Monday, January 31, 2011

Shades of the Dot-Com Bubble

This recent Barron's article on Salesforce.com (CRM) makes the following point:

- The stock trades at 300 times earnings
- There's been a sharp rise in expenses
- Shares outstanding has been growing
- Earnings look less than inspiring when looked at using generally accepted accounting principles (GAAP)

It's always difficult to predict when a speculative stock's valuation will normalize.

Once you get the kind of valuation CRM has more often than not the time it takes to correct is measured in years, not months. A clearly overvalued stock will often just get more overvalued before those willing to play the greater fool game are done with it. So, on the surface, it would seem there's plenty of time to play the speculative game. Many actually try to time (some succeed, most don't, but either way the winner is the "croupier") getting out before the other speculators head for the door.

For me, stuff like this has always fell into the category of AVOID.

Here's why.

Occasionally, this kind of stock will actually even justify what seemed like an inflated valuation. In that specific case, the investor took a huge risk over time by buying at an inflated multiple, in the long run turned out to be right, and ended up breaking even. Sometimes, an exceptional situation like Apple (AAPL)* comes along. Most of the time, if you play in the inflated multiple arena you need to get the trading right or you lose. In any case, if you pay something like a 100x earnings multiple for a stock, huge risks of permanent capital loss are being taken compared to the potential rewards. It's a game where the odds are against the participants but if you can control for those losses it may work out.

For me, there's too much risk of permanent loss of capital. When you avoid the big losses in investing, the gains take care of themselves. It's a simple mathematical truth that percentage gains and losses have an asymmetrical impact on wealth:
  • Lose 60% on a stock and an investor needs to make 150% on the next one to break even
  • Lose 70% on a stock and an investor needs to make 233% on the next one to break even
It all goes downhill quickly from there. Also, it's wise to keep in mind the adverse affects caused by loss aversion.

In contrast, if you buy a durable business at a fair multiple of earnings, the core economics will determine your long-term outcome. No timing or trading skills required. A good business with durable economics bought below intrinsic value and a stock that happens to go down from the price paid is not a problem for the long-term investor. The core economics will still drive your returns over the long run even if what you see on the quote screen looks a little ugly.

In fact, as a long-term owner, the cheap stock will just serve to juice returns via buybacks.

Adam

Long position in AAPL established at lower than recent prices. No position in CRM.

* Apple's stock, even with all the appreciation, is actually still not that expensive: Roughly 12-15x.  At times during the past decade Apple may have seemed somewhat expensive (though nothing like Salesforce.com) but, with the clarity of hindsight, was certainly not. Those who can predict what Apple has been able to accomplish beforehand deserve big returns.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, January 28, 2011

Bogle: A System Destined to Fail

In this SmartMoney interview, Bogle says that in a ~13 percent stock market...

-the average mutual fund earns 10 percent
-the average mutual fund investor earns 6.5 percent

From the interview:

"And I haven't even talked about taxes, which take out another 100 basis points.... That's pretty stunning. This never would've happened if not for the greatest bull market in history. Managers' fees didn't matter because it didn't feel like you were being cheated.

People understand the magic of compounding returns. But few investors know about what I call the tyranny of compounding costs.... You put up 100% of the capital and take on all the risk, but you get only 20-something percent of the return. That's a system that is destined to fail. People will not be that dumb forever."

Let's hope not. In the example above, it would seem like the average mutual fund investor will earn half as much as the overall market (13 percent versus 6.5 percent). It's actually worse than that. When you take into account compounding effects, the average mutual fund investor actually ends up with more like less than one fourth as much money over 25 years.

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.

Lynch: Investing is Art, Not Science

"Investing in stocks is an art, not a science, and people who've been trained to rigidly quantify everything have a big disadvantage." - Peter Lynch

Thursday, January 27, 2011

Fear, Hope, & Greed

From Jeffrey Saut's most recent Minyanville article:

...if an investor began buying one dollar's worth of the SPX at the end of September 2007, and continued to purchase one dollar's worth of the SPX at the end of each month until year-end 2010, the dollar-cost averaged performance is about 15.4% (excluding commissions) over that 40-month period.

Saut then points out that those who did not dollar-cost average had a roughly 18% loss...

That's a whopping 33% out-performance if our fictional investor had been able to conquer their fear and had employed a dollar-cost averaging strategy. Regrettably, there's the "rub."

Ladies and gentlemen, while it's true over the long term that it's all about earnings, in the short to intermediate term the stock market is fear, hope, and greed only loosely connected to the business cycle.

Well said, Mr. Saut.

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 are never a recommendation to buy or sell anything.

Tuesday, January 25, 2011

Beware the Buyback Craze

In this recent post (and several others), I've highlighted how much Buffett likes buybacks when a company comfortably has the financial resources and a stock selling clearly below intrinsic value.

By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders. - Warren Buffett in the 1984 Berkshire Hathaway (BRKa) Shareholder Letter

While Buffett has articulated on many occasions how much he likes buybacks under the right circumstances, historically Buffett has not felt it necessary to allocate any of Berkshire Hathaway's capital toward buybacks.

Here's where it gets a bit tricky. Consider this Barron's article. The evidence seems to show that companies have a tendency to buy high.

Some highlights of points made in the article:

- Buybacks are often done during the good times when company's have lots of cash and stocks are expensive. The article also points out that the biggest buyback year ever was 2007 at $ 863 billion (according to research firm Biryini) when stocks were peaking.

- Buffett called most buybacks in recent times "foolish"; companies were paying too much.

- Buybacks were only $ 125 billion in 2009. If a company has the funds a buyback only makes sense, as Buffett says, if shares are selling below "intrinsic value, conservatively calculated."

A business with durable competitive advantages (wide economic moat) selling below intrinsic value (margin of safety) isn't enough.

Investors need more than that: Management that allocates capital wisely and knows how to widen the moat.

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, January 24, 2011

Barron's: Warren Buffett, Mr. Moneybags

Here's a new article in Barron's on what Buffett may do with Berkshire Hathaway's (BRKa) sizable pile of cash and all the cash that continues to pour in. Berkshire could easily be sitting on $ 50 billion by the end of the year.

The article also points out operating profits at Berkshire should hit $ 12-13 billion in 2011, up from $ 11 billion in 2010, and the company could be holding $ 20 billion more of cash and investments than the $ 30 billion they already had as of 9/30/2010.

Later in the article, Berkshire Hathaway is described as "a cash-spewing conglomerate with annual revenue exceeding $135 billion and some top-notch businesses..."

The Burlington Northern deal looks like one of his best as the railroad will earn roughly $ 3 billion this year alone. So based upon that Buffett paid ~11x this year's earnings for that business.

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, January 21, 2011

Are Large Cap Tech Stocks Undervalued?

We've had quite a rally in the market, and are overdue for a correction, yet tech stocks like Apple (AAPL), and Microsoft (MSFT) all still seem reasonably valued these days*.

What a difference a decade makes.

The chart in this Minyanville article by Jeffrey Saut lays out by sector how much price-to-earnings (P/Es) have compressed in the past ten years. 

At the individual stock level it looks even more favorable.

Apple and Microsoft currently trade at a mid-to-low teens multiple of earnings. Both of those stocks look even more reasonably valued when you adjust for Apple's nearly $ 60 billion of net cash and Microsoft's over $ 30 billion of net cash.

In contrast, stocks like Amazon (AMZN), Salesforce.com (CRM), and Netflix (NFLX) currently sell at 40-50 multiples of earnings (in the case of Salesforce.com closer to 100x). So the sector P/Es don't tell you much.

It seems at least a bit odd that Apple could still be reasonably valued. Somehow the company continues to increase its earnings at a faster rate than what has been a high performing stock.

Apple should comfortably earn $ 20 billion for the fiscal year that will end in September.

Current market value of Apple is ~ $ 300 billion.

So it's selling for a 15x multiple of earnings.

Adjust for the net cash and investments of ~ $ 60 billion on the balance sheet and the multiple looks closer to 12x.

Is a company like Apple worth 12-15x its still rapidly growing earnings? It's tough to know with tech stocks, but seems a not expensive valuation given the company's prospects and specific risks.

Adam

I have small long positions in both Apple and Microsoft. The reason they are not larger positions? Because, in general, technology businesses reside in fast changing and unpredictable competitive landscapes. It's just that these businesses over the past couple of years sold at price levels in the market that provided a very large margin of safety in my view. So until the margin of safety shrinks I'm willing to have some exposure. Unlike shares in some of my favorite businesses (i.e. those in Stocks to Watch bought at the right price) these tech stocks are mostly NOT long-term investments.
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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, January 20, 2011

Buffett: Investment-Oriented Shareholders - Berkshire Shareholder Letter Highlights

From Warren Buffett's 1985 Berkshire Hathaway (BRKashareholder letter:

"Historically, Berkshire shares have sold modestly below intrinsic business value. With the price there, purchasers could be certain (as long as they did not experience a widening of this discount) that their personal investment experience would at least equal the financial experience of the business. But recently the discount has disappeared, and occasionally a modest premium has prevailed.

The elimination of the discount means that Berkshire's market value increased even faster than business value (which, itself, grew at a pleasing pace). That was good news for any owner holding while that move took place, but it is bad news for the new or prospective owner. If the financial experience of new owners of Berkshire is merely to match the future financial experience of the company, any premium of market value over intrinsic business value that they pay must be maintained.

Management cannot determine market prices, although it can, by its disclosures and policies, encourage rational behavior by market participants. My own preference, as perhaps you'd guess, is for a market price that consistently approximates business value. Given that relationship, all owners prosper precisely as the business prospers during their period of ownership. Wild swings in market prices far above and below business value do not change the final gains for owners in aggregate; in the end, investor gains must equal business gains. But long periods of substantial undervaluation and/or overvaluation will cause the gains of the business to be inequitably distributed among various owners, with the investment result of any given owner largely depending upon how lucky, shrewd, or foolish he happens to be.

Over the long term there has been a more consistent relationship between Berkshire's market value and business value than has existed for any other publicly-traded equity with which I am familiar. This is a tribute to you. Because you have been rational, interested, and investment-oriented, the market price for Berkshire stock has almost always been sensible. This unusual result has been achieved by a shareholder group with unusual demographics: virtually all of our shareholders are individuals, not institutions. No other public company our size can claim the same.

You might think that institutions, with their large staffs of highly-paid and experienced investment professionals, would be a force for stability and reason in financial markets. They are not: stocks heavily owned and constantly monitored by institutions have often been among the most inappropriately valued."

Some stocks, more than others, obviously tend to attract what John Bogle calls "rent-a-stock" oriented speculators instead of long-term owners. All other things being equal, a stock predominantly held by renters will swing far above and below approximate business value more often than a stock dominated by investment-oriented owners.

Consider the shareholder demographics of a company like Pepsi (PEP) to that of Salesforce.com (CRM). Which of those two companies would you bet is going to have a larger speculative premium or discount to intrinsic business value at any point in time?*

The fact that the average holding period of stocks is now measured in months instead of years just means the swings above and below business value are likely to be larger than ever. 

Adam

Long BRKb and PEP

Related post: Buffett on High Quality Ownership

* In the mid to late 1990s even Berkshire Hathaway's stock was selling well above intrinsic business value so no company is immune to this.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, January 19, 2011

Bogle on ETFs: Step Up The Stewardship

A couple excerpts from this interview of John Bogle by Morningstar. In the interview, Bogle says that while the ETF may be a great marketing idea it "remains to be seen" if it's a great investment idea. He added:

"The trading volumes are astonishing. Standard & Poor's 500 SPDR, the biggest one, turns over 10,000% a year, and I think 30% turnover is too high."

Bogle added that investors should buy and hold ETFs...not trade them. In the interview he also said that "we get captivated by our emotions" and "have a big behavioral problem in investing." More from the interview on stewardship:

"...we ought to try and have a better way of dealing with our trust, our stewardship of investor assets than pandering, if you will, to their baser instincts...gold is a good example...it's a complete speculation; it producers no income. It has no underlying intrinsic value; you buy it and then sell it to somebody for more than you paid for. And so we have more money flowing into gold and we advertise gold. And we were advertising performance in the go-go era.

This business really has an obligation to look to itself and say, 'Let's step up the management and the stewardship and step down the marketing and the salesmanship.'"

Here's a couple related posts: 
Check out the full interview.

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, January 18, 2011

Barron's: A Gusher of Potential

Here's an article on energy stocks in Barron's.

Check out the convenient table of the stocks highlighted in the article. Clearly, further research is needed to understand any of these well enough to invest. Each company has its own unique mix of oil & gas proven reserves and risks.

The article does highlight several as being attractively valued. Not surprisingly, the cheapest are some of the integrated (ie. those that search for, produce, and refine) oil businesses. Among the pure exploration companies Apache sells for the lowest multiple at 11.5x earnings.

Whether actually cheap or not obviously depends on assumptions on what happens to the price of oil going forward. I have no opinion.

The one stock that jumps out as being clearly expensive is Anadarko. I'm sure there is a good story here but with a 35 multiple seems an outlier among this group.

Adam

Long positions in COP and CVX established at much lower than recent market prices
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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.

Buffett: Lethargy & Sloth

From Warren Buffett's 1990 Berkshire Hathaway (BRKa) shareholder letter:

Lethargy bordering on sloth remains the cornerstone of our investment style. The exception was Wells Fargo, a superbly-managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board.

Back then, fear and pessimism had caused Wells Fargo stock to fall to less than 5x earnings. The total return, including dividends, has been more than 15 fold since then.

Adam

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

Monday, January 17, 2011

Can Johnson & Johnson Get Its Act Together?

Here's a good New York Times article on the ongoing quality problems of Johnson & Johnson (JNJ).

From the article:

With such a diversity of products and operating companies, Johnson & Johnson's overall business has not suffered significantly. But the string of recent recalls at McNeil threatens to weaken the kind of trust that made many people willing to pay more for J.& J. brands.

2010 was a terrible year for the company. The longer these problems persist opens the door for competing brands, generics, and lost pricing power.

While still hugely profitable, just how permanent and material the damage to Johnson & Johnson's reputation and its trust with consumers isn't that easy to quantify.

Adam

Long position in Johnson & Johnson established at lower than recent market prices
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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.

Friday, January 14, 2011

KO and JNJ: Defensive Stocks?

I know it has been a decent but not great decade for stocks like Coca-Cola (KO) and Johnson & Johnson (JNJ). The businesses did just fine while the stocks were less impressive. This comes down to simple math. They sold at extremely high multiples of earnings ten years ago.

Step back a bit and the picture looks a whole lot different.

Twenty five years ago Coca-Cola was selling for $ 3.33 per share (split adjusted so apples to apples).

Today, Its annual dividend alone is $ 1.76 per share.

At that time, Johnson & Johnson was selling for $ 3.24 per share.

Its current annual dividend is $ 2.16 per share.

So at the current dividend rate, both stocks produce more than the full value of the initial investment from the dividends alone every two years.

These days both stocks are selling in the $ 60 to $ 65 per share range.

At current prices, both stocks have increased in value substantially in twenty five years excluding their not insignificant dividends. Include those dividends and the increase in value is more than 30-fold.

Either way, a far better return than the S&P 500.

As larger companies, I wouldn't expect a repeat of something as impressive going forward. Still, I think they're capable of producing more than solid risk-adjusted long-term results especially if purchased at a fair price or, better yet, at a nice discount to value.

What's sensible to buy at a discount to intrinsic value doesn't make sense at some materially higher valuation. As always, the ability to judge value matters a whole lot.

In fact, long-term outperformance (I'd argue at lower risk of permanent capital loss) is not unusual for businesses with durable competitive advantages and high return on capital like Coca-Cola and Johnson & Johnson. In other words, the past twenty five years looks amazingly similar for something like Pepsi (PEP). Try to find any previous twenty five year period where these companies do not outperform. It's not easy.*

Not impossible, just more an exception to the rule.

These businesses are still frequently referred to as "defensive" (seems to be almost daily on various business media outlets) yet have routinely outperformed over a longer horizon. An ability to produce attractive returns at lower risk at a minimum suggests the title "defensive" is an inadequate one. Even if shares of these higher quality businesses did not outperform over the long haul going forward (and they may not, of course), the sheer simplicity of the approach compared to alternatives needs to be considered.

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

Increases to intrinsic business value over the very long haul -- not exceptional trading abilities -- does the heavy lifting as far as generating returns.

Long-term compounding effects.

Considering the alternatives available to market participants, it seems incredible that so many choose to treat the stock market like a casino.

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

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

Adam

Long positions in KO, JNJ, and PEP established at lower than recent market prices

Related posts:
Altria Outperforms...Again - October 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
Defensive Stocks? - April 2009

* Over the shorter run -- less than five years or so -- anything can happen as far as relative performance goes, of course. Over shorter time frames, it's easy to see why these are perceived to be defensive investments. They generally don't go down as much when the market crashes, and they don't go up as fast during bull markets. It's when looked at across several bull and bear markets that their merits become more obvious. Anyone buying the higher quality stocks expecting them to outperform during the next bull market is likely to be disappointed. That is, in part, how they have earned the reputation of being defensive. Yet, this reputation is verifiably incorrect when you look at the historic returns of these stocks over the longer haul -- at least a full business cycle or two.
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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, January 13, 2011

Buffett: "Restricted" vs "Unrestricted" Earnings - Berkshire Shareholder Letter Highlights

This previous post, Turning Gold into Lead, covers why Warren Buffett thinks all earnings are not created equal calling the inferior variety "restricted earnings".

In the following excerpt, also from the 1984 Berkshire Hathaway (BRKashareholder letter, Buffett covers the exact opposite type of earnings: "unrestricted".

Here's his explanation of how unrestricted earnings should be treated:

"For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.

To illustrate, let’s assume that an investor owns a risk-free 10% perpetual bond with one very unusual feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e., a perpetual life and coupons offering the same cash-or-reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting to get his hands on cash should take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.

If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were nil. The opposite course - reinvestment of the coupon - would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.

An analysis similar to that made by our hypothetical bondholder is appropriate for owners in thinking about whether a company’s unrestricted earnings should be retained or paid out. Of course, the analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond case, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment."

For many years Berkshire Hathaway has been able to earn far better than market returns on the earnings it retains. Much of those returns came down to Buffett's enormous skill. It made sense to not pay a dividend.

Today, considering Berkshire Hathaway's size, how long before it cannot put those earnings to good use and earn a greater than market rate of return with all of the dollars?

It could be a while yet, but it seems likely that the distribution of at least a small portion of its sizable quantity of unrestricted earnings in the form of dividends will need to begin.

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.

Wednesday, January 12, 2011

Stocks with 8% Plus Earnings Yield

The following is a list of Dow Jones Industrials that still have an 8% or greater earnings yield based upon 2010 consensus operating earnings estimates:

Chevron (CVX): Earnings Yield 10.2%
Hewlett Packard (HPQ): 10.6%
Intel (INTC): 9.6%
Merck (MRK): 9.1%
J.P. Morgan Chase (JPM): 8.6%
Pfizer (PFE): 12.2%
Travelers (TRV): 11.1%

Naturally, earnings yield for these stocks is generally a bit higher based upon current 2011 estimates.

Microsoft (MSFT) was close to making this list but could not make the cut with a 7.9% earnings yield. If the company's $ 30 billion+ net cash position is taken into account (ie enterprise value) the earnings yield sits comfortably above 8%. The same holds true for Cisco (CSCO).

Here's a simple way to check the consensus earnings for the 30 DJIA stocks.

Adam

Currently have long positions in MSFT, CSCO, CVX, and PFE
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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, January 11, 2011

Diageo Dividend Stock Analysis

Diageo's (DEO) brands include Johnnie Walker, Smirnoff, Baileys, Captain Morgan, Jose Cuervo, J&B Scotch, Tanqueray, and Guinness among others. Here's an excerpt from an analysis of Diageo by Dividend Growth Investor:

The company has managed to deliver an average increase in EPS of 8.20% per year since 2000. Analysts expect Diageo to earn $4.97 per share in 2011 and $5.50 per share in 2012. This would be a nice increase from the $4.18/share the company earned in 2010. The company's premium spirits brands have been popular with US consumers who traded up to these premium brands. The North American market accounts for 34% of the company's sales, while emerging markets account for 33% of its sales. Emerging markets have been a bright spot, as the company has been able to achieve strong double digit growth there.

Some previous posts on Diageo:

As a long-term investment I still like Diageo's combination of brands and distribution but in my view the stock is currently a bit too expensive.

Adam

Long position in Diageo established at much lower prices
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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, January 10, 2011

Stock Market Morphs into Casino

As background, here's a quick summary of something that was covered in this previous post:

The average holding period for stocks was between 4 and 8 years from the early 1930s until the late 1970s.

In the 1980s it dropped to more like 2 years.

At the time of that previous post last March, the average holding period for stocks had fallen to more like 6 months and James Montier had the following to say about it:

"...the average holding period for a stock listed on its exchange is just 6 months. This seems like the investment equivalent of attention deficit hyperactivity disorder." - James Montier

Fast forward to today. According to this recent CNBC article, the average holding period has now dropped to 2.8 months (in the 1980s it was more like 2 years) with high frequency trading accounting for 70 percent of market volume.

"The theory that buy-and-hold was the superior way to ensure gains over the long term, has been ditched completely in favor of technology," said Alan Newman, author of the monthly newsletter. "HFT promises gains are best provided by holding periods measuring as few as microseconds, possibly a few minutes, or at worst, a few hours."

Then later in the article...

"The capital raising stock market of the past hundred years has morphed in just the last 10 years into a casino," said Sal Arnuk of Themis Trading and a market infrastructure expert who advised the SEC after last year's so-called Flash Crash. "Who is doing the fundamental work analyzing stocks? In the end, we've greatly increased systemic risk."

The frictional costs and mostly (if not entirely) non-productive activity associated with all this hyperactive trading makes capital raising and allocation systemically less effective.  It's a hidden "tax" on the capital raising/allocation system and ignores Newton's 4th Law ("for investors as a whole, returns decrease as motion increases").

John Bogle recently said that the SPDR S&P 500 ETF (SPY) turns over at 10,000% annualized rate. At that rate, the gap between the returns investors as a whole actually achieve and what the fund returns could easily approach 5% per year due to frictional costs. In the interview, John Bogle references a study of 175 ETFs that showed it was more like a 6% gap per year for investors. In other words, the typical investor would fall behind by 30% over a five year period. I'm guessing most of the active traders involved think they will be above average and end up on the winning side:

"All the equity investors, in total, will surely bear a performance disadvantage per annum equal to the total croupiers' costs they have jointly elected to bear. This is an inescapable fact of life. And it is also inescapable that exactly half of the investors will get a result below the median result after the croupiers' take, which median result may well be somewhere between unexciting and lousy." - Charlie Munger Speech to the Foundation Financial Officers Group

In this case, the total croupiers' cost is the 5-6% of frictional expenses noted above. The fact is all this extra activity means by definition that investors as a whole end up with a 5-6% lower per annum return. Pretty expensive when the 8-10% expected long-term annual market returns are far from a certainty. So in this example the system as we know it today is transferring half or more of returns to the croupiers instead of investors. Jeremy Grantham made the point that fees like this actually "raid the balance sheet".

Yet, keep in mind it is only those participants who decide to play the trading game that have to collectively pay this "tax".  An investor who either buys and holds long-term something like the SPY or buys great businesses at fair prices and holds those shares a very long time avoids these frictional costs.

Check out the full CNBC article.

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, January 7, 2011

Buffett: Turning Gold Into Lead - Berkshire Shareholder Letter Highlights

Warren Buffett wrote the following in the 1984 Berkshire Hathaway (BRKashareholder letter:

"The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let's call these earnings 'restricted' - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.

Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential. (This retention-no-matter-how-unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago. At the time, a punitive regulatory policy was a major factor causing the company’s stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value. But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners. Meanwhile, at construction and maintenance sites throughout New York, signs proudly proclaimed the corporate slogan, 'Dig We Must'.)"

Businesses with relatively more "restricted earnings" generally require a higher margin of safety (all other things being equal) to account for the potential gold-into-lead folly. From the 1997 Berkshire shareholder meeting:

"If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety..."

Also, those businesses with fewer "restricted earnings" are intrinsically more valuable as they have greater flexibility to invest earnings in a manner producing a high return on capital for investors.

The problem is, of course, financial statements alone don't explicitly reveal how much of a businesses earnings is restricted. I mean, it would be nice if "restricted earnings" could be found somewhere on an income statement. Still, it's fairly simple to figure out. Any business that has a high ratio of assets on the balance sheet relative to the profits it generates on average over the entire business cycle is a likely candidate.

The bottom line is it makes sense to pay less for companies with a lot of "restricted earnings" both because the intrinsic value of the earnings is lower and a larger margin of safety is required.

It'd be a lot easier if more businesses were like Coca-Cola (KO) but unfortunately most are not.

Adam

Long BRKb and KO
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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, January 6, 2011

Bigger After 7 Years, Google or Facebook?

A comparison of Google's (GOOG) market valuation and financial performance in its seventh year of operation [2005] to Facebook's in its seventh year of operation [2010].

In 2005 (roughly its seventh full year of operation), Google generated revenues of $ 6.14 billion and net income of $ 1.46 billion.

Google went public with an initial market valuation just under $ 30 billion in 2004 but within a year had a market value north of $ 100 billion. A valuation that seemed extreme but Google had no trouble quickly justifying.

That initial ~$ 30 billion valuation looks like a bargain today.

How does this compare to Facebook?

In 2010, according to this article, Facebook (also in its seventh year of operation) generated revenues of $ 2 billion and had net income of $ 400 million. Impressive. The growth rate is spectacular as Facebook's 2009 revenue was $ 777 million with $ 200 million of net income.

According to this, Goldman recently invested  in Facebook at a $ 50 billion valuation. At that valuation, Facebook is being valued at 25x revenue and 125x earnings.

It's very hard to know what Facebook is/will be worth. We do know that, comparing both companies seventh year of operation apples to apples, Facebook is being given a valuation that is almost 2x that of Google while generating less than 1/3 as much revenue and net income.

Obviously, with Google now earning in two weeks what Facebook earns in a year there's a bit of a gap to close before you can consider these two in the same league financially.

Still, I wouldn't want to bet against Facebook.

...or Google.

I'll be surprised if both don't win big in very different ways.

Adam

Long position in GOOG

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, January 5, 2011

Microsoft: Stock vs Business Performance

Microsoft (MSFT) has been a go nowhere stock for a decade (a fact seemingly mentioned daily on business news) but not because it lacked in business performance. A decade ago, Microsoft generated revenue of ~ $ 25 billion and was earning just over $ 7 billion dollars each year. Microsoft, a large company when it entered the decade, was able to grow that revenue from $ 25 billion to $ 68 billion and earnings from $ 7 billion to north of $ 20 billion in the past ten years.

So more than a respectable decade of work. I'm not a huge fan of Microsoft but its business performance is sometimes ignored because the stock has not performed.

For a short time period in the year 2000, Microsoft had an enterprise value (market cap - net cash on the balance sheet) of over $ 600 billion. Just over a decade ago an investor was paying more than $ 600 billion in enterprise value for $ 7 billion of demonstrated earning power. Today, an investor is paying a bit over $ 200 billion  in enterprise value for more than $ 20 billion in earning power.

Also, consider that there is now 20% less shares outstanding compared to a decade ago. So the stock didn't do well because it entered this past decade overvalued.

The business did just fine.

Adam

Small long position in MSFT
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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, January 4, 2011

4 Dividend Stocks

Here's a recent post on some dividend paying stocks from Dividend Growth Investor.

Each of the 4 stocks have been on my Stocks to Watch list since it was first created.

Johnson & Johnson (JNJ) - Dividend Yield: 3.5%
Procter & Gamble (PG) - Dividend Yield: 3.0%
Philip Morris International (PM) - Dividend Yield: 4.4%
PepsiCo, Inc. (PEP) - Dividend Yield: 2.9%

While JNJ has had many issues with product recalls lately, over the long run each of these businesses are likely to make good long-term core holdings especially when bought at the right price. As I've noted previously, I like the businesses of PG and PM but both now are selling at higher prices than what I'd be willing to pay. The other two are close or currently at prices where I'd consider adding some more shares.*

Great Franchises
What they have in common is a combination of strong brands, global distribution (PM is purely international since the spinoff from Altria), excellent balance sheets, and durable high return on capital. In the long run, it is the durable high return on capital that makes these businesses compounding machines even if the stock prices often don't provide much short term excitement. 

As in all cases, some of the excess returns come down to whether the management allocates capital wisely.

In other words: does not overpay for acquisitions, isn't tempted by growth for growth's sake, and buys back stock only when it is selling below intrinsic value, etc.

By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders. - Warren Buffett in the 1984 Berkshire Hathaway (BRKashareholder letter

Predicting how management is going to behave when it comes to capital allocation is not easy (a long track record is a useful guide though few have one as long as Buffett), but the risk/reward on these seem reasonable. These kinds of businesses are strong enough to overcome some of the more probable dumb moves.

Valuations range from 12.5x 2011 earnings for JNJ to just under 15x earnings for PG.

Adam

* I have long positions in all stocks mentioned. 
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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, January 3, 2011

Munger on Incentives

From Charlie Munger's 1995 speech at Harvard University:

"Well, the top guy is sitting there, he's an authority figure. He's doing asinine things, you look around the board, nobody else is objecting, social proof, it's okay? Reciprocation tendency, he's raising the directors fees every year, he's flying you around in the corporate airplane to look at interesting plants, or whatever in hell they do, and you go and you really get extreme dysfunction as a corrective decision-making body in the typical American board of directors.

They o­nly act, again the power of incentives, they o­nly act when it gets so bad it starts making them look foolish, or threatening legal liability to them. That's Munger's rule. I mean there are occasional things that don't follow Munger's rule, but by and large the board of directors is a very ineffective corrector if the top guy is a little nuts, which, of course, frequently happens."

Check out the entire 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 are never a recommendation to buy or sell anything.

Stocks to Watch

Below is an update of the 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 (preferably well below, of course) I've indicated. Unlike when I first published this list most have become too expensive to buy. A symptom of a happier market.

Naturally, the objective is to buy these significantly below the maximum prices I've indicated I'd pay when the opportunity presents itself. So, for now, some patience is needed then decisiveness if there's an opportunity.

Since creating the initial Stocks to Watch list, none of the 20+ stocks on the list is selling lower. Johnson & Johnson (JNJ) is the worst performer at an 8% total return. All others have returned more (in some cases much more). I don't view that as great news.  It'd be safer and easier to invest right now if some of these stocks were selling at much lower prices. The further below intrinsic value the better. Not only does it allow accumulation of more shares below intrinsic value to happen, the company itself can use excess free cash flow to do the same.

"When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases." - Warren Buffett in the 1984 Berkshire Hathaway (BRKb) Shareholder Letter

Johnson &  Johnson (JNJ) is selling slightly higher than when I first posted it but remains the only stock that still sells below the max. price I'd be willing to pay for it (some others are border line). Pepsi (PEP) is a close call as I've raised what I'd be willing to pay from $ 60/share to $ 65/share. Others on the list are fine businesses and, in my view, if held for a long enough period are likely to create solid returns for shareholders even when bought at current prices.  I just prefer a higher margin of safety.

Those below the dashed line are companies I like but prevailing prices have become too high. 

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

1) currently owned by Berkshire Hathaway (as of 9/30/10) 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.

This list is intended to remain very stable over time with few additions or deletions. I never have a "price target" (A term you'll hear all too often on Wall Street and business news). I'm looking to buy a great business at a reasonable price then allow it to compound in value over a very long time frame. What drives the buy/sell behavior will be when Mr. Market goes to extremes. So these are all intended to be long-term investments. A ten year horizon or longer. No trades here.

All of the stocks on the current list were part of the original Stocks to Watch list unless otherwise noted.

Stock|Max Price I'd Pay|Recent Price (12-31-10)
JNJ|65.00|61.85
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WFC|28.00|30.99
USB|24.00|26.90
MHK|45.00|56.76
KFT|30.00|31.51
NSC|54.00|62.82 - added to the original list on 12/17/09
MCD|63.00|76.76 - added to the original list on 12/17/09
KO|55.00|65.77
COP|50.00|68.10
PM|45.00|58.53
PG|60.00|64.33
PEP|65.00|65.33
LOW|19.00|25.08
AXP|35.00|42.92
ADP|37.00|46.28
DEO|60.00|74.33
BRKb|68.00|80.11
MO|16.00|24.62
HANS|30.00|52.28
PKX|80.00|107.69
RMCF|6.00|9.65
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)

Stocks removed from the 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 max price I've indicated 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 return on capital) and, as a result, intrinsic values will increase over time. Of course, I may be misjudging 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.

Though I could easily be wrong, at the right price I consider these stocks appropriate for my own portfolio (i.e. not for someone else's) given my understanding of the downside risks and potential rewards.

So these don't make sense for others unless they do their own research and reach their own similar conclusions.

Even if not wildly overvalued, these stocks are mostly too expensive to buy right now. The margin of safety is too narrow for my money. There has been no shortage of chances to buy these at a discount to value in the not too distant past. That was the time to act. The risk of missing the chance to own a well understood investment when a fair price is available (error of omission) can be more costly than suffering a short-term paper loss (though, due to loss aversion, many focus much more on the latter). Hopefully, at least some of them will get cheap again.

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

Also, from the 2008 letter:

"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

In other words, not buying what's 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.

Finally, above average long-term returns at lower risk is the objective. Performance over the complete market cycle without needing to trade. For me, performance during a down market and tough economy matters more. Truly good businesses should become stronger in a tough economic environment. Having said that, I am not tempted to trade from "defensive" to "cyclical" stocks (or anything similar to that approach) depending on the market environment. Too much trading leads to unnecessary mistakes. This is about part ownership of businesses. I'll let others play the trading game.

I believe this approach will do just fine in the long run even if it offers a little less excitement.

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.
 
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