Thursday, October 28, 2010

Buffett on Stock Valuations

Here's a good description of how Warren Buffett viewed stock valuations, and how he was viewed more generally, back in the late 1990s.

Excerpt:

Buffett was skeptical of high-tech stocks and...warned of an overvalued market that was heading for trouble. In fact, at that famous summer gathering of media, technology and financial moguls at Sun Valley, Idaho, Warren Buffett was asked to give the concluding talk in July 1999. His remarks, though politely received, supported the view among the smart set that Buffett was out of touch with the "new paradigm" of high technology and ever-rising internet stock valuations.

Buffett's talk...delivered a message that most of his high-tech listeners and their financial sidekicks were not keen to hear. There was no "new paradigm," Buffett said. The market could only yield what the economy produced, and this market was way out of sync in that respect. The next seventeen years, he explained, might not look much better than the dismal 1964-to-1981 period when the Dow had gone exactly nowhere. 


At that time, many didn't really buy into what Buffett was saying would likely happen going forward. In fact, they were expecting far better results* and mostly just viewed him as someone who was simply justifying that he had missed out on the opportunity:

Much of Buffett's message that day was ignored and dismissed – until March 2000, when the "dot com" bubble began to implode. Yet for a time, Buffett was considered by the smart money as "out of it" and "losing his edge;" a guy who had missed the high-tech moment and was now rationalizing his mistake.


These two articles also help capture and summarize what Buffett said at Sun Valley not long before the "dot com" bubble reached peak levels:**

Buffett in Fortune - 1999

Warren Buffett "Preaches" to 1999's Internet Elite

Buffett's message was rather straightforward.

New paradigm?

Not at all.

Thanks to the past decade, stocks overall appear more or less in line with intrinsic value (that's the average...quite a few individual stocks are expensive while others are still cheap).

Though we're not yet seventeen years removed from that Sun Valley talk, Buffett said recently he now views the prospects for stocks favorably going forward. Stocks may have gone nowhere from 1964-1981, but it wasn't necessary to wait until the end of that period to start buying.

In other words, it was a great time to buy well before 1981 even though the market needed until then to finally put the highs of 1964 in the rear-view mirror.

At least it was for those with a long enough investment time horizon.

Adam

* A PaineWebber-Gallup poll done at that time revealed investors were expecting stocks to return something like 13-22% going forward.
** This was covered in Chapter 2 of 'The Snowball'.
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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.

Wednesday, October 27, 2010

Apple's $ 51 Billion Pile of Cash

With $ 51 billion of cash and investments on Apple's (AAPL) balance sheet, and an additional $ 4-5 billion/quarter showing up each quarter, there's plenty of speculation on how that growing pile of cash will be used. Here's what Steve Jobs said on the earnings conference call that only fueled that speculation:

"We strongly believe one or more strategic opportunities will come along we're in a unique position to take advantage of,"
and

"We don't let the cash burn a hole in the pocket or make stupid acquisitions. We'd like to continue to keep our powder dry because we think there are one or more strategic opportunities in the future."

Some examples of the recent speculation:
I doubt that most or any of these larger acquisitions are wise or even necessary. It will be very interesting to watch if all that capital can be put to use productively in the coming years.

A nice problem.

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.

Tuesday, October 26, 2010

Peter Lynch: Investing Principles

Some of the investing principles used by Peter Lynch:
  • Never invest in any idea you can't illustrate with a crayon.
  • The best stock to buy may be the one you already own.
  • In business, competition is never as healthy as total domination.
  • When even the analysts are bored, it's time to start buying.
Check out this more comprehensive list.

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.

Who'll Manage Berkshire's Billions?

Here's an article in Fortune on the man who is now apparently the lead candidate to manage at least some of Berkshire Hathaway's (BRKa) investments:

Today, a large Berkshire Hathaway mystery lifted when a Greenwich, Conn., hedge fund, Castle Point Capital Management, quietly advised its investors that the fund's managing partner, Todd Anthony Combs, would leave to join Berkshire at the end of the year.

Time will tell how significant this move proves to be.

Adam

Long BRKb

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, October 25, 2010

Stocks to Watch

Below is a list of stocks I like* for my own portfolio at the right price.

From my point of view, the shares listed are attractive long-term investments below the prices I've indicated. Many of these have rallied 20-30% or even more so most have become too expensive for my taste.

Since creating this list none of the 20+ stocks is selling lower. It'd easier to invest right now if a few were cheaper.

Those below the dashed line are companies I like but prevailing prices have become too high. The objective, of course, is to buy them well below that price when the opportunity presents itself. So patience for now then decisiveness when there's an opportunity.

As always, the stocks in bold have two things in common. They are:

1) currently owned by Berkshire Hathaway (as of 6/30/10) and,
2) selling below the price that Warren Buffett paid in recent years.

There are several other Berkshire Hathaway holdings on this list but they don't have the 2nd thing going for them.

These are all intended to be long-term investments. A ten year horizon or longer. No trades here.

Stock/Max Price I'd Pay/Recent Price (10-22-10)
JNJ/65.00/63.81
WFC/28.00/26.11
USB/24.00/23.59
---------------------
MHK/45.00/57.46
KFT/30.00/31.90
NSC/54.00/62.10
KO/55.00/61.61
COP/50.00/61.67
MCD/63.00/78.55
PM/45.00/58.13
PG/60.00/63.40
PEP/60.00/65.01
LOW/19.00/22.00
AXP/35.00/39.03
ADP/37.00/43.80
DEO/60.00/73.74
BRKb/68.00/83.34
MO/16.00/24.92
HANS/30.00/51.68
PKX/80.00/107.76
RMCF/6.00/9.50
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)

Stocks removed from list:
  • BNI - I liked purchasing BNI up to $ 80/share. It was bought out by Berkshire Hathaway for $ 100/share in late 2009. Deal closed in early 2010.
The max price I'd pay takes into account an acceptable margin of safety**. That margin of safety differs for each company.

In other words, I believe these are intrinsically worth quite a bit more than the price I've listed in this post and in prior Stocks to Watch posts. I also believe most of these companies generally have favorable long-term economics (i.e. the best of them have high and durable ROC) and, as a result, intrinsic values will increase over time. Of course, I may be wrong about the core economics and that margin of safety could provide insufficient protection against a loss. Still, a year from now I would expect to be willing to pay more for many of these based upon each company's intrinsic value growth over that time frame.

Some of these stocks have rallied quite a bit compared to not too long ago. So they're more difficult to buy with enough margin of safety. Still, that doesn't mean the risk of missing something you like when a fair price is available (error of omission) won't ultimately be more costly than suffering a short-term paper loss.

Here are some thoughts on errors of omission by Warren Buffett from an article in The Motley Fool.

And also...

"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in." - Warren Buffett's 2008 Annual Letter to Shareholders

In other words, not buying what's still attractively valued to avoid short-term paper losses is far from a perfect solution with your best long-term investment ideas.

To me, if an investment is initially bought at a fair price, and is likely to increase substantially in intrinsic value over 20 years, it makes no sense to be bothered by a temporary paper loss. Of course, make a misjudgment on the quality of a business and that paper loss becomes a real one (error of commission).

There is no perfect answer to this problem. When highly confident that a great business is available at a fair price it's important to accumulate enough while the window of opportunity exists.

Sometimes accepting the risk of short-term losses is necessary to make sure a meaningful stake is acquired.

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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to remain long the above stocks (at least those that at some point became cheap enough to buy) unless market prices become significantly higher than intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** The required margin of safety is naturally larger for a bank than for something like KO. When I make a mistake and misjudge a company's economics in a major way, the margin of safety may still not be sufficient. Judging the durability of the economics correctly matters most. If the economics remain intact but the stock goes down that is a very good thing in the long run.

Friday, October 22, 2010

Buffett: Forget Gold, Buy Stocks

From an interview in Fortune with Warren Buffett earlier this week:

My first question, as I sit there on the couch in his office, is: "What about gold? Is this a classic bubble or what?"

"Look," he says, with his usual confident laugh. "You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take?"


So what does he like?

Equities.

In a post two weeks ago I compared gold to productive assets. I was doing my best to make a very similar point about gold. Well, not surprisingly, Buffett's way of saying things is impressively concise compared to my own.

In the late 90s, before one of the worst decade for stocks was about to occur, Buffett was warning that equities were extremely overvalued and that performance going forward would be subpar.

Now, Buffett is bullish.

Adam

Related posts:
Gold vs Productive Assets
Grantham: Gold is "Last Refuge of the Desperate"
Why Buffett's Not a Big Fan of Gold

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.

Buffett on Manic-depressive Lemmings: Berkshire Shareholder Letter Highlights

From Warren Buffett's 1982 Berkshire Hathaway (BRKa) shareholder letter:

...while retained earnings over the years, and in the aggregate, have translated into at least equal market value for shareholders, the translation has been both extraordinarily uneven among companies and irregular and unpredictable in timing.

However, this very unevenness and irregularity offers advantages to the value-oriented purchaser of fractional portions of businesses. This investor may select from almost the entire array of major American corporations, including many far superior to virtually any of the businesses that could be bought in their entirety in a negotiated deal. And fractional-interest purchases can be made in an auction market where prices are set by participants with behavior patterns that sometimes resemble those of an army of manic-depressive lemmings.

The market makes it incredibly convenient to own shares in some of the best businesses in the world.

Market prices change dramatically based upon short-to-intermediate term events while intrinsic value changes little if at all. In fact, consider that a typical recession will make the best companies even better (ie. make them intrinsically more valuable by: streamlining operations, buying weaker competitors who can't handle the short-term economic stress, taking market share, making investments etc.) yet stock prices will almost always temporarily go down.

Adam

Long BRKb

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, October 21, 2010

Buffett on Diversification

The following is from a Buffett partnership letter that was written in early 1966:*

"We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.

We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations."

"...I am willing to concentrate quite heavily in what I believe to be the best investment opportunities recognizing very well that this may cause an occasional very sour year--one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater."

"It is worth pointing out that our performance in 1965 was overwhelmingly the product of five investment situations."

"All texts counsel 'adequate' diversification, but the ones who quantify 'adequate' virtually never explain how they arrive at their conclusion. Hence, for our summation on overdiversification, we turn to that eminent academician Billy Rose, who says, 'You've got a harem of seventy girls; you don't get to know any of them very well.'"

Those who might have somewhat less -- or a whole lot less -- investment skill plainly need more diversification. This necessitates a realistic assessment of capabilities and limits.

The Buffett partnership letters can be found here.


* Written in early 1966 by Warren Buffett to discuss the previous year's performance.

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, October 20, 2010

Roubini Revelations & Prechter Plunges

From Jeffrey Saut's latest in Minyanville:

"...I think it's a mistake to get too bearish despite 'death crosses,' Hindenburg Omens, Roubini revelations, and Prechter plunges."

Read the full post.

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.

Tuesday, October 19, 2010

Coca-Cola's 3Q 2010 Earnings

With the 3Q conference call about to start at 9:30 am this morning, here's a quick summary of the latest Coca-Cola (KO) earnings report.

For the 3rd quarter ended October 1, 2010, net income grew to $ 2.055 billion from $ 1.896 billion driven by strong international volume growth. Quarterly revenue grew 5% to nearly $ 8.43 billion.

Earnings per share grew nearly 9% to 88 cents/share compared to the same period last year. Growth in earnings per share is closer to 12% when adjusting for one time charges primarily related to the CCE transaction.

Excerpt:

The Coca-Cola Company reports strong third quarter operating results, with volume increasing 5% in both the quarter and year-to-date, ahead of our long-term growth target and cycling 2% volume growth in the prior year quarter. Importantly, North America volume grew 2% in the quarter , building on our momentum in this key market as we continue to evolve our franchise system and integrate the acquisition of CCE’s North American business.

International volume increased 6% in the quarter. Eurasia and Africa volume grew 12% in the quarter , with broad-based growth across all business units and beverage categories, including 30% volume growth in Russia and double-digit growth in Turkey, Southern Eurasia and East and Central Africa. India achieved its 17 th consecutive quarter of volume growth despite record rainfall in the quarter and cycling very strong 37% growth in the prior year quarter. Pacific volume grew 11% in the quarter , cycling 6% growth in the prior year quarter. These results were supported by 12% growth in China, as well as growth of 11% in Japan, 19% in the Philippines and 13% in Korea. Latin America volume grew 4% in the quarter , cycling 7% growth in the prior year quarter, with Brazil volume up 13%. Mexico posted even volume results despite adverse weather and cycling 9% growth in the prior year quarter. Europe volume was slightly positive in the quarter, rounding to even , a sequential improvement supported by mid single-digit volume growth in France and the Nordic Region as well as volume growth in Great Britain, Germany and Northern Central Europe. These positive results were partially offset by continuing macro-economic pressures in South and Eastern Europe and the Adriatic Region.

Strong growth continued in countries with per capita consumption of Company brands less than 150 eight-ounce servings per year, with volume up 10% in the quarter and year-to-date in those countries.

According to Coca-Cola more share buybacks will be happening in the very near future. In fact, the company announced plans to buy back $ 2 billion of its stock by the end of this year.

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, October 18, 2010

Buffett's $ 200 Billion Dollar Blunder

On CNBC today, Warren Buffett said Berkshire Hathaway (BRKa) was his dumbest stock purchase. He thinks it cost something like $ 200 billion so that means Berkshire Hathaway (with a different name, of course) would now be worth twice as much.

Basically, the money they had to put into the textile business instead of the insurance business destroyed that much value.

In the interview he provides more details. He also said:

"...incidentally, if you come back in ten years, I may have one that's even worse."  (LAUGHTER)


Check out the full interview.

Adam

Long BRKb

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, October 15, 2010

Worst Decade Since "Old Hickory"

Reliable records on stocks extend back to the first half of the 19th century. According to this Wall Street Journal article, 1999-2009 was worst decade for stocks on record. If the data is correct (apparently, reliable stock market data begins in the 1820s), it means that 1999-2009 was at least the worst decade for stocks since around the time a hero from the war of 1812, Andrew Jackson, became the 7th President of the United States (1829-1837).

The article points out that in late 1999 the S&P 500 traded at 44 times earnings compared to a long-term average more like 16. That's at the heart of the underperformance. Many of the companies themselves did rather well "catching up" to their overvaluation.

In the article, Jeremy Grantham says "you'd better believe you're going to get dismal returns" with those kind of valuations and that stocks began the decade "horribly overpriced".

Some might have the impression that 1999-2009 stock performance is partly a reflection of poor business performance. That's not really the case. In a recent post, Jeffrey Saut said that markets tend to be driven by "fear, hope and greed only loosely connected to the business cycle."

That statement certainly applies to this past decade.

Here's an example. Coming into the decade Wal-Mart was earning $ 1.40/share. By the end of the decade Wal-Mart was earning more like $ 3.70/share. So that stock may have gone sideways but lots of value was created if you believe those earnings are sustainable and growing (I certainly do). The problem with Wal-Mart wasn't business performance it was just that investors collectively were paying too much (35-40x) for those earnings back in 1999. The stock went sideways and earnings caught up.

Today, even though the market overall isn't all that expensive, there are still plenty of individual businesses right now that appear to be in a similar situation. Businesses with terrific future business prospects selling for an unsustainable multiple of earnings. In many cases, the multiple will end up getting even more stretched but ultimately it normalizes. Predicting when is difficult if not impossible but you don't want to be there when it does.

Many businesses did just fine during the past decade. The problem wasn't business performance it was that the average stock in 1999 was priced to reflect 2009 or later intrinsic values. The S&P 500 was a decade ahead of itself. The NASDAQ, of course, was even worse.

Yet, the averages don't tell the whole story because, just like right now, plenty of individual stocks were cheap at that time.

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, October 13, 2010

Munger on Accountants

Charlie Munger talks about the accounting profession during a recent University of Michigan interview.

"Idiots and knaves were making a fortune selling shoddy mortgages with ridiculous theories. It was very regrettable behavior. And it was the easy money that allowed it and, of course, the adults who could have fixed it like the accountants who had ridiculous standards without which the bad behavior wouldn't have worked.

The accountants utterly failed us. And, by the way, there is practically no sign of any intelligent reversal of the failure of that profession. I have yet to meet many accountants who are the least bit ashamed for their contribution to our recent troubles but it was immense."


As Always, not afraid to bluntly speak his mind.

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.

Tuesday, October 12, 2010

The IPO Downturn


During the 1990s the US routinely had 40 IPOs per month. Some months even exceeded 100.

The average number so far this year is under 14 and, of course, was even lower during the crisis.

The question is why?

The importance of fixing this seems pretty obvious. Getting at the root cause(s) of what's driving the trend and actually fixing it is something else altogether. A rigorous assessment of the forces that discourage the launch of new public companies is needed.

It's not just that more IPOs are needed but higher quality ones with long-term impact. Check out the chart in their post.

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, October 11, 2010

Buffett: Stocks Clearly Cheaper than Bonds

From this CNBC article:

"I can't imagine anybody having bonds in their portfolio when they can own equities, a diversified group of equities. But people do because they, the lack of confidence. But that's what makes for the attractive prices. If they had their confidence back, they wouldn't be selling at these prices. And believe me, it will come back over time."

Quite a contrast to what Buffett was saying ten years ago or so.

 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, October 8, 2010

Gold vs Productive Assets

I understand that all the gold that's ever been mined fills something like just a couple olympic-sized swimming pools* and, after the recent run up in prices, its combined value stands at around $ 7 trillion.

So let's say we happen to have $ 7 trillion laying around to invest.

We could 1) use those dollars to buy a couple of pools of yellow metal (and presumably a very expensive and large army to guard it) or, 2) instead, use those dollars to acquire 100% ownership of all the following businesses:

Company/Market Cap
Apple/$ 264 billion
Microsoft/$ 212 billion
IBM/$ 175 billion
Google/$ 169 billion
Oracle/$ 139 billion
Cisco/$ 127 billion
Hewlett Packard/$ 93 billion
Exxon/$ 325 billion
Chevron/$ 168 billion
Berkshire Hathaway/$ 205 billion
Walmart/$ 197 billion
Coca-Cola/$ 137 billion
Pepsi/$ 105 billion
All 3 Major U.S Railroads/$ 85 billion combined
Johnson & Johnson/$ 174 billion
Procter & Gamble/$ 172 billion
Philip Morris International/$ 103 billion
Kraft/$ 54 billion
McDonalds $ 80 billion
General Electric/$ 182 billion
Verizon and AT&T/$ 260 billion combined
Petrochina/$ 223 billion
BHP Billiton/$ 222 billion
Boeing/$ 50 billion
Every team in the MLB, NBA, NHL and NFL
Combined value: ~ $ 4.1 trillion**

If we still wanted some gold exposure, could easily still afford 3 of the biggest gold mining companies. Hey, and just for the heck of it, with some of our pocket change we could purchase all the cars that Ferrari, Porsche, Lotus and Aston Martin produce this year. No big deal.

So we'd own 27 of among the largest companies in the world, 120 or so major sports teams, 3 gold mining companies, and a full year's production of some great cars.

After that buying spree, we'd still have over $ 2.7 trillion of cash left in the bank. Plenty of dry powder.

Two swimming pools of metal or all of the above productive assets plus remaining cash? Take your pick.

Now, there may be some slight anti-trust issues but it shouldn't matter...we can afford great lawyers (and politicians of course).

The above companies have productive assets that generate collectively $ 300 billion of free cash flow (FCF) in a bad year. Now that we own them outright, those annual cash flows are ours to spend/invest however we choose. Gold is, in contrast, a non-productive asset that generates negative FCF since you've gotta guard it, store it, insure it etc.

It is not a stretch to expect the cash flows from our businesses to grow over time especially if that $ 300 billion of fresh annual cash is invested wisely. So the intrinsic value is very real and growing. This becomes even more true if the dreaded inflation kicks in that those two pools of metal are supposed to provide protection against. Over the long run, in almost all cases, the value of those businesses will adjust upward with inflation.

"I remember the $0.05 hamburger and a $0.40-per-hour minimum wage, so I've seen a tremendous amount of inflation in my lifetime. Did it ruin the investment climate? I think not." - Charlie Munger

Gotta go with the two pools of yellow metal, right?

I understand the arguments in favor of gold over fiat currencies. If you don't trust paper money, and cannot find a productive asset to invest in, gold can theoretically function as a temporary store of wealth***. I just consider it incorrect to think of gold or have it sold as a true alternative to investments in productive assets.

Gold will probably hold its own simply as a reflection of the real wealth and value creation that goes on everyday. In other words, as we become richer from the value-creating activities, some of us will use that wealth to buy the yellow stuff. Yet, that begs the following question:

What would the value of gold be if the useful wealth creation that goes on everyday (some of it found among the companies listed above) ceased to occur?

The answer to that question reveals that gold's value is derived...not intrinsic.

Adam

Related posts:
-Grantham: Gold is "Last Refuge of the Desperate"
-Why Buffett's Not a Big Fan of Gold

* I have no opinion on gold prices (even if it happened to fill three swimming pools). I figure once buyers are willing to pay $ 7 trillion for two or three swimming pools of the yellow metal the price can become just about anything.

** Assuming ~ $ 1 billion per sports team.

*** Though hardly a slam-dunk. It has functioned poorly as a store of wealth for extended periods of time with the early 1980s to 2000 being a recent example. Even when it "works" what you own doesn't do anything useful besides stare back at you. If things go badly in the world would you rather own some gold bars or fertile farmland?
---
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, October 6, 2010

Buffett on Acquisition Decisions: Berkshire Shareholder Letter Highlights

Warren Buffett had the following to say about acquisitions in the 1981 Berkshire Hathaway (BRKa) shareholder letter:

Our acquisition decisions will be aimed at maximizing real economic benefits, not at maximizing either managerial domain or reported numbers for accounting purposes. (In the long run, managements stressing accounting appearance over economic substance usually achieve little of either.)

Regardless of the impact upon immediately reportable earnings, we would rather buy 10% of Wonderful Business T at X per share than 100% of T at 2X per share. Most corporate managers prefer just the reverse, and have no shortage of stated rationales for their behavior.


He later adds...

In fairness, we should acknowledge that some acquisition records have been dazzling. Two major categories stand out.

The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.

The second category involves the managerial superstars - men who can recognize that rare prince who is disguised as a toad, and who have managerial abilities that enable them to peel away the disguise.


Buffett makes it clear he doesn't qualify for the Category 2 variety:

And, despite a reasonably good understanding of the economic factors compelling concentration in Category 1, our actual acquisition activity in that category has been sporadic and inadequate. Our preaching was better than our performance. (We neglected the Noah principle: predicting rain doesn't count, building arks does.)

Then says:

Currently, we find values most easily obtained through the open-market purchase of fractional positions in companies with excellent business franchises and competent, honest managements. We never expect to run these companies, but we do expect to profit from them.

We expect that undistributed earnings from such companies will produce full value (subject to tax when realized) for Berkshire and its shareholders. If they don't, we have made mistakes as to either: (1) the management we have elected to join; (2) the future economics of the business; or (3) the price we have paid.

We have made plenty of such mistakes - both in the purchase of non-controlling and controlling interests in businesses. Category (2) miscalculations are the most common. Of course, it is necessary to dig deep into our history to find illustrations of such mistakes - sometimes as deep as two or three months back.

Lots of mistakes will occur even for those who know what they're doing with a long track record of investment performance.

Mistakes may be inevitable but the key is learning how to keep them small.

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.

Tuesday, October 5, 2010

Altria Outperforms...Again

Bespoke Investment Group recently highlighted Altria's (MO) outperformance (historic and recent) vs the S&P 500.

Stocks like Altria, Coca-Cola (KO), and Pepsi (PEP) among others over the long run (i.e. ideally at least a business cycle or two) tend to outperform the S&P 500. That makes them both good on offense and defense though they are often treated as being just good for the latter.

To demonstrate this, a worthwhile exercise is trying to find a consumer staple stock that has not outperformed the S&P 500 over any 20-year period (usually an easy thing to check these days on a number of financial sites). There are exceptions -- usually caused by excessive valuation at the beginning of a 20-year period -- but otherwise it's actually very difficult to find one that has underperformed. Even mediocre consumer staple businesses tend to do at least okay over the long run.
(Over the shorter run -- less than five years or so -- anything can happen as far as relative performance goes, of course. In fact, during a bull market there's more likely to be a disadvantage.)

From Bespoke Investment Group's post on Altria:

"...MO's historical yearly performance versus the S&P 500 shows just how much of a powerhouse the stock is. Since 1981, MO has averaged a yearly gain (not including dividends) of 18.54%, while the S&P 500 has averaged a gain of 8.77%. In the 23 years that the S&P 500 has been up for the year, MO has outperformed the index 20 times. In the 9 years that the S&P 500 has been down, MO has outperformed the index all 9 times."

The article makes the point that Altria's outperformance excludes dividends. Keep in mind that Altria has consistently had one of the largest dividends among S&P 500 stocks (Altria has routinely had a 5-8% per year dividend on top of that 18.54% annualized return). So it's worth remembering that the simple act of buying shares of a company like Altria for the long haul would have done rather well by any measure.

Also, check out Altria's performance over a longer time horizon. A big part of Altria's long-term performance is, in fact, the combination of a low valuation -- in part due to the fact that there have been no shortage of reasons to NOT own a tobacco stock* during the past several decades -- and a substantial dividend. Well, those dividends could be reinvested when the stock was frequently cheap -- enhancing returns. Buybacks would offer a similar effect. That a consistently cheap stock would enhance long-term returns** may at first seem a bit odd but, well, it's straightforward arithmetic. When the shares of a stable business with sound economics remain cheap for an extended time, the fact that incremental shares can be bought -- via dividends and/or buybacks -- at a discount to intrinsic value improves results for continuing shareholders.***

The compounded effects are not small. The next time shares of a quality holding rallies in the near-term this is worth considering carefully. A near-term increase in price is hardly a good thing for the long-term owner.

Still, the franchises that sell small-ticket consumer products (though, for some, tobacco businesses -- considering the nature of their products -- may not be considered desirable investments for obvious reasons but beverages and candy work just fine), have strong brands, and some real scale tend to be compounding machines. In my view this remains an underutilized approach especially if the investor understands business economics and competitive advantages well enough, can estimate intrinsic value, and has the discipline to always buy at a discount.

In any case, it's not the past performance that matters. What about going forward? The spectacular returns above do seem unlikely going forward.
(Though I don't mind being pleasantly surprised.)

For example, if Altria were to consistently sell at a smaller discount to value (or maybe even become downright expensive) than it has in the past a big part of the reason for the outperformance will have been eliminated. Dividend reinvestments and buybacks will work much less well. So, if the stock does generally remain more expensive, Altria's long-term performance relative to the S&P 500 likely won't look anything like the past.

Compounding is not difficult to understand yet just how powerful it is seems to get underestimated or, at least, underutilized. It may not always be intuitive but can be made to work brilliantly over longer horizons. Knowing this, huge amounts of energy (more than ever, it seems) is still expended on trades that are made over extremely short time horizons where the power of compounding cannot possibly be a factor. So there's this extremely powerful force, that works great passively over time if you buy good assets, yet collectively market participants are trading more than ever. Basically, trusting the power of compounding less than ever. The question is why?

No matter what reasons exist for the above disconnect, it does seem that the advantages of leading consumer staples businesses remain less than fully appreciated. Consumer staples are still routinely thought of as merely defensive stocks even with all evidence pointing to them being both good defense and, at least over the longer haul, good offense as well.
(Some try and jump in and out of so-called defensive stocks depending on whether a defensive posture is warranted or not. Well, at least based upon the number of active market participants who underperform, what might appear a reasonable idea on paper seems difficult at best to put into practice.)

Having said that, I do think the long-term performance of these rather boring businesses naturally leads to questions like:

"How can something that straightforward not be figured out by now?"

or

"That's in past, how can that kind of growth in value continue?"

Well, consider what was said in 1938 about Coca-Cola.

"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." - From the Yacktman Fund 1Q 2010 Letter

Also, along the same lines remember what Buffett had to say about Coca-Cola when he finally bought it in the late 1980s.


Owning some of the great franchises continues to makes sense for my money but they still have to be bought at a nice discount to intrinsic business value. What's sensible to buy at a discount to intrinsic value doesn't make sense at some materially higher valuation.***

Otherwise, these can be good defense and offense.

What ultimately matters, of course, is how a business and its shares will perform going forward. Getting that at least mostly right still requires plenty of work.

In other words, just because a particular business (or type of business) has done well in the past guarantees nothing.

Adam

Long position in MO, KO, and PEP

Related posts:

Altria vs Coca-Cola - July 2010
Grantham on Quality Stocks Revisited - July 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - November 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - April 2009
Best and Worst Performing DJIA Stock - April 2009
GM vs Philip Morris (Altria) - April 2009
Defensive Stocks? - April 2009

* For starters, there's the persistently declining volumes along with legal, regulatory, and tax challenges. Then there's the fact that many institutions and other market participants, understandably, don't want to be associated with the tobacco business. Yet the fact that the stock was cheap, returns on capital were healthy, and pricing power remained substantial made it into a fine investment. This may be a bit counterintuitive but there's much to be learned from it. 
** Some think the only way to produce above average returns is by owning part of a transformational businesses. Well, here's a business that's far from transformational, where volumes have been in decline for decades, with huge legal and regulatory risks, and many market participants that are uncomfortable owning the common stock. Yet, despite all this, that stock has still performed very well for long-term owners. Strangely, it is all the negatives that made the shares consistently cheap (making dividends and buybacks more effective) and later the led to the outsized returns. At times, what doesn't quite fit expectations deserves extra attention. Of course, it's always possible that some of these challenges start to really erode Altria's core economics. The past can only reveal so much. That possibility also deserves careful consideration. Altria, along with just about any tobacco business, have a unique set of risks versus other consumer staples businesses. With any investment, no matter how seemingly attractive the core economics may be, margin of safety is all-important. Margin of safety always comes down to the specific risks of each business. This protects against the unforeseen real, even if fixable, serious 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
*** Depending on the type of account buybacks are generally more tax efficient than dividend reinvestments. Other than the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned. Naturally, a continuing shareholder could also choose to commit additional cash to buy more shares when inexpensive.
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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, October 4, 2010

The Gorilla Suit

Here are five behavioral impediments that contribute to bubbles repeatedly following the same path. By extension, I think it also helps explain why the over and under valuation of assets, even short of a bubble, happens so frequently.

The following are some excerpts from page 4 and 5 of James Montier's white paper: "Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt"

1) Overoptimism
Everyone simply believes that they are less likely than average to have a drinking problem, to get divorced, or to be fired. This tendency to look on the bright side helps to blind us to the dangers posed by predictable surprises.

2) Illusion of Control
This is where we encounter a lot of the pseudoscience of finance, e.g., measures such as Value-At-Risk (VaR). The idea that if we can quantify risk we can control it is one of the great fallacies of modern finance. VaR tells us how much you can expect to lose with a given probability, i.e., the maximum daily loss with a 95% probability. Such risk management techniques are akin to buying a car with an airbag that is guaranteed to work unless you crash!

3) Self-serving Bias
...the innate desire to interpret information and act in ways that are supportive of our own self interests. As Warren Buffett puts it, "Never ask a barber if you need a haircut." If you had been a risk manager in 2006 and suggested that some of the collateralized debt obligations (CDOs) that your bank was working on might have been slightly suspect, you would, of course, have been fired and replaced by a risk manager who was happy to approve the transaction. Whenever lots of people are making lots of money, it is unlikely that they will take a step back and point out the obvious flaws in their actions.

4) Myopia
All too often we find that consequences occurring at a later date tend to have much less bearing on our choices the further into the future they fall. This can be summed up as, "Let us eat and drink, for tomorrow we shall die." Of course, this ignores the fact that on any given day we are roughly 260,000 times more likely to be wrong than right with respect to making it to tomorrow. Saint Augustine’s plea "Lord, make me chaste, but not yet" is pure myopia. One more good year, one more good bonus, and then I promise to go and do something worthwhile with my life, rather than working in finance!

5) Inattentional Blindness
Put bluntly, we simply don't expect to see what we are not looking for. The classic experiment in this field shows a short video clip of two teams playing basketball. One team is dressed in white, the other in black. Participants are asked to count how many times the team in white passes the ball between themselves. Now, halfway through this clip, a man in a gorilla suit walks onto the court, beats his chest, and then walks off. At the end of the clip, participants are asked how many passes there were. The normal range of answers is somewhere between 14 and 17. They are then asked if they saw anything unusual. Nearly 60% fail to spot the gorilla! When the gorilla is mentioned and the tape re-run, most participants say that the clip was switched, and the gorilla wasn't in the first version! People simply get too caught up in the detail of counting the passes. I suspect that something similar happens in finance: investors get caught up in all of the details and the noise, and forget to keep an eye on the big picture.

Check out the entire white paper.

 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, October 1, 2010

HFT: The Real Double Dip

I was misinformed. I guess the stock market is not about effective allocation of capital. It's about the search for a millisecond speed advantage or a smarter algorithm. Utilizing human capital, some of our most talented, for the development of sophisticated computer games that extract fractions daily from financial capital under the guise of adding liquidity.

Excerpts from a CNBC article:

The rapid-fire growth of high-frequency trading, HFT, has spawned a new breed of market mavens whose backgrounds are far different than the traditional suit-clad Wall Street titans. 

Their resumes are rich in rocket science and other non-financial fields and they may never have traded a stock, read an earnings report or scrutinized a balance sheet.

They are engineers, mathematicians and computer scientists...

The article later added this about new programs being offered at top universities. A masters degree in Financial Engineering is apparently available through NYU. Here's what Allan Maymin (a recent graduate now working as a quantitative analyst) said in the article:

"The future of Wall Street, in my mind, is computer on computer action...Humans come in, they check their stuff daily, and it's just computers battling intraday."

A masters degree in Financial Engineering? Computer on computer?

Ugh.

There's been lots of talk about the risks of a double dip recession but this situation is a real but very different kind of double dip. 1) A drop in the productive use of intellectual capital, and 2) a reduction in our financial capital as a larger than necessary portion of our savings and investment is converted into the additional frictional cost associated with all this useless activity.

Equities are investments in an uncertain future stream of cash flows, created by an entity over a long period of time, via productive tangible and intangible assets. Some involved in HFT have said their typical holding period is measured in seconds. Even if measured in minutes it's obvious that the fundamental outlook of a business does not change that often. So HFTs don't need to be informed or interested in things like the fundamental economics of what they are buying and selling. The time frame is too short to matter.

The question is: Why do we need 70% of daily volumes generated by participants uninformed and uninterested in the fundamental economics of the equities they are trading?

Isn't that likely to increase mispricing?

More importantly, increase the misallocation of capital?

Now, it turns out a highly temperamental Mr. Market that tends to misprice and misallocate creates opportunities that actually make investing long-term easier for the patient individual. A capable person with the stomach for it who knows how to value a business can do just fine with the current system. So what's the problem, right?

Well, I just happen to think the fact that an individual can still generate favorable returns misses the point.

To me, the question is does the advent of participants involved in things like HFT increase or decrease the effectiveness of our system of capital allocation overall. I maintain that you cannot have a good system with that many participants unaware of the underlying economics of what they are buying and selling. Larger than necessary distortions will occur. I am not suggesting that the temperamental nature of markets will be going away anytime soon. I'm just saying it's foolish to have a system of capital allocation with so many participants not anchored by the economics of the things they are buying and selling.

Also, as the article points out, many of the participants involved in these mostly non-productive activities are PhDs, physicists, engineers, mathematicians, and other scientists. Certainly this cannot be the best use of their talents.

I see little benefit and big costs. Not all these costs can be quantified but that doesn't make them unimportant.

"You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically (1) everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." - Charlie Munger in a speech at UC Santa Barbara

Some examples of those costs whether they can be measured or not:
  • Less effective allocation of intellectual and financial capital
  • Dollars, intended for capital formation, instead being converted into income (what Grantham points out is a "raid" of the balance sheet. )
  • Reduced confidence in the capital formation process
The capital formation center that is our equity markets should be driven by informed capital allocators who make/lose money based on the quality of their individual economic judgments. Rewards should come from dollars committed over a long period of time and the average holding period today of 6 months just doesn't cut it (and if the holding period is measured in seconds well that is just silly). Today, creating an algorithm or approach that can outrun/outsmart the other guy and committing dollars to very very short-term bets is increasingly the emphasis. I'm sure it's a blast and do not blame anyone who does it given the current rules. I just think changing the rules of the game to re-focus market participants on actual capital formation and allocation makes sense. Activities that facilitate providing capital to an existing business or some useful new idea should be the priority with an emphasis on longer term outcomes.

If it were my call I'd alter the rules and incentives at work here. It's a dumb use of talent and drain on capital as far as I'm concerned.

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.
 
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