Friday, May 22, 2009

Inactive Investing

Much of achieving attractive long-term results comes down to buying quality assets at a discount then keeping frictional costs down.

Easier said than done.

One effective way to manage risk and reward is to buy shares of businesses with high and durable returns on capital (ROC) at attractive prices (i.e. discount to a conservative estimate of value).

The heavy lifting so to speak -- as measured by total return -- comes from the high ROC of the businesses themselves, instead of some special talent for trading.

In other words, the core economics and resulting increases to per share intrinsic value primarily drive returns.

Of course, it's not as if future returns on capital can be perfectly measured or predicted. Yet, to at least increase the likelihood of a good outcome, look to those businesses with high and sustainable ROC; those that possess, even if to varying degrees, rather wide "economic moats": AXP, PG, PM, KO, JNJ and DEO among others, come to mind.

Each seems likely to remain high ROC, wide moat, businesses that happen to be selling at reasonable valuations these days. Still, even the very best businesses can have things go very wrong for shareholders from time to time.

Capital might be allocated poorly, for example.

Also, even if capital is allocated well, just about any business gets tested at some point.

That's where always buying with a margin of safety comes in.

Having said that, here's a good example of how high ROC combined with a stock that mostly remains cheap over time impacts long-term returns:

$ 10,000 invested in Philip Morris (now Altria: MO) in 1957 was worth over $ 80 million fifty years later (incl. reinvested dividends).

So the stock generated an annual return of nearly 20% during that time frame.

The magic of compounding.

In contrast, $ 10,000 invested in General Motors in 1957 was well on its way to becoming worth nothing fifty plus years later. (Also with dividends reinvested. In this case, the investor would do better to not reinvest the dividends or, better yet, not invest at all.)

That means a roughly 6x increase in value has been an average decade for MO. It also happens to be pretty much what Altria produced this past decade. Odds seem at least reasonably good that both Altria and the recently spun off Philip Morris International (PM) will continue to do just fine (though likely not nearly as spectacular as in the past) over the long haul.*

Declining volume pressures will likely continue to be a major challenge, but that's not exactly a new problem for the tobacco business.

The story is not pretty but it's the core economics and price versus value that matters.

A big part of the returns produced by Philip Morris/Altria came from dividends that were reinvested in a stock that was consistently inexpensive. This works, other than potentially different tax implications depending on the type of account, much the same way as share buybacks

Excluding the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to intrinsic value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned.

The fact that these stocks remained mostly inexpensive did not come down to just concerns about declining volumes. It was the threat of major legal liabilities, and the fact that some investors won't touch a tobacco stock, that also contributed to the shares of Philip Morris/Altria mostly being cheap for many years. So the stock will actually do better going forward if prices remain relatively low. 

Consider that the next time you're inclined to cheer when a stock price goes up in the short run yet your investing horizon is long-term.

Choosing between GM and Philip Morris was quite a flip of the coin back in the late 1950's. I'm guessing most investors back then thought of GM as a juggernaut while the tobacco business was a company heading into a world of uncertain legal liabilities and, over time, reduced demand. Both businesses have had their fair share of challenges since then yet only one of them maintained attractive core economics despite its troubles.

It is interesting to note how well most of the high quality franchises (i.e. those that sell small-ticket consumer items, leading brands, and strong distribution capabilities) have performed in most every 20 year period (i.e. something like 1971-90, 1972-91, 1972-92, etc...) going back decades. Once again, the reason is durable high returns on capital.**

If bought well, sustainable competitive advantages and attractive core business economics pay off in the long run.

Growth rate matters less.

A company that can sustain a relatively high ROC, over the long haul, will tend to converge on that rate of return if you hold it long enough.

The hard part is knowing which businesses can sustain it.

So here's one way to think about it that may be useful. Think of good businesses as a kind of strange long-term certificate of deposit (CD).

For example, if a business has a sustainable ROC of approximately 15% it effectively becomes a kind of bizarre CD:

In a high ROC business: As you increase the time frame the range of possible annual returns gets narrower and converges on the higher ROC rate.

In a low ROC business: As you increase the time frame the range of possible annual returns gets narrower and converges on the lower ROC rate.

Take KO as an example of a high ROC business. The free cash flow that KO will generate this year can be used to pay dividends with the rest going into growth opportunities such as new brands...expanding distribution etc. The returns on these new investments tend to be very high and eventually get reflected in the company's intrinsic value. In the first 2-3 years those investments, the economic impact would not typically be obvious because they're small relative to KO's other assets and current earning power. The trick occurs when you compound the new investments made by KO each year over a 20 year horizon or longer. With mostly wise capital allocation (mostly, in this case, via the use of retained earnings) over a long time frame, it's possible for a tidal wave of intrinsic value to be created.

Better to pay a fair price for the wonderful businesses.

Low ROC businesses might work, if very mispriced, over shorter time horizons, but in the long run a 6% ROC business will have a tough time intrinsically doing much better than a 6% return.

"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." - Charlie Munger

In the early days, in fact, Buffett used to buy these so called "cigar butts" (Ben Graham style) and profit when the shares became at least a bit less mispriced.

So Buffett would look for "dollar bills" selling temporarily for 50 cents, then sell it when the market began to price it more appropriately. Eventually, he more or less moved away from the Ben Graham approach. See's Candies is a good example.

While it is unlikely for most of us to achieve the 20% per year long-term returns of Berkshire Hathaway, a sensible inactive approach has the potential to do rather well compared to professional active managers while, just as crucially, taking less risk. I emphasized the word active because it is the activity itself that adds frictional costs (taxes, commissions) and increases the likelihood of making mistakes that ultimately causes the reduced returns.

Newton's 4th Law.

Some might be impressed by a money manager that timed the market effectively during the most recent crash. In other words, whoever was "smart" enough to sell right before the crash must know what they are doing right? Well, attempting to time the market creates new risks even if you happen to get it right from time to time. What about making the mistake of being out when the chance to buy at great prices slowly disappears? This can permanently reduce long term returns.***

It's understandable that many focus on temporary paper losses in the short run.

That doesn't make it wise. Investing means focusing on price versus value and long-term effects.

This means that learning to ignore near-term price action is very important.

In other words, why be bothered by a temporary paper loss of 30-40%, for example, if you buy businesses -- at a plain discount to value -- with favorable economics that should create an attractive outcome over the next twenty years? If the risk and reward balance seems favorable, the temporary losses simply become an opportunity or something to ignore. An asymmetrical dislike of losses compared to the satisfaction from gains at least explains some of this. Most focus on the risk of loss but few put enough emphasis on the risk of missing gains. This bias is costly in investing. If you own quality businesses, the long-term compounding effects should trump what happens in the market.
(Even if a crash occurs which, by the way, should be considered -- at least occasionally -- certain to happen from time to time.)

Some of Buffett's biggest long-term gains came on investments that initially dropped in price by half or so.

So instead of actively trading, use the spare time you have to do important things like evaluating whether the businesses you own are about to have their "economic moat" reduced or eliminated.
(The newspaper business being a good recent example.)

This is a simple (but not easy) approach that helps eliminate the casino-oriented thinking that has become so prevalent among market participants.

Adam

Long AXP, PG, PM, KO, JNJ, DEO, and MO

* As always, I am talking about growth in the intrinsic value of the business not the stock price. In the short run stock prices can be all over the map but in the long run stock prices will tend to track intrinsic value growth.
** The best of these franchises have attractive risk and reward characteristics if bought at the right price. Yet it seems unwise to expect nearly as attractive returns going forward.
*** Buffett and Munger have sold or not owned stocks at times when valuations were not attractive to them. These were not decisions based upon market timing; they were decisions based upon price versus value.
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