...our financial system has directed around $200 billion a year into initial public offerings and additional new public offerings and then additional offerings of company stock--$200 billion. We trade $40 trillion worth of stocks a year. So, that's 200 times as much speculation as there is investment. - John Bogle on Speculation Dwarfing Investment
There's nothing wrong with speculation.
It will always have a place in the markets but the proportion matters.
Adam
* That small investors behave this way is somewhat understandable, since they cannot usually influence the board and management. In many cases it's necessary to move on due to that lack of influence. For agents and/or investors capable of owning enough shares to influence corporate governance practices and other strategic decisions it seems much less understandable.
** Knowing that there are a few smart larger co-owners is always nice when management/board governance/other strategic changes end up being needed in a business. Otherwise, I think about shares of a business the same way I think about owning a good smaller business 100%. A small or medium size private business owner doesn't generally bail if some near-term serious but manageable problem emerges. Why not then, at least most of the time, treat share ownership of public businesses with that mindset? For me, reasons to sell include when the economic moat of a business becomes materially damaged and is likely to become even more so over time. In other words, the core long-term economics fundamentally change. Also, sometimes valuation will go to an extreme high. For me, short-term difficulties associated with the macro environment or a specific but fixable problem in the business aren't generally good reasons to sell a sound business that I like. There are, of course, times that funds are needed for a clearly superior alternative long-term investment. So outside of the business economics fundamentally breaking down, an extreme valuation, or high opportunity costs, my bias is to own the shares of a good business (bought well) for a very long time.
*** By just about any measure speculation is at unprecedented levels. The average holding period of stocks is now around 3 months while the average holding period during most of the past century was measured in multiple years.
Phil Fisher, a respected investor and author, once likened the policies of the corporation in attracting shareholders to those of a restaurant attracting potential customers. A restaurant could seek a given clientele - patrons of fast foods, elegant dining, Oriental food, etc. - and eventually obtain an appropriate group of devotees. If the job were expertly done, that clientele, pleased with the service, menu, and price level offered, would return consistently. But the restaurant could not change its character constantly and end up with a happy and stable clientele. If the business vacillated between French cuisine and take-out chicken, the result would be a revolving door of confused and dissatisfied customers.
So it is with corporations and the shareholder constituency they seek. You can't be all things to all men, simultaneously seeking different owners whose primary interests run from high current yield to long-term capital growth to stock market pyrotechnics, etc.
The reasoning of managements that seek large trading activity in their shares puzzles us. In effect, such managements are saying that they want a good many of the existing clientele continually to desert them in favor of new ones - because you can't add lots of new owners (with new expectations) without losing lots of former owners.
We much prefer owners who like our service and menu and who return year after year. It would be hard to find a better group to sit in the Berkshire Hathaway shareholder "seats" than those already occupying them. So we hope to continue to have a very low turnover among our owners, reflecting a constituency that understands our operation, approves of our policies, and shares our expectations.
What Buffett describes above would seem nearly impossible to find in today's short-term oriented capital markets culture (with many participants now buying/selling via ETFs & employing other short-term trading strategies).
Yet, wherever possible, I'll take investing alongside an investor constituency of informed long-term owners that don't head for the exits at the first sign of trouble in a business (or the macro environment).
These days, quite a few market participants seem to have no shortage of an attention deficit, employing strategies that often make business fundamentals an afterthought (if at all).
Among those that do actually happen to look at fundamental business values from time to time, more than a few seem to embrace the if you don't like near term prospects just sell the stock school of investing. This includes small investor and large institutions alike.* At some level, there's nothing wrong with that, I suppose. Investors and other market participants are free to invest any way they want, of course.
Yet, I'd prefer investing next to a high percentage of co-owners and executives that can be trusted to stick around during the inevitable rough patches (macro or otherwise). Even the best businesses will, at times, experience real but fixable difficulties (I'm not talking about truly broken businesses here). When change intended to improve long-term returns are needed, long-term committed owners, especially those that control a large % of stock, are more apt to use their influence to work with and put pressure on the board and management to fix real problems.**
In the real world, things rarely work anywhere near this ideal but investing with other long-term oriented owners and managers when possible at least improves the odds of shareholder-friendly actions. It also has the advantage of allowing an investor to gain in-depth knowledge and insight into the unique risks/potential of a specific business. It's not possible to know a lot about every business so it helps to concentrate on what one truly can understand. In this approach, returns are generated by the compounded wealth creation of a good business over time, bought at reasonable or better prices, not well-timed trades (something that has been emphasized more than a few times on this blog).
A good business, even one with occasional short-term problems, is a franchise capable of high and sustainable return on capital (superior economics). Long-term portfolio returns can only be above average if the businesses in the portfolio generally produce above average return on capital. A business with below average economics will produce subpar long-term returns even if it is bought at what seems like a substantial discount (though it is possible to make money over a shorter horizon this way).
Now, clearly sometimes having a few co-owners that lack long-term conviction is a benefit. It allows the long-term owners to accumulate more shares from the weak holders. It also may allow the company to buyback shares on the cheap. That's fine up to a point. Yet, there's another less optimal (if more subtle) side to this. Let's say a large block of shareholders (lacking in long-term conviction) are susceptible to selling temporarily depressed shares during times of market stress. This sets up a situation where a smart outside buyer could come along and pay a nice premium to the market price but still well below what remaining committed long-term owners consider anywhere near fair intrinsic value. If enough low-in-conviction co-owners are willing to sell the temporarily depressed shares to this buyer, then the judgment of the business intrinsically being worth more, even if correct, won't matter.
(Of course, it's possible to be a long-term committed owner that is overly optimistic about value and better off with that buyout.)
This may seem improbable but it certainly can happen. So that's just another reason why the more informed and long-term oriented the other owners are the better.
None of this, of course, is particularly easy to judge for a smaller investor, but I still think it's still worth putting any long-term investment through this kind of mostly subjective filter. At some level, the way the market is structured today (speculative activity of various kinds in favor of investing) makes this way of thinking difficult to put into practice.
Difficult yet not irrelevant.
It may be at odds with much of today's investing culture but, at least at the margin, finding businesses where an informed shareholder constituency is generally on board for the long haul is worth it.
Capital put at risk by informed, patient long-term shareholders increases the probability of (though hardly guarantees) improved results. Owners and agents concerned with price action measured in months (or even just a few years) will likely make different decisions than those concerned with the creation of enduring value over, say, 20 years. Most good businesses have the chance to compound at a rate closer to full potential with shareholders, the board, and management all focused upon long-term effects.
Investors as a whole should, on average, end up better off. More importantly, if the main participants were focused upon long-term effects, capital markets would likely function more effectively when it comes to the crucial role of facilitating capital allocation.
Wise capital and other resource allocation is more likely to happen when more owners are in it for the long run (informed about/engaged in what the board and key executives are doing with the resources of the business they own).
Instead, it seems an increasingly extreme amount of mental energy is expended by market participants speculating on near-term stock price action. I think it is safe to say that there are real costs (some hidden, some explicit and obvious) when the proportion of speculative versus investing activities goes to an extreme.***
Well, in a typical recent year, ...our financial system has directed around $200 billion a year into initial public offerings and additional new public offerings and then additional offerings of company stock--$200 billion. We trade $40 trillion worth of stocks a year. So, that's 200 times as much speculation as there is investment. - John Bogle on Speculation Dwarfing Investment
There's nothing wrong with speculation.
It will always have a place in the markets but the proportion matters.
Adam
* That small investors behave this way is somewhat understandable, since they cannot usually influence the board and management. In many cases it's necessary to move on due to that lack of influence. For agents and/or investors capable of owning enough shares to influence corporate governance practices and other strategic decisions it seems much less understandable.
** Knowing that there are a few smart larger co-owners is always nice when management/board governance/other strategic changes end up being needed in a business. Otherwise, I think about shares of a business the same way I think about owning a good smaller business 100%. A small or medium size private business owner doesn't generally bail if some near-term serious but manageable problem emerges. Why not then, at least most of the time, treat share ownership of public businesses with that mindset? For me, reasons to sell include when the economic moat of a business becomes materially damaged and is likely to become even more so over time. In other words, the core long-term economics fundamentally change. Also, sometimes valuation will go to an extreme high. For me, short-term difficulties associated with the macro environment or a specific but fixable problem in the business aren't generally good reasons to sell a sound business that I like. There are, of course, times that funds are needed for a clearly superior alternative long-term investment. So outside of the business economics fundamentally breaking down, an extreme valuation, or high opportunity costs, my bias is to own the shares of a good business (bought well) for a very long time.
*** By just about any measure speculation is at unprecedented levels. The average holding period of stocks is now around 3 months while the average holding period during most of the past century was measured in multiple years.
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