Thursday, April 29, 2010

"Nothing But Costs"

In a recent article, Jeremy Grantham calls raising fees in the investment industry actually is a "raid" of the balance sheet of investors.

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

Good to hear someone from inside the industry be straightforward about this kind of stuff.

As recently as the 1960's financial services was ~2% of GDP while today it is above 6%. Late last year after pointing out this fact to some senior level bankers, Paul Volcker said:

"Is that a reflection of your financial innovation, or just a reflection of what you're paid?"

The individual money manager someone hires may or may not do a good job but collectively the industry is "nothing but costs". These frictional costs literally subtract capital from the system and convert it into income.

"What is Wall Street supposed to do? It's not a creator of wealth. It's a handmaiden to creators of wealth. It occupies an essentially parasitic, but usefully parasitic relationship with the rest of the society. It's totally out of control. It's not making America a great place; it's making America a worse place right now." - Michael Lewis in this Bloomberg article

Usefully parasitic but like Volcker says, all the so-called "financial innovation" has gotten a bit expensive relative to GDP. More importantly, it's expensive relative to the value it actually adds to society.

A hidden tax on capital development.

Adam

Related post:
When Genius Failed...Again

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 28, 2010

Coin Flip

"Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide." - Peter Lynch

Monday, April 26, 2010

1958 Buffett Partnership Letter

Some excerpts:*
  • During the past year, almost any reason has been seized upon to justify "investing" in the stock market. There are undoubtedly more mercurially-tempered people in the stock market now than for a good many years and the duration of their stay will be limited to how long they think profits can be made quickly and effortlessly.
  • I make no attempt to forecast the general market--my efforts are devoted to finding undervalued securities.
  • It is obvious that we could still be sitting with a $50 stock patiently buying in dribs and drabs, and I would be quite happy with such a program although our performance relative to the market last year would have looked poor.
  • ...our performance for a single year has serious limitations as a basis for estimating long term results. However, I believe that a program of investing in such undervalued well protected securities offers the surest means of long term profits in securities.
  • Such a policy should lead to the fulfillment of my earlier forecast--an above average performance in a bear market or neutral market, and a normal performance in a bull market. It is on this basis that I hope to be judged.
Here is a link to highlights of all the Buffett partnership letters* from 1958-1969.

Adam

* Written in early 1959 by Buffett to discuss the previous year's performance. Copies of all the Buffett Partnership Letters can be found here.
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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 are never a recommendation to buy or sell anything.

Friday, April 23, 2010

American Express

Not surprisingly, the earnings strength of American Express (AXP) was reinforced by yesterday's report. Earnings are normalizing quickly. AXP's net income was $ 885 million in the 1st quarter of 2010, more than double 1st quarter 0f 2009. Revenue in 1Q 2010 increased to $ 6.6 billion from $ 5.9 billion in 1Q 2009.

It's worth noting that American Express remained profitable throughout the crisis whereas most other financial institutions posted at least one, if not multiple, quarters of losses. This has a lot to do with AXP's "spend-centric" model, where most revenue comes from the "tolls" collected each time someone uses one of their cards. They get in the neighborhood of 2.5 percent of the transaction value each time a card is used. Most competitors get only a small fraction of that amount and rely on a "lend-centric" model. Also, the average AXP customer spend at least 3x more than customers of other credit card companies.

Some comments by Ken Chenault, chairman and ceo of American Express from the 1Q 2010 Earnings Report:

"Cardmember spending was up 16 percent, rebounding strongly from the recessionary lows of last year," said Kenneth I. Chenault, chairman and chief executive officer. "Credit metrics also continued the improvement that began in the second half of 2009."

And,

"Our ability to generate strong volumes comes at a time when cardmembers are paying down their outstanding debt. This compares favorably to the major issuers who traditionally have had to rely on lending-oriented customers to generate billed business. At a time when so many consumers are focused on value, our relative strength also reflects the importance of pay-in-full charge cards and the appeal of our rewards, customer service and benefit programs."

The company should earn over $ 3.5 billion this year with a return on equity among the highest in the financial services industry. So the earning power is there and should grow in the coming years.

Of course, AXP is not perfect. Its balance sheet is solid now but I did not consider it a strength a few years back. That changed during the financial crisis. The strain of the crisis put pressure on AXP to strengthen its funding sources. Prior to the crisis, my biggest concern with AXP had been too much reliance on capital markets for short-term funding (commercial paper). That does not seem like a dangerous thing until a time like 2008 when capital markets stopped functioning properly and seized up.

Today, they rely very little on commercial paper and have continued to increase their use of FDIC insured deposits. These days most funding comes from 1 of 3 sources: long-term debt, FDIC insured deposits, and securitizations (they also have other sources of liquidity...since they converted to a bank holding company this includes the discount window from the fed). The important thing to me is they no longer need to routinely roll over so much short-term debt and that they are increasing their insured deposits. Also, AXP has more equity and less total debt (including what was previously off-balance sheet securitizations*) and generally carries more cash compared to back in 2007. Not perfect...but a better situation.

So the pressure of the crisis pushed the company to make its balance sheet more sturdy. As a result, I think AXP is a better company. It can still be messed up much more easily than a Coca-Cola or Diageo, but in the context of financial services, it has a great model.

Unfortunately, the stock is no longer cheap. As of a few minutes ago it was trading at ~$ 48.80/share giving it a ~$ 58 billion market cap.

Adam

Long position in AXP

* The off-balance sheet securitizations were moved onto the balance sheet this quarter.
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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 22, 2010

Energy Drinks

Even with traffic down at convenience stores, the energy drink segment continues to grow. According to a report using data from Nielsen Co., energy drink sales have improved recently with Hansen's Monster (the # 2 energy drink in the US behind Red Bull) growing faster than the overall energy drink market.

article

...growth of the overall energy drink category and Hansen Natural Corp., maker of Monster, both accelerated in the four weeks leading up to March 20. Overall energy drink sales in convenience stores rose 5.1 percent and Hansen's sales rose 8.6 percent. Convenience stores account for about 75 percent of energy drink sales.

Hansen Natural Corp. should earn ~$ 220 million this year on over a $ 1.2 of sales. Its current market value is ~$ 3.7 billion with no debt and over $ 400 million of cash on the balance sheet. They have created a very successful brand but distribution still depends on the likes of Coca-Cola. With a ~15x enterprise value/earnings it is definitely not an inexpensive stock. As of now, the company's economics are excellent with extremely high returns on capital. If those returns on capital are at all durable over time then the current multiple is cheap. The difficult part is: 1) a lack of product breadth (90% of sales comes from energy drinks), 2) dependence on others for distribution, and 3) fierce competition between Hansen and larger (financially stronger) companies. These 3 things will continue to be hard to gauge risks going forward. As a result, estimating intrinsic value is not easy for this one.

On the other hand, if someone wants to make a concentrated investment in one of the two leaders of the energy drink segment Hansen is pretty much it. I've noted what I'd pay for HANS in Stocks to Watch for quite a while (up to $ 30/share). I think a large margin of safety is warranted on HANS to account for the 3 risks noted above (Current market price is ~ $ 41/share).

It is possible that Hansen will be acquired one of these days by Coca-Cola or Pepsi to more firmly tie this strong brand with distribution. That's a reasonable guess but who knows. Coca-Cola seems more likely considering the existing distribution relationship. The CEO of Coca-Cola Enterprises (CCE) has said recently he'd like to have more Monster to distribute.

Hansen has obviously done a lot of things right up to now. They have been going up against some pretty tough competitors for a long time and winning. Building a highly profitable $1 billion brand in a decade or so with competitors like Coca-Cola, Pepsi and Red Bull is no small feat. It will interesting to see if they can continue to execute as they move from being primarily a US brand to a global one.

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.

Wednesday, April 21, 2010

POSCO: Most Competitive Steelmaker

From this article:

POSCO Wins Back Most Competitive Steelmaker Title

Korean steelmaker POSCO has reclaimed the title of the world's most competitive steelmaker after losing it six years ago.

World Steel Dynamics (WSD), a steel information service, ranked POSCO as the most competitive steelmaker among the 32 major steelmakers.

Adam

Small long position in POSCO

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 19, 2010

Salomon

Some comments from Charlie Munger about his experience with Salomon almost twenty years ago:

At Salomon we asked, "Where is the list of things you won't do because they’re beneath you?" We never saw it. Envy and greed lead people to doing almost anything that looks profitable and does not require use of a machine gun. Investment bankers were better when I was young. They used to care about the quality of deals – they cared a lot. Ethics attenuated a lot. This was not good.

The deterioration would be an interesting subject for social science. You'd have to understand psychology – it would be very difficult for somebody to do it.

Why is the high road the best way in investment banking? It's not very crowded. [Laughter]

Seems a bit more relevant in the wake of the SEC's charges of fraud against Goldman Sachs. Today, many investment banks still seem to have no such list and a trading culture dominates.

A big overhaul to Wall Street's culture via changes to incentives (toward "long-term greedy") and requiring that the senior players once again have more skin (i.e. more of their own capital) in the game seems badly needed.

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.

Hayek

"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design." - Friedrich Hayek

Klarman: True & False Lessons From The Financial Crisis

Thursday, April 15, 2010

Munger on Multi-tasking

"How did Berkshire's track record happen? If you were an observer, you'd see that Warren did most of it sitting on his ass and reading. If you want to be an outlier in achievement, just sit on your ass and read most of your life. But they fire you for that!

Look at this generation, with all of its electronic devices and multi-tasking. I will confidently predict less success than Warren, who just focused on reading. If you want wisdom, you'll get it sitting on your ass. That's the way it comes." - Charlie Munger


The above quotes are from Whitney Tilson's 2007 Wesco annual meeting notes.

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.

Wednesday, April 14, 2010

POSCO's Earnings

POSCO (NYSE: PKX) reported 1Q 2010 earnings yesterday. The South Korean company, one of the best steel manufacturers in the world, looks to have had another very solid quarter. I'm guessing that they will soon be earning at least $ 3.5 to 4.o billion/year.

Obviously, the steel business is very cyclical yet unlike many steelmakers, POSCO remained profitable in 2009. POSCO earned $ 2.82 billion in a year where most competitors lost money or struggled to break even. Impressive financial performance considering the economic stresses of 2009. In contrast, US Steel (NYSE: X) went from earning $ 2.1 billion in 2008 to losing $ 1.4 billion in 2009.

The market value of POSCO is ~$ 37 billion (@ the current ADR price of ~$ 121/share). Not cheap relative to earnings for a steel company but they appear to be a solid business within a tough industry.

Here is an article in the Wall Street Journal on POSCO's 1Q earnings. Net profit for the most recent quarter was $ 1.29 billion.

Adam

Small long position in POSCO

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.

Tuesday, April 13, 2010

1938: Fortune Magazine on Coca-Cola

From the Yacktman Fund and Yacktman Focused Fund 1Q 2010 letter, a reference to what Fortune Magazine was saying about Coca-Cola (KO) in 1938:

Some think if an investment idea is well-known and seems obvious it can't be really good. In 1938, Fortune Magazine concluded "Several times every year, a weighty and serious investor looks long and with profound respect at Coca-Cola's record, but comes regretfully to the conclusion that he is looking too late." Since that time, Coca-Cola has grown significantly both domestically and around the world. It was not too late in 1938, and we believe it is far from that today.

In the letter, there is other commentary by the Yacktman team on Coca-Cola worth checking out. They explain their view of why Coca-Cola is likely to produce double digit long-term returns at lower risk than the market.

Adam

Long KO

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 12, 2010

Berkshire Hathaway's Top 5 Holdings

Kraft is practically a startup among this group...

Top 5 Stocks in Berkshire Hathaway's portfolio
  1. Coca-Cola - Founded in 1886
  2. Wells Fargo - Founded in 1852
  3. American Express - Founded in 1850
  4. Procter and Gamble - Founded in 1837
  5. Kraft - Founded in 1903
The average year these top five holdings were founded is 1865. In 1987, 150 years after P&G was founded some investors were probably saying: "P&G is an investment that provides safe but modest returns" or "too bad we missed the opportunity to buy it years ago when it was smaller".

You'll still hear these kinds of statements just about everyday on business news for businesses like P&G.

Yet, 20 years later in 2007, P&G's stock was up 1000% excluding dividends. How many back in 1987 would have expected that? By comparison, the S&P 500 was up a little over 400% during that period. This 1000% return happened even if you were unlucky and bought the stock before the 1987 crash* happened. It makes little sense to expect those kind of returns going forward but I never underestimate the economics of these franchises that seem "boring and safe". They reliably deliver good to great returns (at lower risk) with a time horizon that is long-term and, of course, if purchased at fair prices (ie. not 1999).

Adam

* If you bought it after the 1987 crash returns increase to ~1400% excluding dividends.
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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 8, 2010

Munger: Keeping it Simple

Charlie on Berkshire Hathaway's straightforward approach to the insurance biz. What he says about insurance applies to investing.

"More insurers don't copy BRK's model (underwriting for profit and stepping out of the market for extended periods of time when pricing is bad) because our model is too simple. Most people believe you can't be an expert if it's too simple." - Charlie Munger at the 2007 Wesco Meeting

Sidekick has sage advice of his own

This comment by Charlie on insurance is true of investing more generally. As an example, market participants seem too rarely to choose buying at a fair price then holding, for long periods, the durable high return on capital franchises as a core part of their investing strategy.

Some do. Many do not.

Why? Possibly, at least in part, because it's just too damn simple.

Instead, it is common to treat these companies as places to park money until some "high beta" opportunity comes along.
(I use the term "high beta" here since it is commonly used, though it is one I'd never use otherwise. Beta is often thought of as a proxy for risk. It is not. To me, things like CAPM are very flawed and EMH is, well, an abomination.)

In this BBC interview last year, Charlie Munger states why his investing ideas are not widely used. He says it is because the ideas are "too simple".

It's not difficult to understand why some businesses are likely to produce returns in excess of the market (likely but obviously not guaranteed...moats do get wrecked) decade after decade even if bought at slightly higher than what seems reasonable P/FCFs*.

Still, many choose** the path toward more the complex and risky strategies.

"The hedge fund known as Long Term Capital Management collapsed...despite I.Q.'s of its principals that must have averaged 160. Smart people aren't exempt from professional disasters from overconfidence. Often, they just run aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger

Buying simple things that you understand also reduces the chance of making big mistakes. Fewer mistakes combined with low frictional costs allow the long-term effects of compounding to be the dominant factor.

Adam

* One of the nice thing about this style is that minimal trading skill is required since the emphasis is on the long-term effects of the company's economics. So you buy, sit back, and monitor threats to the moat. Is the moat getting wider or narrower? Is management actively attempting to reinforce/widen that moat?
** I am not suggesting that this approach will outperform the best money managers. It won't. It's just that many investors take on risk and complexity that is not necessary.
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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.

Wesco Annual Meeting

The Wesco 2010 Annual Meeting is a month away or so. As we approach that meeting, I will be posting some of Charlie Munger's comments made at the meeting in prior years.

Berkshire's investment in POSCO
I would argue that what POSCO does is not a commodity business at all – it's a high-tech business. They learned from Nippon Steel and they’re now even more advanced. I'd argue that if you have the most technologically advanced steel company in the world making unusual, [non-commodity] stuff, then business can be quite attractive for a long time.

Should USG [a Berkshire holding] have issued stock to fund a recent acquisition?
I'm hesitating because I'm trying to decide whether to duck that question or give the correct answer. [Laughter]
That was a foolish thing to do, but they can't help it: some of them went to business school. [Laughter and applause]


The above comments are from Whitney Tilson's notes taken at the 2007 meeting.

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.

Monday, April 5, 2010

Les Schwab

Charlie Munger uses simple microeconomics to explain the success of the Les Schwab tire store chain. The following is from a speech he gave at the University of California back in 2003:

Case Study: Les Schwab Tires

"There's a tire store chain in the Northwest, which has slowly succeeded over 50 years, the Les Schwab tire store chain. It just ground ahead. It started competing with the stores that were owned by the big tire companies that made all the tires, the Goodyears and so forth. And, of course, the manufacturers favored their own stores. Their 'tied stores' had a big cost advantage. Later, Les Schwab rose in competition with the huge price discounters like Costco and Sam's Club and before that Sears Roebuck and so forth. And yet here is Schwab now, with hundreds of millions of dollars in sales. And here's Les Schwab in his 80s, with no education, having done the whole thing. How did he do it? (Pause). I don't see a whole lot of people looking like a light bulb has come on. Well, let's think about it with some microeconomic fluency.

Is there some wave that Schwab could have caught? The minute you ask the question, the answer pops in. The Japanese had a zero position in tires and they got big. So this guy must have ridden that wave some in the early times. Then the slow following success has to have some other causes. And what probably happened here, obviously, is this guy did one hell of a lot of things right. And among the things that he must have done right is he must have harnessed what Mankiw calls the superpower of incentives. He must have a very clever incentive structure driving his people. And a clever personnel selection system, etc. And he must be pretty good at advertising. Which he is. He's an artist. So, he had to get a wave in Japanese tire invasion, the Japanese being as successful as they were. And then a talented fanatic had to get a hell of a lot of things right, and keep them right with clever systems. Again, not that hard of an answer. But what else would be a likely cause of the peculiar success?

We hire business school graduates and they're no better at these problems than you were. Maybe that's the reason we hire so few of them." - Charlie Munger


It's definitely well worth checking out the rest of what Munger had to say during the speech.

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.

Thursday, April 1, 2010

Heads I Win, Tails I Win...

...even more.

2009 Compensation for Top 5 Hedge Fund Managers:
  1. David Tepper: $ 4.0 billion
  2. George Soros: $ 3.3 billion
  3. James Simons: $ 2.5 billion
  4. John Paulson: $ 2.3 billion
  5. Steve Cohen: $ 1.4 billion
Some managers are no doubt very good. When you look over multiple years, investors in many hedge funds (not necessarily those run by the above five) end up with modest returns after subtracting the fees (often 2% of assets, 20% of profits) that are paid to hedge fund managers. The reason? Hedge fund managers get paid well in years when the returns are high yet still can get paid (merely a lot) when the returns are not.

To make the point clearer, here's a simplified example (using the 2% and 20% fee structure):

In year 1, if a hedge fund with $ 10 billion in assets delivers a 50% return. The hedge fund makes $ 1.2 billion and investors make $ 3.8 billion.

Ok, that may or may not seem fair but...

In year 2, the same fund drops 33%. The hedge fund makes over $ 200 million (the 2% fee on the average amount of assets as they decline during the year...~$ 11.5 billion for the year) and the investors have $ -4.8 billion ($ -4.6 billion from the decline in assets and $ -200 million in fees) of losses.

Summary of the 2-Year Returns
  • Investors: A -10% return and $ -1.0 billion loss. The $ 10 billion of assets at the beginning of year 1 are now worth ~$ 9.0 billion ($ +3.8 billion year 1 and $ -4.8 billion year 2).
  • Hedge Fund Manager: $ 1.4 billion in compensation. This comes straight from the $ 1.2 billion in first year plus the $ 200 million in the 2nd year (an infinite return since no capital of their own is required...though, to be fair, some certainly have plenty of their own money invested).
The incentives provided by the prevailing method of compensation in the industry seem designed to not serve investors. I would like to think that there are examples of better incentive pay structures out there, it's just that the 2% of assets, 20% of profits is the norm.

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.

Profiting from the Obvious

"We try more to profit from always remembering the obvious than from grasping the esoteric." - Charlie Munger

Six Stock Portfolio Update

Portfolio performance since mentioning on April 9, 2009 that I like these six stocks as long-term investments if bought near prevailing prices at that time (or lower, of course).

While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.

Stock|% Change*
WFC | 67.6%
DEO | 53.3%
PM   | 42.0%
PEP  | 29.5%
LOW| 22.1%
AXP | 138.3%

Total return for the six stocks combined is 59.1% (including dividends) since April 9th, 2009. The S&P 500 is up 41.4% (also including dividends) since that date. This is a conservative calculation of returns based upon the average price of each security on the date mentioned. Better market prices were available in subsequent days so total returns could have been improved with some careful accumulation.

The purpose here is not to measure and compare total returns over such a short time frame. This portfolio is meant to be, in part, an easy to verify working example of Newton's 4th Law.

Many equity investors would get improved long-term returns, at lower risk, if they: 1) bought (at fair prices) shares in 5-10 great businesses, 2) avoided the hyperactive trading ethos that is so popular these days to minimize mistakes & frictional costs, and 3) sold shares in these businesses only if the core long-term economics become impaired or opportunity costs are extremely high.

A six stock portfolio is very concentrated but this approach rejects the idea that vast diversification is needed. I've noted this in a previous post.

"I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken.

In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices." - Charlie Munger in this 1998 speech to the Foundation Financial Officers Group


"Diversification serves as protection against ignorance..." - Warren Buffett

Having said that, those with less experience investing clearly require more diversification. For some investors, index funds may make more sense than buying individual stocks. It's important to know which camp you fall into before investing.

The above concentrated portfolio of six stocks won't outperform in every period. In the long run it has a reasonable probability of doing well compared to the S&P 500 due to lower frictional costs and the quality of the businesses. The growth in value comes from the intrinsic value created by the businesses themselves, not some special aptitude for trading or timing the market. It probably won't outperform the very best portfolio managers but should do very well against many mutual funds** over a period of 10 years or longer.

In any case, this simple experiment is designed so it's easy for anyone to check the results over time using this blog. If this six stock portfolio*** isn't performing well against the S&P 500 it will be obvious.

Finally, an opportunity may come along where the capital from one of these stocks is needed.

My view is under such a scenario the threshold for making changes needs to be high. That hypothetical new investment must have clearly superior economics.

In addition, if something appears to fundamentally threaten the moat (ie. the effect of the internet on the newspaper biz) of one of these businesses a change may also be warranted.

So I may rarely add or switch some of the stocks in this portfolio but I will only make a change if the situation described above exists (ie. if the core long-term economics of one of these stocks become impaired or opportunity costs of not making a change is extremely high).

Adam

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

* As of 3/31/10.
** 
There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500. Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear (the same is true for stocks).
*** I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses that were selling at reasonable prices on April 9th. At any moment, there is always something better to own in theory but I don't think you can invest that way (as if stocks are baseball cards) and have consistent success. So there are certainly quite a few other shares in businesses that would be good alternatives to these six. The point is for me to get a handful of them at a fair price and then let time work.

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