Thursday, April 30, 2009

Six Stock Portfolio Update

The portfolio outlined on April 9th, 2009* remains the same. Due to recent price increases the margin of safety on several of the stocks has unfortunately been reduced. I think they are all still selling significantly below intrinsic value, though most are now above the prices that I'd like to pay.

The portfolio consists of Wells Fargo (WFC), Diageo (DEO), Philip Morris International (PM), Pepsi (PEP), Lowe's (LOW), and American Express (AXP).

Return for the six stocks combined is 8.5%** using average market prices available for each stock on April 9th, 2009. Of course, that return is meaningless considering the short time frame. The only implications are that it is now slightly more challenging to pick up more shares. I will recommend adding to positions if market provides buying opportunities for any of these stocks and adjust cost basis accordingly.

The good news is PEP is lower and PM has not done a whole lot.

I like owning these all six of these stocks if shares can be bought at a nice discount to intrinsic value.

The idea is to own these a decade or more from now. Over the next five years may add 1-2 stocks to the portfolio. This is focus investing not trading. Lots of homework with minimal trading activity. Rarely but occasionally I may switch one of the above "core six".

Hopefully at least some of the prices on these stocks will be going down in the coming months.

As I've said previously, I do not believe this portfolio will necessarily outperform the markets in the next 2-3 years. It will definitely under-perform if we get into another one of these bubbles. Having said that, I believe this portfolio will easily outperform the market over the next decade...and just as importantly...with minimal trading activity required and lower risk.

We've seen bubbles produce the appearance of increased wealth instead of durable wealth creation. Unlike the bubbles (Commodities, Emerging Markets, Housing, Technology to name a few) of recent years one crucial difference is that the above portfolio is not only likely to go up significantly...the companies should intrinsically be worth it and provide a more durable investment platform. In other words it won't just go up...it's likely to stay there. I try to avoid the "get out before it goes over a cliff!" style of investing.

Build a portfolio with shares of businesses that are so good you can almost ignore it.

Adam

Long position in DEO, AXP, PEP, PM, WFC, and LOW

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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** As of 4/29/09.

Tuesday, April 28, 2009

Buffett on Economic Goodwill: Berkshire Shareholder Letter Highlights

From Warren Buffett's 1983 Berkshire Hathaway (BRKa) shareholder letter:

"To see how it [accounting Goodwill] differs from economic reality, let's look at an example close at hand. We'll round some figures, and greatly oversimplify, to make the example easier to follow.

Blue Chip Stamps bought See's early in 1972 for $25 million, at which time See's had about $8 million of net tangible assets. This level of tangible assets was adequate to conduct the business without use of debt, except for short periods seasonally. See's was earning about $2 million after tax at the time, and such earnings seemed conservatively representative of future earning power in constant 1972 dollars.

Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.

In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See's – doing it, furthermore, with conservative accounting and no financial leverage. It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.


Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry."

I believe this is the essential point that Buffett was making about Coca-Cola in this new Fortune Magazine interview. Coca-Cola earns approximately $ 7 billion after tax on GAAP tangible common equity of $ 8 billion. Do you think TCE maybe does not reflect Coca-Cola's value? Even common equity (which includes accounting Goodwill and other intangibles) comes up woefully short of correctly reflecting Coca-Cola's value.

The consumer franchise that Coca-Cola has built produces economic Goodwill that you will not find on the balance sheet.

This is a limitation of accounting...nothing more.

The better banks have similar consumer franchises and some are low cost producer's (i.e. able to obtain cheaper deposits) resulting in economic Goodwill that will not be found on the balance sheet. Simple measures like TCE ignore this economic value and can easily understate (and in some cases overstate) a bank's health. The current dialogue on the banks largely misses this reality.

The regulators, of course, can do whatever they want. It just doesn't necessarily mean that forcing a capital raise on a bank makes economic sense. Hey, some banks certainly need capital but that's not because of low TCE. It's because they lack earning power relative to the quality of their assets.

Kraft is a more crazy example since they reliably produce $ 2.5 billion of annual cash earnings with (according to GAAP) TCE of $ -18 billion (Yes negative. Quick...bring in the regulators...they are bankrupt). Yet a conservative capitalized economic value of Kraft today is north of $ +30 billion.

So either accounting has its limits or, using the Kraft example, we live in a world where someone will pay you $ 18 billion to take a likely to grow perpetuity of $ 2.5 billion in future annualized cash earnings off their hands.

Adam

Long BRKb
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, April 27, 2009

Coca-Cola vs Kraft

In this new Fortune article, Buffett states that Coca-Cola (KO) has no Tangible Common Equity (TCE).

I believe he could have just as easily said Kraft (KFT).

It turns out that Kraft has approximately minus $ 18B of TCE while Coca-Cola has plus $ 8 billion. In both cases, the accounting captures only a portion of economic Goodwill and that makes TCE or even (Common Equity) poor measures of the economic value. The fact that economic Goodwill matters more than accounting Goodwill is something Buffett wrote about at the end of the 1983 Letter to Shareholders.

The durable earning power of the franchise over time tells you more about a company's strength than TCE or any other simple snapshot measurement.

I've said before that this is more about the inherent limitations of accounting.

Adam

Long position in KO and KFT

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Sunday, April 26, 2009

Is Tangible Common Equity Overhyped?

Some, including Warren Buffett, seem to think it is. I covered this to an extent in a recent post.

From this recent article by Tom Brown on the limits of tangible common equity (TCE):

Coca-Cola, Buffett notes, has no tangible equity at all, and nobody seems upset. Yet for some reason the number has become the most important statistic in banking. As regards Wells Fargo's notoriously low TCE ratio, in particular, Buffett isn't bothered:

"To the extent that [Wells Fargo's] tangible common equity is low, a) nobody was even talking about that a year ago. And b) they should be talking about earning power."

Precisely. And earnings power, in turn, is determined by the cost and stickiness of your deposits and the quality of your assets. What you name the various slices of your capital base is pretty much beside the point.

Or would be beside the point, except that the market's new emphasis on tangible capital now threatens to lead to a government semi-takeover of some of the country's biggest banks.


Tangible common equity (TCE) is just one measure and totally insufficient as "the" measure of bank health. It's just one static frame in a movie that tells you little about a bank's asset quality or capacity to use earnings over time to absorb future losses.

Warren Buffett on Wells Fargo

Example - Bank A could theoretically still have a high TCE but a bunch of poorly underwritten, risky, asset time bombs on its balance sheet while bank B has low TCE but incredibly rigorous underwriting standards and a balance sheet full of low risk assets. Also, all else equal, Bank A may have an expensive deposit base and lower net interest income (i.e. lower return on assets) while bank B has a low cost deposit base and high net interest income (i.e. higher return on assets). In this case, bank B would clearly be the stronger bank but if static TCE is the main criteria it would do worse on the stress test. That makes no sense.

What makes sense to me is this: If a bank demonstrates it can build capital the old fashioned way (via earnings over time using the harshest stress test assumptions) it would not be required to raise capital even if the current capital ratios are a bit on the low side.

Adam

Long position in Wells Fargo

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Charles Mackay

Sound familiar?

"Money, again, has often been a cause of the delusion of the multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper."

This quote is by Charles Mackay, who wrote "Extraordinary Popular Delusions and the Madness of Crowds" back in 1841.

 In it, he describes the South Sea Company bubble (early 1700's), the Mississippi Company bubble (early 1700's), and the Dutch Tulip Mania (early 1600's) -- among other things.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Jeremy Grantham

If you've never read Jeremy Grantham before...check out his 4th quarter letter. Great stuff that's full of insights.

Grantham previously called the 2003-2007 period "the biggest sucker rally in history". Most think of him as a perma-bear because he has seen stocks as being overvalued since the late 1990's.

Like Buffett, many said he did not "get it" back in then.

Recently, he's turned relatively bullish (for him) on stocks for the first time in over a decade.

By the way, that "suckers rally" delayed the chance to buy stocks (with a reasonable margin of safety) for over five years. The general over-valuation of stocks for the past decade meant that most passive investors were(via 401k, IRA etc) systematically overpaying for equities. Stocks may still go down (I have no idea) from here but, at least, many are selling near or even below fair value for the first time since the early 1990's. In the long run stocks will track growth in intrinsic value. We are at least close to being back on the trend line.

Unfortunately, I'm guessing many who should be buying now will avoid the market after the experience of the past decade. In 1999, most people felt pretty good owning stocks at the worst possible time to buy. It's called the tech bubble for good reason but at the time, GE and Coke were selling at valuations north of 50x normalized earnings. So the over-valuations were not isolated to technology by any means. Today companies like GE and Coke sell at more like 12-14x.

So unlike 1999 it feels pretty terrible to own equities...we'll see if that means some money can be made over the next decade.

I'm looking forward to Grantham's 1Q letter.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, April 24, 2009

Mohawk Industries

Mohawk (MHK) is a floor covering business that I like quite a bit. It along with competitor Shaw Industries control more than 40% of the $ 20 billion+ US floor-covering market. MHK's market share has been increasing over the past decade. It has broad distribution and product breadth in an industry that continues to consolidate around the two dominant players. The economics appear to be very good for the leaders in this industry.

Of course, it is a very cyclical industry and the past 2 years have been tough. Similar to other cyclical businesses, MHK's stock will routinely drop 50-80% from peak to trough during a business cycle (the intrinsic value certainly does not..that's more steady than Mr Market). However, if you buy it at a fair price during recessions I believe MHK makes a great complimentary holding to the more steady businesses out there.

So this one's likely to be a bit more exciting than the P&G's of the world.

Yesterday's impressive forecast of 2Q earnings may hint that things are getting better in housing related businesses. The current quarter loss looks ugly (being a cyclical business that's the nature of the beast) but management's forecast of 2Q looks like the business environment may be stabilizing. You can't buy businesses like MHK based upon Price/Earnings (In fact, in my view you cannot buy any business based solely upon P/E...but that's another discussion). Companies like MHK always look expensive on a P/E basis during recessions and cheap at the peak of an economic expansion. In reality just the opposite is true. As a result, what makes something like this tricky to value with an appropriate margin of safety is you either have to:

1) discount normalized future earning power

or

2) buy when the company's P/E looks expensive (as a result of a temporarily depressed earnings in a recession...P/E may go to infinity as the E disappears for a while) and sell when it looks cheap (due to inflated earnings that are not sustainable throughout the business cycle).

I prefer the 1st method.

It's too late to buy MHK considering the size of today's move. The opportunity cost of sucking one's thumb instead of buying promptly can be just as real as the paper losses. Unfortunately, satisfaction with gains is not symmetrical with the dislike of losses. Waiting to see how Thursday's earnings report would go seemed like a good idea. I will continue to watch it and hope for a pull back.

Not acting decisively when you think you have a good idea can be costly.

In my view, MHK will easily go up a factor of 5 (trough to peak) during a full business cycle. The trough was ~$ 17/share (so far). Currently, it is selling in the mid $ 40's/share. At today's price MHK does not have sufficient margin of safety.

I'd expect future intrinsic value to grow to $90-100/share within 5 years (as I've said in previous posts I am not talking about the stock price but what I believe the company will be worth). I put MHK's current intrinsic value at $ 60-70/share.

The challenge with owning a cyclical business is ignoring the paper losses and volatility. With the inherently higher risks (both business specific and the current economic environment) I'd want to buy this at a 50% discount to intrinsic value. So we'll see if it gets below $ 35 again. If not...I missed it.

Adam

Long MHK

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, April 23, 2009

Staples vs Cyclicals

According to Jack Meyer, who managed the endowment, pension, and other assets as President and CEO of the Harvard Management Company from 1990 to 2005, investors wrongly think they'll be able to identify money managers that will deliver above average results:

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value. The investment business is a giant scam."

Now, buying -- ideally when very cheap or, at least, a plain discount to value -- then owning long-term the shares of some high quality businesses like Coca-Cola (KO), Pepsi (PEP), Procter & Gamble (PG), Philip Morris International (PM), and Diageo (DEO) offer a more simple (if not easy) alternative.* Their likely long run advantages, especially adjusted for the risk of permanent capital loss, aren't small. As it stands right now, the shares of these businesses seem to be selling at very reasonable recent prices relative to current per share intrinsic value. How long the window remains open -- where a margin of safety exists -- is naturally impossible to know. I've mentioned before that, even if shares of businesses like this do not outperform over the long haul going forward (and they may not, of course), the sheer simplicity of the approach compared to alternatives needs to be considered.

So does the reduced likelihood of permanent capital loss and more narrow range of outcomes. In fact, if the quality franchises produced merely market returns they'd still win in my book. The reason is that, if bought well, the same return will have been arguably achieved at less risk of permanent capital loss (not temporary paper losses).

Though each franchise has its own unique risks, these generally have, give or take, attractive business economics and future prospects. The durability of their advantages is more understandable than most other businesses in my view.

It is a totally different situation for market participants who's primary focus is the trading of price action.

Anyone buying the higher quality stocks expecting them to outperform during the next bull market is likely to be disappointed. That is, in part, how they have earned the reputation of being defensive. Yet, this reputation is verifiably incorrect when you look at the historic returns of these stocks over the longer haul (a full business cycle or two). Over shorter time frames, it's easy to see why these are perceived to be defensive investments. They generally don't go down as much when the market crashes, and they don't go up as fast during bull markets. It's over a number of bull and bear markets that their merits -- especially if adjusted for risk --  become more obvious. And when I say adjusted for risk I don't mean beta. I mean the risk of permanent capital loss (not near-term paper losses).

They tend to just quietly work out okay in the long run with little or no trading required. Of course, buying with a margin of safety is still very important. As I've said, what's sensible to buy at a plain discount to intrinsic value won't make sense at some materially higher valuation.

What really matters is, of course, how these businesses and ultimately their shares will perform going forward. Getting that at least mostly right still requires plenty of work.

In other words, just because something has done well in the past guarantees nothing.

Also, attempting to trade them based upon market conditions seems very likely to only hurt long-term results between the added frictional costs and mistakes that get made.

So look elsewhere for exciting stock market price action.

Some of the more cyclical sectors that are down 70-80% will outperform during the next bull market. Just keep in mind that you are taking more risk and, ultimately, many of these more economically-sensitive businesses are inferior in the long run.

That doesn't mean shares of all economically-sensitive businesses are inferior. There are some good ones. LOW, WFC, and AXP are examples I've mentioned in the past that I like for my own portfolio.
(As always, I never have an opinion on what others should or should not own.)

I've said previously...

Some commentators seem to suggest it's possible to jump in and out the shares of a high quality business based upon whether a defensive posture is warranted or not.

Well, correctly doing this without making mistakes (and creating unnecessary frictional costs) seems like a good idea mostly in theory, less so in practice.

As Jack Meyer points out above, a number of professional managers -- though certainly not all -- will perform poorly against benchmarks like the S&P 500 in the long run. Defensive stocks, on the other hand, tend to do just fine if bought cheap enough and held for a longer time period.
(Over the shorter run -- less than five years or so -- anything can happen as far as relative performance goes, of course.)

At a minimum, I'd argue this deserves more attention than it gets.

That doesn't mean no one can successfully time the market. I'm guessing there are some who effectively do that sort of thing. It's just that the evidence suggests the odds are not good when you include all the frictional costs involved and seemingly inevitable mistakes (every additional move isn't just a chance to improve results...it's a chance to make a mistake and hurt results). Also, identifying the managers who will actually do well long into the future is difficult at best.

Buy great companies at a fair (or better than fair) price. Otherwise, try to ignore the near-term -- or even intermediate-term -- market fluctuations and stock price action.

Finally, if someone is able to spot the next Google, Apple -- the next big thing -- they should go for it.

I have no idea how to do that without making costly mistakes.

Adam

Related posts:
Best and Worst Performing DJIA Stock
Defensive Stocks?

Long positions in KO, PEP, PG, PM, and DEO. My preference happens to be PM and DEO but consider each of these long positions to be worthy investments when bought at the right price. 
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, April 22, 2009

Tangible Common Equity

Every since Mr Market decided suddenly that Tangible Common Equity (TCE) was THE measure of a bank's health a couple of months ago I've been well...amazed. It's another great example of how some investors and media outlets can just grab onto something whether or not it makes sense.

Some think TCE is the focus of the bank stress tests. If it turns out the basis of the stress testing is to use this simplistic and flawed measure of bank health -- and, as a result, some of the better banks are forced to raise lots of capital at a discount to per share value -- that will be unfortunate.

Just a guess but I think we will find out the tests look at a more comprehensive set of measurements.

In this interview in Fortune Magazine, Warren Buffett had this to say about TCE as a measure of bank health:

"You don't make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on. And that's where people get all mixed up incidentally on things like the TARP. They say, 'Well, where'd the 5 billion go or where’d the 10 billion go that was put in?' That isn't what you make money on. You make money on that deposit base of $800 billion that they've (Wells) got now. And that deposit base I guarantee you will cost Wells a lot less than it cost Wachovia. And they'll put out the money differently." - Warren Buffett

We should know the answer soon.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Warren Buffett on Charlie Munger

Warren Buffett on his vice chairman:

"When I call Charlie with an idea...and he says, 'That is really a dumb idea,' that means we should put 100% of our net worth into it. If he says, 'That is the dumbest thing I've ever heard,' then you should put 50% of your net worth into it. Only if he says, 'I'm going to have you committed,' does it mean he really doesn't like the idea."

Seems to have worked pretty well for them.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, April 17, 2009

Best and Worst Performing DJIA Stock

CNBC is celebrating 20 years on the air today. They just mentioned the best and worst performing Dow stock since CNBC went live.

CNBC Turns 20

The best performing Dow stock over the past 20 years is Procter & Gamble. The Dow Jones Industrial Average returned 248% over the same period of time.

Procter & Gamble (PG) had a 780% increase in past 20 years (excluding dividends). Companies like P&G are categorized incorrectly as just "defensive stocks" (related previous post) in my view. Yet, stocks like P&G are routinely described this way. They certainly tend to do well in down markets but "defensive", at the very least, seems an incomplete description.

Generally speaking, in addition to P&G, companies like Coca-Cola (KO), Pepsi (PEP), Philip Morris International (PM), Diageo (DEO) and similar -- those that make and distribute leading branded small-ticket consumer products (fast-moving consumer goods: FMCG) on a big scale -- are higher quality businesses. As always, shares of even the highest quality businesses still must be bought at a plain discount to estimated value.*
(Over the shorter run -- less than five years or so -- anything can happen as far as price action and relative performance goes.)

P&G's performance is what happens to shares of durable high return businesses if allowed to compound long-term and bought well in the first place. The reasons for this is not particularly complicated. The $ 12 billion of free cash flow that P&G will approximately generate this year can be used to pay $ 5 billion in dividends with the rest going into some combination of buying back stock**, developing/acquiring new brands, or expanding distribution etc. The returns that P&G will generate on these new investments will eventually be roughly reflected in per share intrinsic value. Add the impact of new investments and buybacks to the high returns on capital that P&G generates from its already existing assets and, over a longer time frame, the stock is likely to compound nicely in per-share value.

So it's not magic (even if how compounding works sometimes seems that way). It's just consistent with what Ben Franklin said long ago.

"Remember, that money is of the prolific, generating nature. Money can beget money, and its offspring can beget more, and so on. Five shillings turned is six, turned again it is seven and threepence, and so on, till it becomes a hundred pounds." - Ben Franklin

Any one of these businesses can and, in fact, likely will go through extended periods of difficulty from time to time and, of course, so might the stocks. Some investors/traders will -- and it's somewhat understandable even if more generally unwise -- attempt to jump in and out of the shares based upon short-term or even intermediate-term factors. Yet, the casino-like culture that has emerged seems to have Sisyphus as its inspiration instead of good old Ben. As a result, a lot of unnecessary frictional costs and mostly useless hyperactivity have become embedded in the system.

"And that's where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers." - Warren Buffett in the 2005 Berkshire Hathaway Shareholder Letter

"...the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.

Long ago, Sir Isaac Newton gave us 3 laws of motion, which were the work of genius. But Sir Isaac’s talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases." - Warren Buffett in the 2005 Berkshire Hathaway Shareholder Letter

Bottom line: It's better to own great businesses (those with durable advantages), bought at fair prices (better yet, at a plain discount to well-judged intrinsic value), with the intention to hold them a long time. They won't necessarily do well over shorter time frames (less than five years or so) but the durability of their economics increase the likelihood they'll do just fine over the longer haul. Even if shares of the higher quality businesses did not outperform over the long haul going forward (and they may not, of course), the sheer simplicity of the approach compared to alternatives needs to be considered.

So does the reduced likelihood of permanent capital loss and more narrow range of outcomes.

Now, anyone buying the higher quality stocks expecting them to outperform during the next bull market will likely be disappointed.

That is, in part, how they have earned the reputation of being defensive.

Look elsewhere for exciting price action.

Yet, this reputation seems verifiably incorrect when you look at the historic returns of these stocks over the longer haul (a full business cycle or two). That, of course, guarantees nothing going forward but is, at least, noteworthy. Also, over shorter time frames, it's easy to see why these are perceived to be defensive investments. They generally don't go down as much when the market crashes, and they don't go up as fast during bull markets. It's over several bull and bear markets that their historic merits become more obvious.

Still, as I've said, just because something that seems to be a higher quality investment has done well in the past guarantees nothing.

Oh and by the way GM was, not surprisingly, the worst performing Dow stock over the past 20 years at -94%.

Adam

Related post:
Defensive Stocks?

Long positions in KO, PEP, PG, PM, and DEO. My top choice wouldn't be PG among the higher quality franchises even if it is as good an example as any of a higher quality franchise. My preference happens to be PM and DEO but consider each of these long positions worthy investments when bought at the right price. With any investment, no matter how seemingly attractive, margin of safety is all-important. What's sensible to buy at a price that represents a nice discount to intrinsic value doesn't make sense at some materially higher valuation. Margin of safety protects against the unforeseen real, even if fixable, business problems. Still, it's worth considering this: "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 at USC Business School in 1994
** Only if selling at a discount to intrinsic value.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, April 15, 2009

GM vs Philip Morris (Altria)

The following is a good example of how much durable high return on capital (ROC) and a consistently low stock price in the long run matters in investing. Let's say $ 10,000 was invested in the following two stocks back in 1957.

Fifty plus years later, $ 10,000 invested in General Motors (GM) back then was well on its way to being worth nothing.

(Unless, of course, the cash dividends were invested elsewhere over time.)

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

The tobacco company generated an annual return of nearly 20% during that time frame.

So an asset that returns that much annually left to the magic of compounding turns $ 10,000 into more than $ 80 million in roughly 50 years.

A big part of the returns produced by Philip Morris/Altria came from dividends that were reinvested in a stock that was consistently inexpensive.*


The fact that some investors won't touch a tobacco stock along with the risk of litigation, regulation, taxation, and declining volumes kept shares of Philip Morris/Altria mostly cheap for many years.

That means a roughly 6x increase in value has been an average decade for MO. That also happens to be pretty much what Altria produced this past decade. Odds aren't too bad 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).


Also, all else equal, total return will be improved if the shares are priced, more often than not, at a nice discount to intrinsic value (to improve the effectiveness of buybacks and dividend reinvestment).

Those with a long-term investing horizon should consider that the next time they cheer for a near-term stock price increase.

Adam


Long position in MO and PM

* This works in a similar way to share repurchases other than tax considerations. Dividends can be taxed. That is not the case for share repurchases. Excluding the tax differences, share repurchases 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.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Defensive Stocks?

Companies like Johnson & Johnson (JNJ) and Procter & Gamble (PG) are usually referred to as "defensive stocks". Well, as it turns out, that's not really been the case based upon returns over the past 20 years. The word "defensive" implies more modest overall returns as a trade-off for more downside protection.

In fact, those two stocks -- and others with similarly durable economic characteristics -- historically have had higher long-term overall returns combined with their defensive characteristics.

Stock                                         |20-Year Return
Johnson & Johnson (JNJ)|   784%
Procter & Gamble (PG)        |   713%
Coca-Cola (KO)                     |   580%
Pepsi (PEP)                             |   561%
Hershey (HSY)                      |   408%

S&P 500                                   |  179%
Source: Yahoo! Finance

The returns posted above include only the capital gains portion of the 20-year return. Include the dividends and the total return, of course, is actually much higher. As a result, the above naturally understates the performance gap since the dividends these companies pay are typically bigger than an index fund based upon the S&P 500. The bottom line: many of these companies have historically outperformed over the long run at lower risk, at least in part, for the simple reason that they have been higher quality businesses.

At least that is my view.

Durable high returns on capital ends up mattering a whole lot in investing.

Generally, these businesses tend to have it. My preference, these days, happens to be Philip Morris International (PM) and Diageo (DEO), but certainly others could be attractive if bought at the right price.* 
(PM was a spin-off from Altria (MO) in 2008. DEO was formed in 1997 through a merger between Guinness and Grand Metropolitan. Neither PM or DEO has 20 years of U.S. trading history as separate marketable stocks so their results have not been included above. Guinness and Grand Metropolitan did trade publicly before the merger.)

Altria also did extremely well -- including, of course, the value of the recent spin-offs -- over the past 20 years. In fact, Altria's stock performed better than all the other stocks above (well, at least those with a long enough trading history). Over the long haul, few stocks can match Altria in terms of historic total returns. Starting in early 1957 -- when the S&P 500 was launched -- through 2006, Altria's stock produced a 19.88% annual return (incl. reinvested dividends). 

So a $ 10,000 investment would have increased to over $ 80 million during that time. In comparison, $ 10,000 in the S&P 500 would have increased to $ 1.68 million.

There is, of course, nothing wrong with those S&P 500 results. For some perspective, keep in mind that investment professionals -- those who actively engage in stock picking in an attempt to perform better than a broad-based index -- tend to have a tough time matching the S&P 500.

I've included Hershey (HSY) above but, unlike the others, it is just not a stock I follow closely enough (for ownership to be a consideration).

I also don't happen to closely follow something like General Mills (GIS) though it's certainly another relevant example. The company's shares have similarly done just fine compared to the S&P 500 over the past 20 years. I just happen to be a bit less comfortable with that particular business.

The list doesn't end there. My point being, though there are always exceptions, it is difficult to find shares of businesses that produce leading small-ticket consumer branded products (fast-moving consumer goods: FMCG), with sufficient distribution and scale, that did not produce at least solid total returns over those 20 years. The best of these generally have a combination of the strongest brands, outstanding distribution, and scale. This doesn't mean their future prospects remain as attractive as they have been in the past. In fact, I'd be surprised if that's the case. Nor does it imply that these businesses and their shares are equally attractive. They surely are not. Some seem more likely than others to be able to at least maintain a healthy economic moat. Some appear to have superior core economics. Those that do, if bought at reasonable or better prices, should at least improve the chances for attractive long-term investment outcomes.

For me, some have easier to understand advantages and prospects. It just never makes sense to buy something that's not well understood (necessarily unique for each investor). This is true no matter how good business prospects appear to be. It's a useful principle.

Ignoring "the noise" (and there's usually lots of it) depends on strong and warranted levels of conviction. Investing in what's understandable and likely to have a narrower range of outcomes is not a bad place to start when it comes to this.

Now, the reality is that prior performance should provide motivation for further analysis but that's about it. In other words, the fact something has done well in the past shouldn't, in itself, be all that interesting. The competitive landscape inevitably changes over time potentially damaging -- at least to a degree -- what were once attractive business economics. This is true even for very good businesses.

Still, check out the long-term investment results over different time horizons (i.e. something like several different 20 year time horizons other than the past 20 years) for these and other similar high quality businesses. Also, check out much longer time horizons. I think any objective look at this will more than suggest that many -- even if not all -- shares of the higher quality businesses historically produced rather solid or better long-term risk-adjusted results.
(Over the shorter run anything can happen as far as relative and absolute performance goes. I'd argue that at least a full business cycle or two is needed to judge performance.)

Well, especially if bought at a nice discount to intrinsic value but, at the very least, at a reasonable valuation. What's a smart buy at a plain discount to value isn't at some higher premium price no matter how good the business may be.

Also, as with any business, whether management is capable of sustaining and even increasing the moat matters a whole lot. As does competent capital allocation and a sound balance sheet.

These are elements of intrinsic value that are hard to measure yet still very real.

Of course, what ultimately matters is how these businesses and their shares perform going forward. Getting that at least mostly right still requires plenty of work.

In other words, just because something that seems to be a higher quality investment -- and has done well in the past -- guarantees nothing.

"If past history was all there was to the game, the richest people would be librarians." - Warren Buffett

The question is whether the best of these continue to possess durable advantages.

At a minimum, the above at least suggests that those who knew how to judge business value could have: 1) taken "inventory" of leading small-ticket consumer brands in use everyday, 2) bought the corresponding stocks at a fair price (or, better yet, when they were occasionally selling at a plain discount to value), 3) held them long-term, and 4) achieved more than satisfactory risk-adjusted results. This is a simplification, of course, but a deliberate one to emphasize that sound investments are sometimes in plain view.

Minimal trading and frictional costs.

Complex strategies not always required.

This all promises nothing about the future but does seem, at least, not a bad place to start.

The best of these franchises continue to have attractive risk and reward characteristics if bought at the right price. Still, it seems unwise to expect nearly as attractive returns going forward.
(Now, if performance turns out to be better than expected, there'll be no complaints.)

In contrast, the average actively managed mutual fund underperforms the S&P 500. According to Vanguard founder John Bogle, from 1984 to 2002 mutual funds on average delivered a 9.3% annual return compared to the S&P 500's return of 12.2% a year.**

"The reason for that lag is not very complicated: As the trained, experienced investment professionals employed by the industry's managers compete with one another to pick the best stocks, their results average out. Thus, the average mutual fund should earn the market's return—before costs. Since all-in fund costs can be estimated at something like 3% per year, the annual lag of 2.9% in after-cost return seems simply to confirm that eminently reasonable hypothesis." - John Bogle

Some commentators seem to suggest it's possible to jump in and out the shares of a high quality business based upon whether a defensive posture is warranted or not.

Well, correctly doing this without making mistakes (and creating unnecessary frictional costs) seems like a good idea mostly in theory, less so in practice. In fact, there's plenty to suggest this might be less than a brilliant approach. It's not just that the average mutual fund underperforms. It's worse than that.

Here's what Jack Meyer, who managed the endowment, pension, and other assets as President and CEO of the Harvard Management Company from 1990 to 2005, had to say:

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value." - Jack Meyer

Of course, there are more than a few exceptional professional money managers with proven track records but, in the real world, it's just not easy to identify who'll outperform beforehand.

Investors add complexity and risk to the investing process that often isn't necessary.

For many reasons, shares of these and similar higher quality businesses seem unlikely to perform nearly as well on an absolute basis in the future.

Maybe that's a conservative view. Maybe not.

In addition, judging value well and buying them at a plain discount to intrinsic value (i.e. with a margin of safety) still, as always, matters a bunch. Again, what's sensible at a plain discount to intrinsic value doesn't make sense at some materially higher valuation. Also, a stock that persistently sells at a discount to per share intrinsic value allows buybacks and reinvested dividends to be more effective. This can improve -- all else equal -- long-term results. A high market price relative to value is only beneficial when it comes time to sell. Naturally, this also means that a stock that frequently sells at a full (or a premium) valuation reduces long-term results. So if some of these stocks were to get fully valued and stay fully valued returns will actually be worse over the longer haul. Something to consider the next time a stock owned for the long-term heads higher in the near-term.

A near-term rally may be good for the trader (with a long position) but certainly is not for continuing shareholders who've invested with decades in mind.

In any case, the relative risk-adjusted merits for the best of these consumer businesses seems likely to remain not insignificant if the shares are bought reasonably well in the first place. They can offer a simple (if not necessarily easy) yet effective means of producing results.

It's worth mentioning that Warren Buffett's long-term results didn't necessarily come from trying to outperform during bull markets. He once wrote:

"Our performance, relatively, is likely to be better in a bear market than in a bull market..."

and

"In a year when the general market had a substantial advance, I would be well satisfied to match the advance of the averages."

The point is certainly not that consumer defensive stocks are capable of matching Buffett's long-term performance.

Not at all.

The point is that judgments about performance shouldn't be solely based upon what happens during a bull market; it's that outperformance during bull markets isn't necessarily required to get good overall long-term results. The focus should be on the combined result across all market environments over many years and, better yet, multiple decades. In fact, these so-called defensive stocks will likely live up to their reputation during bull markets and bear markets. That means they are not likely to quite keep up during a steadily rising market. If they did it'd likely be resulting from market price action outpacing increases to per share intrinsic value. Not sustainable. It's in bear markets and difficult economic environments that that they will usually demonstrate their strengths. This bull and bear market dynamic tempts some market participants to try and only own the more defensive stocks at the right time. Well, that seems like a better idea on paper than it is in reality. Mistakes and frictional costs make that rather tough to reliably do well.

I'm guessing this won't stop some from trying to pull it off.

A few might even do this effectively but, at the very least, some skepticism is warranted.

When it comes to consumer defensive stocks, it's attractive core economics and the persistence of their earning power -- on a compounded basis over long time horizons -- that's the key. Well, it is as long as excess capital is generally put to good use and the price paid is at least reasonable.

The importance of performing relatively well during bear markets is sometimes underappreciated. While there's no way to know how well the better among these consumer defensive stocks will do in the future -- in the context of risk, reward, and possible alternatives -- they're not the worst place to begin looking for long-term investments.

Adam

* Long positions in PG, JNJ, KO, PEP, MO, PM, and DEO. These are stocks I consider attractive long-term investments if bought at the right price for my own portfolio. In other words, I never will have an opinion as to what others should or should not be buying or selling. My judgment may also turn out to be very wrong, of course. Going forward, I happen to think that both PM and DEO have very attractive business economics and durable advantages that are at least as good as most "defensive stocks" (and likely better than some of the others listed above). I don't think the reputation for these being defensive stocks is incorrect, it's just incomplete. Yes, defensive stocks usually have less than exciting price action and volatility and are likely to do better in bear markets. Yes, they're also likely to not do particularly well in bull markets. Anyone buying these stocks expecting them to outperform during the next bull market is likely to be disappointed. That is, in part, how they have earned the reputation of being defensive. Yet, this defensive reputation isn't quite correct when you look at their historic returns over the longer haul. So it's when they're looked at over longer time frames (more than a full business cycle or two) that the picture becomes more clear. Long-term offense and defense. Higher quality businesses. Of course, like any investment, they've still got to purchased with a margin of safety. Many of these seem not particularly expensive at all in April 2009, but who knows if that persists. As with any business, a healthy balance sheet still matters but, generally speaking, the best of these tend to have more than respectable financial strength. Capable management and wise capital allocation naturally also matters. Now, even if shares of the higher quality businesses didn't match long-term market performance going forward (and they may not, of course), the sheer simplicity of the approach compared to alternatives needs to be considered. So does the reduced likelihood of permanent capital loss and more narrow range of outcomes. In fact, if the quality franchises produced merely market returns over the longer haul, they'd still win in my book. The reason is that, if bought well, the same return will have been arguably achieved at less risk of permanent capital loss (not temporary paper losses).
** This study was limited to mutual funds. Some might wonder how hedge funds have performed long-term. Here's a paper by Burton Malkiel and Atanu Saha that provides some insights on hedge fund risk and returns.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, April 9, 2009

Intrinsic Value: The Six Stock Portfolio

Below, I've noted how I think current market prices compare to likely per share intrinsic value of some very good businesses.

These are shares I like for my own portfolio over a very long time frame.* In other words, I never have a view what others should own. In fact, for many reasons, I think it unwise for any investor to buy or sell a common stock based upon the views of someone else. To me, the only good way to develop real (and warranted) conviction about a particular investment is through one's own work.

This is less about stock picking (and not about trying to gauge near-term price action), more about finding shares of great business franchises to own long-term that are available at discount to value, conservatively calculated.

On prior occasions, Warren Buffett has explained that investing can be simple but it's not necessarily easy.

Well, the approach below attempts to respect this dictum (as well as many of Mr. Buffett's other investing principles).

So the idea is to buy several great durable businesses with high returns on capital at a fair or better than fair price and own them long-term. I've posted what I believe the shares of the six businesses below will be worth in three years not what the stock prices will be (though in the long run those stock prices will approximate value). An estimate of intrinsic value is, of course, never a precise number.

I think about it this way. Within three years or so, there's a good chance the stock prices will begin to close the gap and more closely reflect the intrinsic value of these businesses. Some, inevitably, more quickly than others.

In addition, purchased at or near current prices, I believe shares of these businesses can return (including dividends) in the range of 10% to 14% per year, on average, over the longer haul.** I could easily be very wrong, of course. The returns, if they materialize, will come primarily from long-term increases to intrinsic value, not some clever attempt to own the stocks at just the right time. It starts with owning durable business franchises with attractive returns on capital. That, in addition to paying a price that represents a nice margin of safety, is what matters when it comes to generating investment results over the long run. It comes down to owning what inherently has a sustainable competitive advantages and, ideally, is run by talented managers that will build on that advantage over time.
(The business must also be comfortably financed. That means being financed in a way that is conservative in nature but appropriate for the specific business and industry characteristics. So this assessment includes judging balance sheet strength but isn't limited to that and can't be viewed in a vacuum. What's sufficiently comfortable under one scenario would be hardly at all in another.)

So, if I can't figure out the range of what a business is likely to be approximately worth in one or, ideally, more like two decades using conservative assumptions, I'd rather not own it now. I do not spend much time and energy concerned about stock price action in the short run or even longer. In fact, if the price continues to stay meaningfully below intrinsic value, it just provides an opportunity to buy more shares over time. It also allows the company to buyback shares cheap to the benefit of continuing shareholders. Otherwise, it's better to use available time and energy evaluating whether the core franchise is being strengthened or weakened. Even the best business franchises can run into A) short-term troubles (AXP) or can even be B) permanently damaged (newspapers).

A) = opportunity, B) = threat

The portfolio*** is made up of the following stocks: Diageo (DEO), American Express (AXP), Pepsi (PEP), Philip Morris International (PM), Wells Fargo (WFC), and Lowe's (LOW).

Stock | 3-Yr Intrinsic Value | Recent Price
DEO   |          $70-80/share    |$ 45/share
AXP   |         $55-65/share      | $ 15/share
PEP    |         $75-80/share     | $ 52/share
PM     |         $60-70/share     |$ 36/share
WFC  |         $45-55/share      |$ 14/share
LOW  |         $35-40/share     |$ 18/share

The financials I've listed have, at this time, difficult to gauge regulatory risks. The prices I've posted assume reasonableness in the policy area will prevail in the coming months. Any of these could pull back in the near term and I do not believe this portfolio will necessarily outperform in the next 2-3 years. Having said that, over the next decade or so, I'd expect these to perform well at less risk than the market as a whole.

As always, I attempt to buy shares at a price that provides a nice margin of safety. What makes sense at one price is dumb at another. That's true for even the best business. Generally speaking, my preference is to buy shares of the financials listed here when selling for at least a 50% discount to my necessarily rough estimate of current per-share intrinsic value and the others at a 30% discount.

Sometimes slightly more or less based upon factors that are unique to each business.

Adam

Long position in DEO, AXP, PEP, PM, WFC, and LOW

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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** The average annual return will, of course, almost certainly be vastly different than what happens in any particular year. These are common stocks, after all, so wide year-to-year fluctuations driven by market mood swings and other factors more or less specific to the individual business should be considered the norm. The focus here is on intrinsic per share business performance over the long haul, not near-term price action. The key is to buy shares at a discount to value in the first place.
*** This portfolio is concentrated by design. Some might consider such a concentrated portfolio to be extremely risky. My view is that concentration can be a good thing in the long run even if it sometimes increases volatility and near-term underperformance. Concentration forces the investor to own what they understand and prefer the most. It works if the investor feels rightly confident that what they've decided to own has sound long-term economics, durable advantages, and reasonably capable management (those who are smart capital allocators among other things). It works if the business has sufficient financial strength (and, where appropriate, is improving that strength) to weather inevitable, hard to foresee, future economic storms and specific business difficulties. More diversification makes sense if the investor is less comfortable with judging the long-term prospects of individual businesses. I say this knowing that, over the long haul, each one of these six businesses is almost certain to get into difficulties, maybe even serious, from time to time. I think of risk in terms of the possibility of permanent loss of capital, not temporary paper losses, and certainly not worse-than-useless measurements like beta or anything similar. Importantly, this approach requires minimal trading activity and, for that matter, trading acuity. Fewer moves means fewer potential mistakes and reduced frictional costs. It all comes back to whether business prospects and value can be judged well then paying the right price. Now, if the economic moat of one of these became materially damaged in some way then, of course, a change might be in order. Otherwise, my preference is to minimize moves and get results primarily via what these businesses will produce over time.

Wells is Profitable...Very Profitable...Earns $ 3 billion in 1Q09

After months of some folks claiming the US banking system is insolvent Wells Fargo comes out with this earnings pre-announcement. They earned $ .55/share. A record for them. Consensus was .26/share.

Influential analyst Meredith Whitney had them rated a sell and believed Wells would earn .06/share.

Roubini has been saying US banks are insolvent.

I don't think so.

Adam

Long position in Wells Fargo
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
 
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