Friday, December 30, 2011

Quotes of 2011

A collection of quotes said or written at some point during this calendar year.

Amazon's Jeff Bezos on Inventing & Disrupting
"Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We're willing to plant seeds, let them grow—and we're very stubborn. We say we're stubborn on vision and flexible on details." - Jeff Bezos

The Bond Market Rules
"Unrecognized as saviors, the bond vigilantes are demanding the keys to the Eternal City. If the Italian people are very lucky and very wise, they will allow themselves to be ruled by the bond market." - Thomas Donlan

PIMCO's Bill Gross
"Wall Street sort of lost its way, in that investment banking became a function not of allocating capital properly, but levering capital and levering the returns on capital as opposed to transferring capital to productive industries." - Bill Gross

Bogle Back to the Basics - Speculation Dwarfing Investment
"...our financial system has directed around $200 billion a year into initial public offerings and additional new public offerings and then additional offerings of company stock--$200 billion. We trade $40 trillion worth of stocks a year. So, that's 200 times as much speculation as there is investment. One only has to understand that all this trading back and forth, by definition, doesn't enrich the investor, because if I buy, you sell and vice versa, but what it does is enrich the croupier in the middle, which we call Wall Street..." - John Bogle

Final Wesco Meeting: More From Charlie Munger
"I like people admitting they were complete stupid horses' asses. I know I'll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn." - Charlie Munger

Warren Buffett on the 'New Normal' & 'Black Swans'
"I think the luckiest person around is the baby that's born in the United States today. I don't think there's any question about it. I mean...that person is going, on average, to enjoy a far better life, you know, than John D. Rockefeller had many years ago or that I have now....and so I think if there's a new normal, it will be a higher normal in terms of the average person of how they lived 20 years from now and 50 years from now." - Warren Buffett

"...we will have black swans, but we'll overcome black swans." - Warren Buffett

Final Wesco Meeting: A Morning With Charlie Munger
"Clever derivatives broke dozens of companies. It killed them. Bankrupt. We don't need these kinds of innovation in finance. It's OK to be boring in finance. What we want is innovation in widgets." - Charlie Munger

"When we bought See's Candies, we didn't know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important." - Charlie Munger

Munger on the Financial Sector
"Why should an investment banker go to Greece to teach them how to pretend their finances are different from what they really are? Why isn't that a perfectly disgusting bit of human behavior?" - Charlie Munger

Klarman: Trophy Properties vs Fixer-Uppers
"Price is perhaps the single most important criterion in sound investment decision making. Every security or asset is a 'buy' at one price, a 'hold' at a higher price, and a 'sell' at some still higher price. Yet most investors in all asset classes love simplicity, rosy outlooks and the prospect of smooth sailing. They prefer what is performing well to what has recently lagged, often regardless of price. They prefer full buildings and trophy properties to fixer-uppers that need to be filled, even though empty or unloved buildings may be the far more compelling, and even safer, investments." - Seth Klarman

Barron's Interview: Donald Yacktman
"I have to go back a minimum of 18 years to find blue-chip or high-quality companies selling at these kinds of prices relative to other things out there. It is a very unique period." - Donald Yacktman

2010 Berkshire Shareholder Letter: $ 66 Billion in Cost-Free Deposits
"At Berkshire, we have now operated at an underwriting profit for eight consecutive years, our total underwriting gain for the period having been $17 billion. I believe it likely that we will continue to underwrite profitably in most – though certainly not all – future years. If we accomplish that, our float will be better than cost-free. We will benefit just as we would if some party deposited $66 billion with us, paid us a fee for holding its money and then let us invest its funds for our own benefit." - Warren Buffett

Buffett: Six-fold Increase in Living Standards
"Money will always flow toward opportunity, and there is an abundance of that in America. Commentators today often talk of "great uncertainty." But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.

Don't let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective. 

We are not natively smarter than we were when our country was founded nor do we work harder. But look around you and see a world beyond the dreams of any colonial citizen. Now, as in 1776, 1861, 1932 and 1941, America's best days lie ahead." - Warren Buffett

Happy New Year,

Adam

Long position in Berkshire Hathaway (BRKb). No position in Amazon (AMZN).

Quotes of 2010

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, December 29, 2011

Financial Amnesia

A lack of financial memory is a significant contributor to the historic pattern of recurring financial bubbles.

"Let it be emphasized once more, and especially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith in his book: A Short History of Financial Euphoria (Page 87)

Factors that led to the financial crisis and lessons learned were recently highlighted by the Chartered Financial Analyst Society of the UK (CFA UK), a leading trade body. Below, I've included some excerpts from CFA UK's Response to the Joint Committee on the draft Financial Services Bill.

As Galbraith points out in the above quote, every 20 years or so the new players involved in the financial system, the so-called smart money, become convinced "it's different this time" because of some new innovation, financial or otherwise:

CFA UK blames what it calls "financial amnesia" among financial professionals. That a failure to learn and heed lessons of the past led to the most recent financial crisis and will likely lead to future ones.

Galbraith would approve.

From CFA UK's Response to the Joint Committee on the Draft Financial Services Bill:

Financial amnesia is when financial market participants forget or behave as if they have forgotten the lessons from financial history. Financial market participants are composed of two main groups, regulated financial firms and regulators. Despite the history of bitter experience, the same mistakes occur with alarming regularity (see Appendix 1). The three key lessons that participants appear to forget are: 

Lesson 1: "Innovation", the illusion of safety and "this time it's different": "The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version" (Galbraith).The expansion of credit plays a key role in fuelling "innovation" while the creation of an illusion of safety results in a "this time it's different" approach that enables the continuation of unsustainable activity and risk taking. Sadly, each time it is always the same and never different.

Lesson 2: Regulated financial firms are prone to failure: It has been presumed that regulated financial firms by acting in their own self interest and in the interests of their shareholders, impose market discipline. History has demonstrated that because failure to impose market discipline is not uncommon, over-reliance on market forces can be misleading.

Lesson 3: Ineffective regulation. The frequency of market failure places a greater onus on the regulator to be more effective in encouraging and imposing market discipline. Sadly, regulators focus on the symptoms of failure rather than its root causes. Furthermore, regulators often ignore the root cause of their own inability to act promptly and thereby contribute to the risk of systemic governance failure. 

The letter goes on to say that regulators should learn from financial history and require:

1) Firms conduct themselves to the highest professional and ethical standards and place clients’ interests first.
2) Enhance financial capability so that consumers become a more robust source of market discipline on firms.
3) Establish a regulatory philosophy and approach which acknowledges that we live in a world populated by people who do not always act rationally and imperfect markets.

Those three things are desirable outcomes that make a ton of sense. The fact that such little progress has been made in achieving those outcomes never ceases to amaze.

While this was written in the context of the United Kingdom it clearly applies to the United States. Financial professionals and market participants more generally need a better awareness of financial history.

From this Financial Times article posted on CNBC:

Financial Amnesia a Factor Behind the Crisis

Fund managers and financial advisers should be forced to study financial history to reduce the likelihood of future market panics and crashes, according to a leading trade body for investment professionals.

The article goes on to say...

CFA UK, which represents 9,000 investment professionals, argues that the study of financial history should form a major part of all compulsory education for retail and wholesale investment professionals. "Financial amnesia disarms individuals, the market and the regulator," the body said. "It causes risk to be mispriced, bubbles to develop and crises to break."

It's an uphill battle because this recurring problem goes back a long way.

Charles Mackay, author of Extraordinary Popular Delusions and the Madness of Crowds (1841)*, said it was common after an episode of financial euphoria to place blame on those in power (execs, directors, politicians etc). That's certainly not surprising. Yet, Mackay also made the point that "nobody seemed to imagine that the nation itself was as culpable". John Kenneth Galbraith made a similar assertion about the Crash of 1929 and other episodes of financial euphoria.

Here is a more complete version of the quote from Mackay. Describing the aftermath of the South Sea Bubble, he said:

"Public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the legislature upon South Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South Sea company. Nobody blamed the credulity and avarice of the people-the degrading lust of gain...or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned."

The above doesn't seem much different than some of our more recent bubbles. An inevitable painful economic contraction followed the bursting of the South Sea Company bubble.

History repeats frequently when it comes to financial euphoria. As James Grant wrote in his book Money of the Mind:

"Progress is cumulative in science and engineering, but cyclical in finance."

We should do everything possible to avoid the next but, if the seemingly obvious lessons from these episodes going back almost 400 years haven't been learned yet, chances are it will happen again in some form.

Still, it's good to see someone like CFA UK taking what seems a leadership role. Requiring the study of financial history is a good start but is unlikely to even begin to solve the problem. The idea of undertaking an annual "amnesia check" (as is suggested in the Financial Times article) sounds good but is likely also insufficient. Whether changes with some "teeth" can modify behavior to the point that it prevents the next crisis remains to be seen. Considering the track record some skepticism seems more than warranted.

That, of course, doesn't mean it's not well worth trying to make improvements in this area. Any sincere effort to do so should be applauded.

I'd also go a bit further. It would help if financial education was more robust in general so, as CFA UK suggests above, "consumers become a more robust source of market discipline on firms."

Adam

Related posts:
When Genius Failed...Again
Smart Money?
The Madness of Crowds

* Three chapters of that book describe bubbles like the Mississippi Company bubble in the 1700's, the South Sea Company bubble in 1700's, and the Dutch tulip mania in the 1600's.
---
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, December 28, 2011

Buffett on Gold, Farms, and Businesses

From an interview in Fortune with Warren Buffett back in 2010:

"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?"

Buffett goes on to say he prefers equities.

Keep in mind he said the above when gold was much lower than it is today.

More recently, Buffett added the following during this CNBC interview:

Joe Kernen: You have said many times that if you could own, vs. gold, all the farmland in the United States, you'd rather have that than all the gold in the world. Have you gone in and looked at any farmland, any real estate like that?

Warren Buffett: No. I own one farm that I bought about 25 years ago my son farms, and so we're exposed to farming in the Buffett family. He's going to take care of me if it turns out that farms are really the thing to have instead of businesses. But I believe in owning productive assets...whether it's farms, apartment houses or businesses. And they'll do very well over time, and sometimes one class is doing better than another.

When Buffett says that he likes businesses that naturally includes stocks which are, simply put, the convenient partial ownership of businesses. In the late 90s, before one of the worst decade for stocks was about to occur, Buffett warned that equities were overvalued and that future returns were likely to be sub-par.

Buffett on Stock Valuations

Here's a good description of the situation at that time:

"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."

These two articles also help capture and summarize what Buffett said in Sun Valley and just how he was thinking back then:*

Buffett in Fortune - 1999

Warren Buffett "Preaches" to 1999's Internet Elite

When equity investors could only see blue skies and sky high returns going forward, Buffett was warning of trouble ahead. Well, it hasn't been 17 years yet -- nor does it need to end up being precisely 17 years for his essential view to end up being correct -- but so far the market has, in fact, pretty much gone nowhere.

At that time, not many seemed interested in giving his warning much weight.

Now, when many investors seem to want nothing to do with equities, Buffett is generally bullish on stocks.**

Based upon track record who's more likely to be correct?

Ten or so years from now will it be obvious that the same mistake, only in reverse, was being made?

Adam

Related posts:
-Edison on Gold: Fictitious Value & Superstition
-Munger on Buying Gold
-Thomas Edison on Gold
-Grantham on Gold: The "Faith-based Metal"
-Buffett: Forget Gold, Buy Stocks
-Gold vs Productive Assets
-Grantham: Gold is "Last Refuge of the Desperate"
-Why Buffett's Not a Big Fan of Gold

* The 1999 speech in Sun Valley was covered in Chapter 2 of 'The Snowball'.
** As always, the investing horizon has to be at least five years and more like ten years. It's about growth in intrinsic value over a long period not the price action (up or down) in a week, month, or even a couple years. What matters is the compounded return that can be produced for the risk that is taken. Near current valuations, likely risk-adjusted returns make some stocks very attractive. As always, paying a plain discount to value helps regulate the risk.
---
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, December 27, 2011

All Hail the Hunch

From this Matt Ridley article on the importance of intuition in decision making:

Wall Street Journal: All Hail the Hunch - and Damn the Details

...Dr. [Gerd] Gigerenzer has developed the startling claim that intuition makes our decisions not just quicker but better.

The article later added...

...complex problems do not necessarily need complex solutions, and more detailed analysis does not necessarily improve a decision, but often makes it worse. He believes, in effect, that less is more: Extra information distracts you from focusing on the few simple aspects of a problem that matter most.

The above brought to mind some things Charlie Munger and Warren Buffett have said on the importance of simplifying:

"...our model is too simple. Most people believe you can't be an expert if it's too simple." - Charlie Munger at the 2007 Wesco Meeting

"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 this speech at UC Santa Barbara

"Stocks are simple. All you do is buy shares in a great business for less than the business is intrinsically worth, with managers of the highest integrity and ability. Then you own those shares forever." - Warren Buffett

"The business schools reward difficult complex behaviour more than simple behavior, but simple behavior is more effective." - Warren Buffett

"If you need to use a computer or calculator to make the calculation, you shouldn't buy it." - Warren Buffett at the 2009 Berkshire Hathaway Shareholder Meeting

"Warren talks about these discounted cash flows. I've never seen him do one." - Charlie Munger

"It's true," replied Buffett. "If (the value of a company) doesn't just scream out at you, it's too close." - from the 1996 shareholder meeting

More from the Wall Street Journal article....

The complex algorithms that gave AAA ratings to debts that should not have passed the smell test demonstrated all too well the futility of knowing too much.

Simplifying where possible is crucial. I think the essential insight, that hunches often produce quicker and better results, is useful but this could easily get taken too far.

Munger has previously mentioned this injunction of Albert Einstein: "everything should be made as simple as possible – but no more simple."

Things need to be kept as simple as possible but, depending on the specific problem, shouldn't be oversimplified. Effective critical thinking is required to solve difficult problems.

Figuring out the right balance is the tough part.

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, December 23, 2011

Beta, Risk, and the Inconvenient Real World Special Case

Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns... - Investopedia

From The Superinvestors of Graham-and-Doddsville:

"The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million." - Warren Buffett

For some additional thoughts on beta and risk from well known value investors check out this Gurufocus article. In addition to the above quote from Buffett, it includes quotes from Charlie Munger and Seth Klarman among others.

Jeremy Grantham added this about these flawed models* in the context of 'quality' stocks in his 1Q 2010 letter:

"Warren Buffett doesn't really talk much about the fact that he is playing in a superior universe. Why should he? It's like having the Triple A bond outperforming the B+ bond in the long term by 1% a year when, in a reasonable world, it 'should' yield, say, 1% less. And how nicely this messes up the Fama and French argument on risk and return."

Later in the letter he added...

"Since the market is efficient, to Fama and French quality must be a risk factor! So, by protecting you in the 1929 Crash and in 2008, and by having a low beta for that matter, Quality as represented by Coca-Cola and Johnson & Johnson must be a hidden risk factor. Oh, I know: 'The real world is merely an inconvenient special case!'"

Since that was written by Grantham the higher quality stocks have become more expensive. Yet, the essential insight remains true: quality stocks over the long haul tend to produce greater returns at less risk despite what fans of Fama and French might otherwise predict (especially when bought cheap, of course).**

Some otherwise smart people seem to get annoyed when a simple good idea works better than a complicated bad one.

In this Barron's interview from a while back, Marty Whitman added what he thinks about modern portfolio theory when asked about it:

"...as far as value investing, control investing, distress investing and credit analysis is concerned, that stuff is absolute garbage."

Hard to disagree.

Never underestimate how long it takes for flawed yet influential ideas to fade away.

Adam

Related posts:
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* To me, much of modern finance theory is not just flawed in some harmless way. It's difficult to quantify the damage done, but it is not difficult to argue that their influence has been less than a wonderful thing.
** It's worth noting that their three factor model attempts to bring size and value into the equation. Others might find this of some use or interest. I do not.
---
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, December 22, 2011

A Familiar Pattern: Investors Buying High, Selling Low

This recent CNBC article highlights the fact that equity mutual funds continue to have substantial outflows. Apparently, investors have taken $ 34 billion of of equity funds while buying lots of bonds.

Investors Lose Faith in Stocks as Billions Pour Out of Funds

Contrast the above with this New York Times article from back in 1999:

Fueled by Market, Stock Funds Received $26.4 Billion in March

Investors poured about $26.4 billion into stock mutual funds in March, the biggest monthly inflow since last April...

So in 1999, roughly 12 months before the market peaked and the bubble started to burst, investors were buying stocks hand over fist.

Now many investors want nothing to do with them.

Unfortunately, it's a reliable pattern.

Verily, hedge funds are having a terrible year, having been caught "short," as well as underinvested with only a 43.8% net long investment position. Or how about the endowment funds that are only ~12% net long US stocks? How can those endowment funds achieve their mandates of roughly 8% per year using 2%-yielding 10-year Treasury Notes? The answer is they can't! - Jeff Saut in this recent Minyanville article

So it's not just the individual investor. As has been noted in prior posts, pension fund managers in the early 1970s went from buying stocks aggressively at very expensive prices (50x and higher P/E ratios) then wouldn't touch them several years later when they'd become much cheaper.

Stocks may go even lower for a period of time but they're never cheap when the news is good.
(The market overall right now may not be extremely inexpensive, but it's not difficult to find cheap individual stocks.)

As far as price action goes, it's impossible to know what will happen in the short or even intermediate term. The Market will continue to behave rather manic then depressed over shorter time frames but, in the long run, the "weighing machine" still works.

Buy shares of good businesses at a nice discount to value then ignore the near term price action noise.

Adam

Related posts:
Investors Can Have Cheap Stocks or Good News...Not Both
Rear-view Mirror Investing

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, December 21, 2011

Amazon's Jeff Bezos On Inventing & Disrupting: "We're Stubborn on Vision and Flexible on Details"

"We're a company very accustomed to operating at low margins. We grew up that way. We've never had the luxury of high margins, there's no reason to get used to it now." - Jeff Bezos in Wired Magazine

Recently, Wired Magazine interviewed Amazon's (AMZN) Jeff Bezos.

Well worth a read.

Amazon Owns the Internet

The interview reveals a lot about the way Bezos thinks about and approaches business.

It's not at all hard to see why Amazon likely has quite a future with him running the show.

Some excerpts from the interview:

On Inventing and Disrupting
"...one of our greatest cultural strengths is accepting the fact that if you're going to invent, you're going to disrupt."

He later added...

"As a company, we are culturally pioneers, and we like to disrupt even our own business."

On the Two Ways to Build a Successful Business
"One is to work very, very hard to convince customers to pay high margins. The other is to work very, very hard to be able to afford to offer customers low margins. They both work. We're firmly in the second camp."

On Thinking Long-Term
"Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We're willing to plant seeds, let them grow—and we're very stubborn. We say we're stubborn on vision and flexible on details."

I've posted on other occasions that I don't care for Amazon's stock. Yet, it's hard to not respect and be impressed with Bezos as a leader. The stock has actually fallen quite a bit (actually more than 25%) from the recent all time highs yet still sell at a very high multiple of current and next year earnings.*

Unfortunately, not only do the shares still seem difficult to value, but they also don't stack up all that well against investment alternatives where the risk-reward, at least for me, is not as difficult to understand.

That's certainly my view but if someone is going to prove that to be wrong, it'll be Jeff Bezos.

Still, even if Amazon's intrinsic value grows spectacularly in the coming decade the risk-adjusted returns will likely be less so due to the high earnings multiple being paid.

It's not that long run returns will necessarily be negative.**

It's that, near the current stock price, investors seem likely to get compensated rather modestly even if Amazon achieves spectacular long-term business results. So what happens to returns if the future ends up being less than spectacular? The ride back to a more normal multiple will hurt.

I'd be somewhat surprised if, in the long run, the company doesn't end up thriving. I won't be surprised if long-term shareholders (i.e. not traders) don't get spectacular market returns.

For me, shares of other good businesses offer a more understandable trade off between potential upside if things go well versus downside if things do not.

The company seems very likely to be an important force for a very long time and, eventually, maybe even make a ton of money.

Too bad the it's not easier to figure out what the shares are likely worth within a narrow enough range.

Check out the full interview.

Adam

No position in AMZN

Related posts:
Amazon Sells Kindle Fire Below Cost
Technology Stocks

* The forward 2012 earnings estimates are, somewhat understandably, all over the map. Remarkably, so are the 2011 estimates. That's a bit harder to understand. So there is really no meaningful consensus on what Amazon's earning power really is. Using the average of the 2011 earnings estimates among analysts (certainly, a less than perfect way of looking at it) the price to earnings ratio is ~150x. Using the average of next year's earnings estimates the price to earnings ratio is ~90x. So, using all but the most optimistic view, the share price seems high compared to what Amazon is capable of earning in its current form . Some argue, and it is consistent with what Bezos says above, that Amazon's earning power is held back by the long-term investments the company is making. That may turn out to be true. Yet, as an investor, I'd want to pay a price that provides some protection if that turns out to not be the case.
** Though, near its current price, the risk of negative returns is uncomfortably high if things go a bit less well than expected. Having said that, sustained high return on capital over 2 or 3 decades eventually does make an initially expensive looking investment make sense. In the very long run, results tend to be drawn like a magnet toward the return on capital earned by the business. I don't think I have any capacity to even roughly estimate Amazon's return on capital or its sustainability over such a long time horizon. Others obviously may be able to.
---
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, December 20, 2011

Warren Buffett on Profitability: For Commodity Businesses, "Nothing Fails Like Success"

From Buffett's 1982 Berkshire Hathaway (BRKashareholder letter:

"Businesses in industries with both substantial over-capacity and a 'commodity' product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles. These may be escaped, true, if prices or costs are administered in some manner and thereby insulated at least partially from normal market forces. This administration can be carried out (a) legally through government intervention (until recently, this category included pricing for truckers and deposit costs for financial institutions), (b) illegally through collusion, or (c) "extra- legally" through OPEC-style foreign cartelization (with tag-along benefits for domestic non-cartel operators).

If, however, costs and prices are determined by full-bore competition, there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous.

Hence the constant struggle of every vendor to establish and emphasize special qualities of product or service. This works with candy bars (customers buy by brand name, not by asking for a 'two-ounce candy bar') but doesn't work with sugar (how often do you hear, 'I'll have a cup of coffee with cream and C & H sugar, please').

In many industries, differentiation simply can't be made meaningful. A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent.  For the great majority of companies selling 'commodity' products, a depressing equation of  business economics prevails: persistent over-capacity without administered prices (or costs) equals poor profitability.

Of course, over-capacity may eventually self-correct, either as capacity shrinks or demand expands. Unfortunately for the participants, such corrections often are long delayed. When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment. In other words, nothing fails like success.

What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years. Frequently that ratio is dismal. (It seems as if the most recent supply-tight period in our textile business - it occurred some years back - lasted the better part of a morning.)

In some industries, however, capacity-tight conditions can last a long time. Sometimes actual growth in demand will outrun forecasted growth for an extended period. In other cases, adding capacity requires very long lead times because complicated manufacturing facilities must be planned and built."

Capacity-tight conditions can persist for a very long time.

After several years of experiencing what seems like a favorable profitability environment, an investor can be lulled into thinking the recent experience represents what is normal.
(When something goes on for many years, it's not hard to make the mistake of projecting things indefinitely forward.)

So watch a commodity business put up five or seven years (maybe more) of outsized profitability and it's easy to incorrectly interpret the performance as ongoing. Yet, in all likelihood, over a long enough cycle, that profitability will eventually shrink or even become persistent losses (possibly for a very long time) as the capacity/demand imbalances are corrected.

When an executive at a commodity business decides to invest in new capacity, assumptions need to be made in order to judge the likely pricing environment many years down the road. Get it wrong (either due to weaker demand than expected or too much unexpected new capacity) and the returns end up sub-par or much worse.

No business is easy but getting that judgment consistently right seems difficult at best.

When the added capacity (often with a substantial time lag...enough for the macro world to have changed a whole lot) does come on line, what seemed like persistent profitability can shift and dramatically so.

The problem is that for most commodity businesses the fixed investments are enormous. Also, commodity prices fluctuate in ways that a differentiated product or service generally does not.
(Compare Coca-Cola's beverage or Pepsi's snack prices over a few business cycles to suppliers of copper, oil, sugar, etc.)

All commodity business equity investments need to be looked at carefully in this light.

Is the recent period (even if a very long cycle) of profitability a precursor to something much different once new capacity comes online or demand takes a hit?

Does the business have a sustainable cost advantage and a conservative balance sheet that lets it outlast competitors during the supply-ample years?

None of this is really an issue for businesses that can differentiate their offerings and wrap a trusted brand around it.

Products and services that can be differentiated, in contrast to commodity-like businesses, are more likely to experience a temporary but manageable hit to profitability -- all else equal -- during times of meaningful economic stress.

Adam

Long position in BRKb

* The commodity price spikes that occurred in recent years were certainly a headache for consumer goods businesses, but the hit to profitability for most of them was actually rather modest. Naturally, this requires that reasonable degree of leverage is employed.
---
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, December 19, 2011

Investors Can Have Cheap Stocks or Good News...Not Both

From this MarketWatch article:

One study by John Bogle, the founder of mutual-fund firm Vanguard Group, found that for the 20 years ending 2003, the S&P 500 Index SPX returned 13% per year, while the average mutual fund returned 10.3% and the average investor achieved just a 7.9% annualized return.

American Association of Individual Investors (AAII) has surveyed its members since 1988. It revealed...

The highest weight to cash — and lowest weight to equities — in the history of the survey was in March 2009, right at the bottom of the worst bear market since the 1930s. When was the highest weight to equities? January 2000, near the absolute top of the stock market's 20 year bull run.

Clearly, panic and greed lead people to do the wrong thing at the wrong time — and to do so consistently.

It's not just the individual investor.

I've referenced previously that, in the early 1970s when Nifty Fifty stocks were sporting 50x to 100x price to earnings ratios, pension fund managers were putting 90% of their cash flow into stocks. From this Fortune article written by Warren Buffett in 2001:

...this was Nifty Fifty time--pension managers, feeling great about the market, put more than 90% of their net cash flow into stocks, a record commitment at the time. And then, in a couple of years, the roof fell in and stocks got way cheaper. So what did the pension fund managers do? They quit buying because stocks got cheaper!

Here's what private pension funds looked like as  % of cash flow put into equities:

- In 1971, it was 91%, a record high.
- In 1974, it was 13%.

Later in the article Buffett added...

That sort of behavior is especially puzzling when engaged in by pension fund managers, who by all rights should have the longest time horizon of any investors. 

and...

Yet they behave just like rank amateurs (getting paid, though, as if they had special expertise).

In 1979, when I felt stocks were a screaming buy, I wrote in an article, "Pension fund managers continue to make investment decisions with their eyes firmly fixed on the rear-view mirror. This generals-fighting-the-last-war approach has proved costly in the past and will likely prove equally costly this time around." That's true, I said, because "stocks now sell at levels that should produce long-term returns far superior to bonds."

So in 1972 pensions fund managers were aggressively buying stocks:

Six years later, the Dow was 20% cheaper, its book value had gained nearly 40%, and it had earned 13% on book. Or as I wrote then, "Stocks were demonstrably cheaper in 1978 when pension fund managers wouldn't buy them than they were in 1972, when they bought them at record rates." Warren Buffett in Fortune, 2001

Is a similar mistake being made now?

Some of the highest weightings to equities occurred in the early 1970s and around the year 2000. Both were times when equity valuations had reached extremes. Now, at least for many high quality large capitalization stocks, valuations these days seem not rich at all.

You can have cheap equity prices or good news, but you can't have both at the same time. - Joe Rosenberg in this recent Barron's interview

The Best Opportunities in a Half-Century

Jeff Saut added in this recent Minyanville article that institutional investors (hedge funds, pensions, endowments) are, once again, very underinvested in equities:

Verily, hedge funds are having a terrible year, having been caught "short," as well as underinvested with only a 43.8% net long investment position. Or how about the endowment funds that are only ~12% net long US stocks? How can those endowment funds achieve their mandates of roughly 8% per year using 2%-yielding 10-year Treasury Notes? The answer is they can't! - Jeff Saut

There's plenty of evidence, and this article provides just one example, that the small investor is doing the same.

If the recent wild leaps and plunges in financial markets have prompted you to cash out your stocks, you're not alone. Individual investors are bolting for the exits.

It's not that stocks can't still go down a whole bunch over the next year or two but the evidence strongly suggests that many market participants, professional or not, have a great tendency to get it wrong.

Well, at least more so than some might otherwise expect.

Adam

Related post:
Rear-view Mirror Investing

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, December 16, 2011

Boring Microsoft...Boring Apple?

Here's a good article by Vitaliy Katsenelson on Microsoft. It points out Microsoft's price to earnings ratio ended the 1990s at 50x but recently traded for less than 7x if you take out the $ 6/share in net cash.

IBM (IBM) has received plenty of attention after Buffett decided to buy a large stake in the shares. A case is made in this recent Barron's article that Microsoft (MSFT) is better than IBM by every metric.

Katsenelson additionally made the following points:

- Valuation offers a margin of safety
- P/E expansion a significant source of returns
- The company should trade at premium, not a discount, to the market

In my view, Microsoft doesn't have to be a better business than IBM at its current valuation.


At 50x earnings a little over a decade ago, there was little chance investors would get a decent return even if Microsoft executed reasonably well. Since then, the company has tripled its earnings (actually nearly quadrupled on a per share basis since shares outstanding has dropped from 11.1 billion to 8.5 billion via buybacks).

So there's been plenty of per share intrinsic value created. It's just that the value had to catch up to the stock price.

With Microsoft now selling at less than a 7x enterprise value (market cap minus net cash) to earnings, an awful lot has to go wrong for the stock to not produce very nice returns for owners over the next decade or so.

In fact, at that valuation and with sound capital allocation, Microsoft wouldn't even need to grow (it could actually afford to shrink a bit) to produce solid returns.

Now, Microsoft has been less than impressive when it comes to capital allocation. They have also, in fact, missed some important strategic opportunities over the past decade.

To the company's credit, the share count has been lowered by a material amount. Still, considering the exceptional free cash flow and balance sheet, a more aggressive buyback seems warranted while the stock remains cheap.

I won't be holding my breath.

Yet, while plenty of chances to create value have been missed*, eventually the price gets low enough to account for all but the most catastrophic future economic outcomes. For long-term holders of the stock to do poorly going forward, a series of extremely dumb capital allocation decisions or material damage to a core Microsoft franchise would have to occur.

Maybe that is a possibility, but an investor has to decide when the market price compensates enough for those risks.

Microsoft is far from my favorite business.

They're probably not going to suddenly getting wiser on the capital allocation front.

They'll likely continue to miss opportunities while some of their toughest competitors do not.

That doesn't change the fact that the valuation is not something you expect to see everyday.

Of course, amazingly Apple (AAPL) also has a single digit earnings multiple after backing out the $ 87/share of net cash and investments on the balance sheet.**

Not exactly expensive.

I mean, considering some of Apple's capabilities, a more inflated earnings multiple would seem hardly surprising.

(Whether it would be wise to pay it is another story.) 

In any case, when it comes to tech stock valuations, what a difference a decade or so makes. 

Still, as I've previously explained, there's just no technology business that I'm comfortable with as a long-term investment.

In other words, the discount to conservative value generally needs to be quite large -- an extreme mispricing --  for most tech stocks to be worth the trouble.

Adam

Long MSFT and AAPL


Related post:
Technology Stocks

* Missed opportunities? Certainly. Still, any company that can quadruple earnings per share in a decade despite missteps probably has something going for it.
** Apple is selling at $ 380/share minus the $ 87/share  = $ 293/share. Consensus estimates are running at nearly $ 35/share so the enterprise value to earnings is a bit over 8x.

---
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, December 15, 2011

Barron's 10 Favorite Stocks for 2012

Barron's: Our 10 Favorite Stocks for 2012

Some things of note about this list:

- With the exception of Berkshire, each pays a dividend with the average yield at ~3%

- Half have price/earnings ratios less than 10x

- Four are European

Barron's Ten Favorite Stocks for 2012
Berkshire Hathaway (BRKa)
MetLife (MET)
Sanofi (SNY)
Seagate (STX)
Vodafone (VOD)
Royal Dutch Shell (RDSA)
Freeport McMoRan (FCX)
Comcast (CMCSA)
Procter & Gamble (PG)
Daimler (DDAIF)

Some of the above seem worth a further look (though I tend to avoid automobile manufacturers no matter how cheap they may seem to be...there's just too many other good alternative shares to own).

Quite a few large cap European stocks are, in fact, selling at what at least looks like a nice discount to value.

Obviously, they're not entirely immune from the euro zone's troubles (not much is).

Yet, while they're based in Europe with its many serious economic difficulties ahead, much of their intrinsic value comes from activities outside the region.

Adam

Long positions in BRKb, SNY, and PG

Wednesday, December 14, 2011

McDonald's: 8,640% Gain Since 1980

From this Bespoke Investment Group article.

The Golden "Golden Arches"

Below is a chart showing the performance of five of the biggest Dow stocks going all the way back to 1980.  As shown, McDonald's (MCD) has absolutely blown the four other companies (GE, DIS, IBM and XOM) out of the water with a gain of 8,640% (not total return). 
Source: Bespoke Investment Group
Check out the Bespoke article to get a good look at the chart.

As Bespoke Investment Group notes, that 8,640% gain excludes dividends so this number understates the total return produced by quite a bit. Over that same time frame, you'll find that total returns that are 10,000% and higher among the likes of Coca-Cola (KO), Pepsi (PEP), Colgate (CL), and Altria (MO) among many others.

In many ways, McDonalds is a very different business from the consumer staples listed above. So what do they have, at least mostly, in common besides excellent long-term returns? Well, these all sell trusted consumer brands, have meaningful advantages of scale, and strong distribution capabilities.

Things, in combination, that often create a formidable economic moat.

From this USC Business School speech by Charlie Munger:

"And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30 cents, am I going to take something I don't know and put it in my mouth which is a pretty personal place, after all for a lousy dime?

So, in effect, Wrigley, simply by being so well known, has advantages of scale what you might call an informational advantage.

Another advantage of scale comes from psychology. The psychologists use the term 'social proof'. We are all influenced subconsciously and to some extent consciously by what we see others do and approve. Therefore, if everybody's buying something, we think it's better."

Munger later added...

"The social proof phenomenon which comes right out of psychology gives huge advantages to scale ‑ for example, with very wide distribution, which of course is hard to get. One advantage of Coca-Cola is that it's available almost everywhere in the world.

Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup which is slowly won by a big enterprise gets to be a huge advantage.... And if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you."

The question is this. Are similar enough forces in place that will produce above average returns from these businesses going forward. More from Charlie Munger:

"We've really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money's been made in the high quality businesses. And most of the other people who've made a lot of money have done so in high quality businesses."

You never know but, if bought at reasonable valuations, I'm thinking the higher quality businesses will do just fine on a long run risk-adjusted basis despite all the noise in the macro environment.

Adam

Related previous posts:
Munger on Elementary, Worldly Wisdom - Part II
Munger on Elementary, Worldly Wisdom

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, December 13, 2011

Buffett on "Truly Extraordinary" CEOs: Berkshire Shareholder Letter Highlights

Warren Buffett, in the 2005 Berkshire Hathaway (BRKashareholder letter, used the arrival of Jim Kilts at Gillette in 2001 as an example of "the truly extraordinary CEO".

According to Buffett, Kilts transformed a company that was struggling from capital-allocation blunders and made moves that "dramatically increased the intrinsic value of the company".

In Buffett's view, as a result of "his accomplishments, Jim was paid very well – but he earned every penny."

So the rare but an extraordinary CEO can be worth every penny he or she is paid.*

Unfortunately, executive compensation systems seem designed to encourage anything but the extraordinary.

From the 2005 Berkshire letter:

Executive Pay Versus Performance
Indeed, it's difficult to overpay the truly extraordinary CEO of a giant enterprise. But this species is rare.

Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won't change, moreover, because the deck is stacked against investors when it comes to the CEO's pay. The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.

Take, for instance, ten year, fixed-price options (and who wouldn't?). If Fred Futile, CEO of Stagnant, Inc., receives a bundle of these – let's say enough to give him an option on 1% of the company – his self-interest is clear: He should skip dividends entirely and instead use all of the company's earnings to repurchase stock.

Let's assume that under Fred's leadership Stagnant lives up to its name. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $25.80. Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined by 20% during the ten-year period.

The problem doesn't end there.

Low Return Projects & Acquisitions in Lieu of Dividends
Fred can also get a splendid result for himself by paying no dividends and deploying the earnings he withholds from shareholders into a variety of disappointing projects and acquisitions. Even if these initiatives deliver a paltry 5% return, Fred will still make a bundle. Specifically – with Stagnant’s p/e ratio remaining unchanged at ten – Fred's option will deliver him $63 million. 

Finally...

Adjusted Strike Price Stock Options
It doesn't have to be this way: It's child's play for a board to design options that give effect to the automatic build-up in value that occurs when earnings are retained. But – surprise, surprise – options of that kind are almost never issued. Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation "experts," who are nevertheless encyclopedic about every management-friendly plan that exists. ("Whose bread I eat, his song I sing.")

The worst part of all is that getting fired can be especially bountiful for CEOs:

Today, in the executive suite, the all-too-prevalent rule is that nothing succeeds like failure.

Buffett points out that having served as a director on the board of twenty public companies, only CEO has put him on an executive comp committee.

I wonder why.

Adam

Long position in BRKb

Related posts:
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager

* Of course, beyond the $ 100k/year Buffett is paid, his wealth has come primarily from the compounded value of Berkshire shares he bought using his existing wealth a number of decades ago. An exceptional CEO with less than exceptional compensation. Imagine if all those years ago Buffett had demanded the "2 and 20" fee arrangement that is the norm among hedge funds. I took a hypothetical look at it in a previous post and this follow up.
---
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.
 
Site Meter