Tuesday, January 31, 2012

Edward Owens: Vanguard Healthcare Fund Update

Edward Owens has been manager of the Vanguard Healthcare Fund (VGHCX) since 1984. The fund has returned more than 12%/year for the past 15 years and more than 16%/year since inception.

Vanguard Healthcare has very low turnover (~9%) so the investments by the fund tend to have a longer term horizon. Nearly 40% of the fund's holdings are represented by the top ten.

Top Ten Holdings
Merck (MRK)
United Health (UNH)
Forest Labs (FRX)
Abbott Labs (ABT)
McKesson (MCK)
Roche Holdings (RHHBY)
Pfizer (PFE)
Amgen (AMGN)
AstraZeneca (AZN)
Eli Lilly (LLY)

Owens added no new stocks to the portfolio this past quarter and there were no additional shares bought among the top ten positions.

Slight reductions in two top ten positions were made:

Abbott (ABT) was reduced by ~10% while Eli Lilly (LLY) was reduced by ~5%.

Several meaningful increases to much smaller positions were made. Yet, even after the increases, none of these positions individually make up even 1% of the portfolio.

Boston Scientific (BSX)
Hospira (HSP)
Zimmer Holdings (ZMH)
CVS Caremark (CVS)

The turnover by investment managers at a number of other mutual funds is so high that what is owned at any given moment doesn't often tell you much.

Less activity in a fund may make it less exciting, but the approach should reduce frictional costs (taxes, commissions). The main driver of long-term returns is generally achieved by owning businesses that themselves compound intrinsically at a high rate and not paying too much for the privilege of ownership.

To me, the approach is an admirable one. Success will always comes down to the quality of the businesses owned and the price that was paid. Things like superior trading skills, well-timed sector rotation, or technical analysis not required.


Long PFE. No positions in other stocks mentioned.

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 30, 2012

Buffett: High Current Yield, Long-term Capital Growth, and Stock Market Pyrotechnics

Warren Buffett wrote the following in the 1979 Berkshire Hathaway (BRKa) shareholder letter:

"Phil Fisher, a respected investor and author, once likened the policies of the corporation in attracting shareholders to those of a restaurant attracting potential customers. A restaurant could seek a given clientele - patrons of fast foods, elegant dining, Oriental food, etc. - and eventually obtain an appropriate group of devotees. If the job were expertly done, that clientele, pleased with the service, menu, and price level offered, would return consistently. But the restaurant could not change its character constantly and end up with a happy and stable clientele. If the business vacillated between French cuisine and take-out chicken, the result would be a revolving door of confused and dissatisfied customers.

So it is with corporations and the shareholder constituency they seek. You can't be all things to all men, simultaneously seeking different owners whose primary interests run from high current yield to long-term capital growth to stock market pyrotechnics, etc.

The reasoning of managements that seek large trading activity in their shares puzzles us. In effect, such managements are saying that they want a good many of the existing clientele continually to desert them in favor of new ones - because you can't add lots of new owners (with new expectations) without losing lots of former owners.

We much prefer owners who like our service and menu and who return year after year. It would be hard to find a better group to sit in the Berkshire Hathaway shareholder "seats" than those already occupying them. So we hope to continue to have a very low turnover among our owners, reflecting a constituency that understands our operation, approves of our policies, and shares our expectations."

What Buffett describes above would seem nearly impossible to find in today's short-term oriented capital markets culture (with many participants now buying/selling via ETFs & employing other short-term trading strategies).

Yet, wherever possible, I'll take investing alongside an investor constituency of informed long-term owners that don't head for the exits at the first sign of trouble in a business (or the macro environment).

These days, quite a few market participants seem to have no shortage of an attention deficit, employing strategies that often make business fundamentals an afterthought (if at all).

Among those that do actually happen to look at fundamental business values from time to time, more than a few seem to embrace the if you don't like near term prospects just sell the stock school of investing. This includes small investor and large institutions alike.* At some level, there's nothing wrong with that, I suppose. Investors and other market participants are free to invest any way they want, of course.

Yet, I'd prefer investing next to a high percentage of co-owners and executives that can be trusted to stick around during the inevitable rough patches (macro or otherwise). Even the best businesses will, at times, experience real but fixable difficulties (I'm not talking about truly broken businesses here). When change intended to improve long-term returns are needed, long-term committed owners, especially those that control a large % of stock, are more apt to use their influence to work with and put pressure on the board and management to fix real problems.**

In the real world, things rarely work anywhere near this ideal but investing with other long-term oriented owners and managers when possible at least improves the odds of shareholder-friendly actions. It also has the advantage of allowing an investor to gain in-depth knowledge and insight into the unique risks/potential of a specific business. It's not possible to know a lot about every business so it helps to concentrate on what one truly can understand. In this approach, returns are generated by the compounded wealth creation of a good business over time, bought at reasonable or better prices, not well-timed trades (something that has been emphasized more than a few times on this blog).

A good business, even one with occasional short-term problems, is a franchise capable of high and sustainable return on capital (superior economics). Long-term portfolio returns can only be above average if the businesses in the portfolio generally produce above average return on capital. A business with below average economics will produce subpar long-term returns even if it is bought at what seems like a substantial discount (though it is possible to make money over a shorter horizon this way).

Now, clearly sometimes having a few co-owners that lack long-term conviction is a benefit. It allows the long-term owners to accumulate more shares from the weak holders. It also may allow the company to buyback shares on the cheap. That's fine up to a point. Yet, there's another less optimal (if more subtle) side to this. Let's say a large block of shareholders (lacking in long-term conviction) are susceptible to selling temporarily depressed shares during times of market stress. This sets up a situation where a smart outside buyer could come along and pay a nice premium to the market price but still well below what remaining committed long-term owners consider anywhere near fair intrinsic value. If enough low-in-conviction co-owners are willing to sell the temporarily depressed shares to this buyer, then the judgment of the business intrinsically being worth more, even if correct, won't matter.
(Of course, it's possible to be a long-term committed owner that is overly optimistic about value and better off with that buyout.)

This may seem improbable but it certainly can happen. So that's just another reason why the more informed and long-term oriented the other owners are the better.

None of this, of course, is particularly easy to judge for a smaller investor, but I still think it's still worth putting any long-term investment through this kind of mostly subjective filter. At some level, the way the market is structured today (speculative activity of various kinds in favor of investing) makes this way of thinking difficult to put into practice.

Difficult yet not irrelevant.

It may be at odds with much of today's investing culture but, at least at the margin, finding businesses where an informed shareholder constituency is generally on board for the long haul is worth it.

Capital put at risk by informed, patient long-term shareholders increases the probability of (though hardly guarantees) improved results. Owners and agents concerned with price action measured in months (or even just a few years) will likely make different decisions than those concerned with the creation of enduring value over, say, 20 years. Most good businesses have the chance to compound at a rate closer to full potential with shareholders, the board, and management all focused upon long-term effects.

Investors as a whole should, on average, end up better off. More importantly, if the main participants were focused upon long-term effects, capital markets would likely function more effectively when it comes to the crucial role of facilitating capital allocation.

Wise capital and other resource allocation is more likely to happen when more owners are in it for the long run (informed about/engaged in what the board and key executives are doing with the resources of the business they own).

Instead, it seems an increasingly extreme amount of mental energy is expended by market participants speculating on near-term stock price action. I think it is safe to say that there are real costs (some hidden, some explicit and obvious) when the proportion of speculative versus investing activities goes to an extreme.***

"Well, in a typical recent year, ...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." - John Bogle on Speculation Dwarfing Investment

There's nothing wrong with speculation.

It will always have a place in the markets but the proportion matters.


Long position in BRKb established at lower prices

* That small investors behave this way is somewhat understandable, since they cannot usually influence the board and management. In many cases it's necessary to move on due to that lack of influence. For agents and/or investors capable of owning enough shares to influence corporate governance practices and other strategic decisions it seems much less understandable.
** Knowing that there are a few smart larger co-owners is always nice when management/board governance/other strategic changes end up being needed in a business. Otherwise, I think about shares of a business the same way I think about owning a good smaller business 100%. A small or medium size private business owner doesn't generally bail if some near-term serious but manageable problem emerges. Why not then, at least most of the time, treat share ownership of public businesses with that mindset? For me, reasons to sell include when the economic moat of a business becomes materially damaged and is likely to become even more so over time. In other words, the core long-term economics fundamentally change. Also, sometimes valuation will go to an extreme high. For me, short-term difficulties associated with the macro environment or a specific but fixable problem in the business aren't generally good reasons to sell a sound business that I like. There are, of course, times that funds are needed for a clearly superior alternative long-term investment. So outside of the business economics fundamentally breaking down, an extreme valuation, or high opportunity costs, my bias is to own the shares of a good business (bought well) for a very long time.
*** By just about any measure speculation is at unprecedented levels. The average holding period of stocks is now around 3 months while the average holding period during most of the past century was measured in multiple years.
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 27, 2012

John Bogle on Speculation & Capitalism's "Pathological Mutation"

"It is said on Wall Street, correctly, 'money has no conscience,' but don't allow that truism to let you ignore your own conscience, nor to alter your own conduct and character." - John Bogle in a 2007 Georgetown speech

John Bogle, founder and former chief executive of The Vanguard Group, mentions the above quote in this 2009 speech. In the more recent speech he also explained what inspired the title of his book Enough:

"I wrote my new book largely because I care deeply about the traditional values that are eroding not only in our financial system, but also in our businesses, in our communities, and even in our own lives. The story of ENOUGH begins with a sort-of-poem by Kurt Vonnegut. It was entitled "Joe Heller," and I chanced upon it in The New Yorker in April 2005. The poem was a tribute to the late author of Catch 22—one of the seminal books of the post-World-War-II era, and one of its most successful. I can summarize the short poem in just a few words:

At a party given by a billionaire on Shelter Island, Kurt Vonnegut tells Heller that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch 22 over its whole history. Heller responds, 'Yes, but I have something he will never have...enough.'"

For Bogle, the rampant greed and disgraceful conduct that now overwhelms "our financial system and corporate world runs deeper than money."

To him, the behavior "subverts our society's traditional values" and results in the "diminution of our national character and values."

More from the 2009 speech by John Bogle:

Capitalism's "Pathological Mutation"
"During the past half-century, the very nature of capitalism has undergone a pathological mutation. We have moved from an ownership society in which 92 percent of stocks were held by individual investors looking after their own interests and only 8 percent by financial institutions, to an agency society in which our institutions now hold 75 percent of stocks and individuals hold but 25 percent.

These institutional agents have not only betrayed the interests of the principals to whom they owe a duty of trusteeship, but have also abandoned their traditional investment principles. For it is these agents who have been the driving force in changing the central characteristic of market participation from long-term investment—owning businesses that earn a return on their capital, creating value by reinvesting their earnings and distributing dividends to their owners—to short-term speculation, essentially trading stocks and betting on their future prices. It is not only hedge funds that are playing this game, but most mutual funds and many giant pension plans.

Today, we are witnessing an orgy of speculation the likes of which have never been seen before."

Speculation in the Drivers Seat
"Revenues of our stock brokerage firms, money managers, and the other insiders soared from an estimated $60 billion in 1990 to some $600 billion in 2007.

So while trading back and forth with one another—foolish as it is—is by definition a zero-sum game, once the costs of our Wall Street croupiers are deducted it is a loser's game."

Later he added...

"That $600 billion in 2007 plus many hundreds of billions in earlier years, obviously represent a truly staggering hit to the gains investors earned in the bull market, and a financial slap in their face in the bear market that followed. Any confidence in Wall Street that our investors once may have had has largely vanished, just as it should have."

John Bogle has long been known as the "conscience of Wall Street" for a reason. In a more recent speech, he said "we need not only ethical principles to guide us, but ethical principals to assure their observance".

Well, I think it's fair to say that the principal -- in this case John Bogle -- behind the principles that led to the creation of Vanguard has, over the decades, made the world more than just a bit better for long-term investors.


Related posts:
Bogle: Back to the Basics - Speculation Dwarfing Investment
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I

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 26, 2012

Are Large Cap Stocks Cheap?

For some context, I'll start this out by looking at valuations in the late 1999. At that time, the top five U.S. companies in terms of market capitalization was Microsoft (MSFT), General Electric (GE), Cisco (CSCO), Exxon Mobil (XOM), and Wal-Mart (WMT).

Combined, these five companies had a market capitalization of roughly $ 2 trillion dollars at the time.

Yeah, that's right.

Now, check out the annual earnings of these five stocks back in 1999:

Microsoft: $ 7.8 billion
General Electric: $ 10.7 billion
Cisco: $ 2.1 billion
Exxon Mobil: $ 7.9 billion
Wal-Mart: $ 4.4 billion

So, back then, these five businesses had ~$ 33 billion of combined earnings power.

With $ 2 trillion of combined market capitalization, that means investors were willing to pay an average of ~60 dollars for every dollar of earnings.

For whatever set of reasons or rationalizations, not nearly enough investors (professional or not) seemed to find this to be a bit of odd situation. I remember it well and still find the rationalizations that were being used to justify the market prices to be completely astonishing to this day.

How can companies of that size possibly be worth on average 60x earning?

An earnings yield of less than 2%, really?

Why wasn't that perfectly obvious?

Well, it wasn't and that's worth remembering.

In contrast, this year these five companies will earn more than $ 100 billion. As far as I'm concerned, if businesses this large can triple earnings in a little over ten years like they did, that's a good decade of work.

Today, these five businesses have a combined market value that is ~ $ 1.2 trillion. So investors are paying a far more reasonable 12x earnings or so. That doesn't mean these stocks will do well in the next few months (or even years), but 12x provides at least some margin of safety in a way that 60x certainly does not.

The next time someone says a particular stock has been performing poorly for a long time, it's worth remembering where some of them started in terms of valuation a little over a decade ago.

Apple (AAPL) is now, of course, one of the top five. Actually, as of yesterday, it is roughly tied for being the most valuable company with Exxon Mobil (~ $ 420 billion). In the late 1990s, Apple was certainly nowhere near this top five. The company was being nursed back to health after its near collapse and had, at the time, a relatively low market value.
(Yesterday's post covers Apple's earnings and what still seems hardly an extreme valuation.)

Back in 1999, there were many favorite rationalizations on display (expert and otherwise) of why paying such extreme multiples of earnings for stocks made sense. Sure stocks seemed expensive but somehow they should be. Those rationalizations clearly made no sense but, at least for some, they seemed to at the time.

At least enough market participants believed it that prices sustained increasingly lofty levels for quite a while.

To me, there's a simple, practical reason that all this is worth remembering.

If someone tries to now rationalize why these stocks are cheap and they should be*, it's worth considering that this is probably the same error in judgment only in reverse.

They are cheap now for the same reason that were expensive then.

Mr. Market is one moody dude.


* It's not all or none, of course. Many understood stocks were overvalued in the late 1990s just as many today see valuations as compelling. Having said that, Dow 36,000 is a book written by James K. Glassman and Kevin A. Hassett that was published in 1999. With stocks already very expensive by any measure at the time, they came up with a rationale why Dow Jones Industrial Average should rise to 36,000 within a few years. From this article in the Atlantic back in 1999: In explaining their new theory of stock valuation, the authors argue that in fact stock prices are much too low and are destined to rise dramatically in the coming years. So that's just one example of someone rationalizing why it was warranted for stocks to have been expensive. These days, there are many rationales for why stocks should be cheap. Some of the current favorites are global deleveraging, various systemic risks, banks, Europe, China, inflation, and deflation among many others. The list goes on. Those are real concerns but there is always something on the radar. Yes, stock prices would likely fall, maybe even for an extended time, if the worst scenarios played out. The fact is no one should own stocks without a very long time horizon. There will never be a shortage of bullish and bearish rationales. To me, it's better to just ignore them all. Investing is mostly thinking for yourself, occasionally gaining an insight, and not getting distracted. Effectively judging value (calculated conservatively) and always paying a nice discount to account for errors and the unforeseeable guarantees nothing, but at least increases the probability of good long-term results. The rest, especially the macro stuff, is mostly noise and distraction. The past century supplied plenty of good reasons to be fearful about the future (there's no reason to not expect more of the same)Despite those oft-warranted fears, many good businesses persisted through the worst and kept creating value. During those rare occasions when economic skies appeared clear and all seemed calm, you can be sure that stocks weren't cheap. So, while there will always be future risks to consider for investors, some known and some unknowable, the good news is the world doesn't end all that often.
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.

Wednesday, January 25, 2012

Apple's Strong Earnings

Apple's (AAPLquarterly earnings were released yesterday and it looks like the company's stock will open at all time highs.

Check out these numbers:

$ 13 billion
That's Apple's quarterly net profit. One quarter. Net profits more than doubled from $ 6 billion a year earlier. Five years ago Apple earned $ 3.5 billion for the entire year. Now it has earned nearly 4x that much in one quarter.

Consider that Apple now earns nearly twice as much per quarter as Microsoft (MSFT). Not too long ago Apple's earnings was a mere shadow of Microsoft's.
$ 97 billion
The amount of cash and investments that Apple has on its balance sheet. No debt. It ended the previous quarter with $ 81 billion. A $ 16 billion increase. The reason cash and investment grew faster than net profits comes mostly down to free cash flow exceeding net profits.
$ 395 billion
Apple's market value as of yesterday's close.

Exxon Mobil's market value is still slightly higher at $ 423 billion (that may change today based upon Apple's pre-market price). The integrated oil company is expected to earn roughly $ 40 billion this year. After earning $ 13 billion in just one quarter, it seems reasonable to think that Apple will earn even more than Exxon Mobil.

If so, that means Apple is selling at a lower multiple of earnings than Exxon Mobil (XOM). That is true even before you back out the nearly $ 100 billion cash on Apple's balance sheet.

So, even if this past quarter is some kind of slight anomaly on the high side for earnings, it seems likely that Apple still sells at a single digit multiple of this year's earnings.

Now, not surprisingly considering the capital intensiveness, Exxon Mobil needs roughly 10x more capital than Apple to run its business and generate those profits. Exxon Mobil's return on capital is more than respectable for an integrated oil company. Having said that, return on capital for Apple is pretty much off the charts (easily over 100% by my math). So the two companies operate in a totally different economic universe.
What will be Apple's very long run profitability? I think, unlike some businesses in less dynamic industries, it's a tough call. At a minimum, any estimate of the intrinsic value of Apple has to have an extremely wide range.

Earnings power could end up being much higher, at least for a while, but who knows. At this point it's tough to bet against them.

Gauging the intrinsic valuation of something has to be based upon some conservative estimate of a very long run stream of cash flows. Valuation can't be based upon a few years of stellar earnings that then drop off. That's a recipe for paying too much and permanent loss of capital. Trying to estimate the future stream of cash flow for Apple seems to me nearly impossible. So it's somewhat speculative in that sense.

Will Apple become the first company actually worth a trillion dollars? Will, instead, the economics begin to hit a wall?

Both of those very different outcomes still seem at least plausible. I'm sure some others see the upside or downside with more certainty (and may very well end up being right).

Today, Apple's economics are driven by what is essentially a product cycle business (this may change over time, of course). The future always comes down to successfully inventing and executing on great new products and anticipating a very dynamic competitive landscape. Seeing things others haven't imagined. That's not often a recipe for a great long-term investment. In contrast, I'm pretty sure people will be buying Coca-Cola (KO) and Pepsi (PEP) products even if they don't innovate. Sales may suffer a bit but they'd probably do okay economically.

I'm not saying that Coca-Cola or Pepsi's business is easy. No business really is.

It's just that in the world Coca-Cola and Pepsi operate, the competitive landscape changes relatively slowly and they have tremendous durable competitive advantages. They may get beat up a bit from time to time (or beat each other up...at least in beverages) but the essential economics remain more knowable while the range of likely outcomes seem at least relatively narrow compared to Apple.

Now, plenty of speculation* occurs in shares of subpar businesses with questionable long-term prospects. Apple is far from being something like that.

It's well established that the company is capable of setting the standard with brilliant innovation and design yet there's much more to the story. It's also a business with formidable supply chain strengths that lead to cost advantages. Those supply chain strengths also feed into the superior product design. The brand equity they've built through their innovative products have also led to substantial pricing power.

The list of advantages doesn't end there but all of these qualities interact in ways that don't seem exactly easy to replicate. The result is superior economics by any measure.

The above characteristics are not usually associated with a business selling at a single digit price to earnings ratio (P/E). Generally, single digits P/E's are associated with businesses that have questionable economics or troubled businesses experiencing no growth or even decline.

Somehow, even at its substantial size, Apple continues to grow as if a smaller company (and growth that has been achieved with just ridiculous return on capital).

Apple has obviously been a tremendous stock over the past decade yet, somehow, the explosive earnings growth of Apple actually seems to have outrun the stock price.

Considering how well the stock has done it probably doesn't seem possible but the E may have actually, at least based upon what can be known up to this point, outrun the P.

The company's many strengths in combination provide at least for some kind of economic moat...at least for now. The problem I will always have is what that moat will be like five and especially ten years from now.

So Apple's never going to be the kind of business that's really in my comfort zone but it's hard not to be impressed.

For my own money, it's worth owning some shares of Apple when the valuation is low enough.

The economics are, for now, exceptional.

The valuation still not at all high given what's knowable.

Yet, I still consider it somewhat speculative. So, unlike businesses with more clear long-term durable competitive advantages, it will always be kept on a shorter leash.


Long positions in AAPL, MSFT, KO, and PEP all bought at much lower than recent market prices.

* Along with speculative prices. In fact, shares of quite a few seemingly inferior businesses in recent times were/are selling at 50x to 100x earnings or more. Oh, and some pretty good businesses also sell at very high P/E'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 are never a recommendation to buy or sell anything.

Tuesday, January 24, 2012

Buffett on Life & Debt

From the "Life and Debt" section of Warren Buffett's 2010 Berkshire Hathaway (BRKa) shareholder letter:

The fundamental principle of auto racing is that to finish first, you must first finish. That dictum is equally applicable to business and guides our every action at Berkshire.

Unquestionably, some people have become very rich through the use of borrowed money. However, that's also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.

Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that's all that is noticed. Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees.

Charlie and I have no interest in any activity that could pose the slightest threat to Berkshire's wellbeing. (With our having a combined age of 167, starting over is not on our bucket list.) We are forever conscious of the fact that you, our partners, have entrusted us with what in many cases is a major portion of your savings. In addition, important philanthropy is dependent on our prudence. Finally, many disabled victims of accidents caused by our insureds are counting on us to deliver sums payable decades from now. It would be irresponsible for us to risk what all these constituencies need just to pursue a few points of extra return.

Later in the letter Buffett added:

By being so cautious in respect to leverage, we penalize our returns by a minor amount. Having loads of liquidity, though, lets us sleep well. Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival. That's what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.

In a recent post, I highlighted the advantage that Wells Fargo (WFC) and U.S. Bancorp (USB) have over some other banks in terms of net interest margin. Simplifying things greatly, both banks obtain a superior spread between the cost of its funds (cheap deposits) and what they're paid for the money that it loans to customers. Still, like any bank, they must employ substantial leverage to generate above average returns.

Berkshire is ultimately also profiting from the spread between cost of funds (mostly its substantial insurance float) and what it does with that money. So it's similar to a bank in that respect. Yet, the way Berkshire goes about making above average long-term returns is very different. What's the main difference? Again, simplifying things a bit, Berkshire employs modest leverage but makes up for it via the extreme "spread"  between its low cost (actually, in some years better than no cost) float and the assets it invests in.*

So Berkshire doesn't need the multiplier of leverage (and, since leverage cuts both ways, nor is it exposed to the downside risk).

"Leverage is the only way a smart guy can go broke." - Warren Buffett on The Charlie Rose Show

Paying nearly nothing for money and buying businesses that often generate a return in the teens is a good way to make a living.

Sounds easy but, of course, it is not.

"The businesses that Berkshire has acquired will return 13% pre-tax on what we paid for them, maybe more. With a cost of capital of 3% -- generated via other peoples' money in the form of float -- that's a hell of a business. - Charlie Munger at the 2001 Wesco Annual Meeting

So these days a good bank might get a 4% spread between what it pays for deposits and the various loans it makes.

Through smart capital allocation, Berkshire can produce 2 to 3 times or more than that spread while using little leverage.

Berkshire is set up to produce an extreme spread between cost of funds and the returns it gets on investments. The result: the company is capable of generating high returns without the need for the kind of leverage that is involved in banking.


Long position in BRKb established at lower prices

* Primarily good businesses (or shares of good businesses), preferred shares, and a sizable bond portfolio.
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 23, 2012

Buffett Boosts Stake in Tesco

Britain's dominant supermarket chain Tesco PLC (TSCDY) has had, to say the least, some disappointing results as of late. Earlier this month the retailer posted weak seasonal figures that the CEO Philip Clarke described as "disappointing".

The company followed that up with its first profit warning in twenty years.

This Bloomberg Businessweek article points out earnings will "be around the low end of" consensus estimates and growth will be "minimal".

The fallout from all this was, unsurprisingly, a substantial decline in the shares of Tesco. Somewhat less expected was Warren Buffett's decision to add substantially to an already sizable position in the shares.

This Reuters article added that, according to a recent filing, Berkshire's position increased from 3.21% to 5.06% between January 12th and 13th. It was roughly a £500 million purchase based upon the closing share price.

The additional shares of Tesco should make the position among the top ten within the Berkshire Hathaway common stock portfolio.

It's hard to know whether an announcement like this is just the first of several shoes to drop. Was the recent profit warning just the first of many as they go about fixing some of the problems within their business?

At current levels of profitability Tesco is selling for roughly 10x earnings. So, on the surface, it seems reasonably valued. The 4% plus dividend seems well covered by current profit levels. The question is whether the current level of profitability remains relatively firm or not while the necessary adjustments to the business are made.

Tesco has industry leading operating profit margins (over 6% is certainly high for retail). Will those margins will be squeezed going forward as it spends money to fix supermarkets and otherwise improve its competitiveness?

The company admits it has issues with customer service and the quality/availability of goods in stores. They seem to have allowed store experience in its home market to become stale and dated while they were investing in overseas expansion. Tesco's overseas businesses have had relatively strong sales growth compared to the home market. With more than 5,300 stores in 14 countries its geographic footprint is considerable.

Last year, Buffett criticized the company for entering into the U.S. grocery market though, based upon his actions, he clearly remains a fan of Tesco's business overall.

Charlie Munger said Tesco's move into the U.S. market was "ill-advised".

"Tesco is God Almighty in England. But you come into southern California and you have Trader Joe's and Costco, that's tough competition," Munger said. "It's a different world."

Munger also jokingly said Tesco's Fresh & Easy U.S. grocery chain should be renamed "Fresh & Hard".

Tesco's record of consistent profitability is impressive. The company seems focused on making necessary changes that strengthen the franchise. That may turn out to be good news for shareholders in the long run if they can execute.

Still, it's not all that easy to gauge how long it will take for the needed changes to have an impact. Nor is it clear whether the cost of these changes will end up altering operating margins and ultimately the company's valuation.


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 20, 2012

Michael Spence: Mind Over Market

Below are some excerpts from an article, Mind over Market, that is part of The New Wealth of Nations series written by Michael Spence. Professor Spence is a recipient of the 2001 Nobel Prize in Economics.

From the Mind Over Market article:

Imperfect Markets
Markets are tools that, relative to the alternatives, happen to have great strengths with respect to incentives, efficiency, and innovation. But they are not perfect...

Decentralized Networks of Increasing Complexity
We live in a world of largely decentralized networks of increasing complexity: electronic networks, networks of supply chains and trade, financial networks that link the balance sheets of disparate entities. Market incentives cause actors to operate or modify parts of the network in ways that maximize efficiency locally. But the presumption – often an article of faith – that the whole remains stable and resilient has no theoretical or empirical support. Indeed, it seems inaccurate.

Redundancy Undersupplied
Resilience is a public good, created by the right kind of redundancy.

In a decentralized structure, redundancy tends to be undersupplied in the process of local optimization. That is why the tsunami that hit Japan last year disrupted many global supply chains: they were (and still are) too efficient from the standpoint of withstanding shocks.

In financial markets, local optimization seems to lead to excessive leverage and other forms of risk-taking that undermine the stability of the system. Much research is needed to understand which interventions or restrictions on individual choice are needed to make certain kinds of market equilibria stable. But, clearly, markets do not do this well by themselves.

The risks associated with the scale, complexity, and interconnectedness of the financial system are clearly not well enough understood. A paper by James Rickards expands a bit on what Professor Spence says above. An excerpt from the paper:

...there can be little doubt that the current period of globalization from 1989–2009, beginning with the fall of the SovietUnion and the end of the Cold War, represents the highest degree of interconnectedness of the global system of finance, capital, and banking the world has ever seen. Despite obvious advantages in terms of global capital mobility facilitating productivity and the utilization of labor on an unprecedented scale, there are hidden dangers and second-order costs embedded in the sheer scale and complexity of the system. These costs have begun to be realized in the financial crisis that began in late 2007 and have continued until this writing and will continue beyond. - James Rickards

I'd say it's more than fair to say the financial system needs to be reigned in somewhat. Changes are sorely needed to reduce systemic risk. Though in itself an insufficient solution, less leverage and more limits on the use of derivatives seems a good place to start. Derivatives in their current form are, of course, a huge source of hidden leverage and hard to measure risk.

One beneficial circuit breaker is a clearinghouse of some kind for over-the-counter derivatives.

Clearing houses add needed transparency (increasingly banks are clearing credit and interest rate derivatives through central counterparties). Also, the kind of intermediation that a clearing house provides by its nature can reduce systemic risk substantially. Those that object to a clearing house claim nonuniformity of contracts make this impossible. That excuse seems like, well, an excuse. Contracts can be modified to create uniformity.

Many other safeguards and limits are almost certainly needed to assure system stability and it's better to do so before we're in the next crisis. I'm guessing, in time, we'll learn, one way or another, much more has to be done to protect the system against the risk of instability and collapse.

I've yet to read it but, in his book Currency Wars, my understanding is that Jim Rickards provides a useful foundation for understanding complex systems and he suggests what we should do proactively to prevent the next financial crisis. The paper by Rickards is a good way to get some background on his thinking.

Ultimately, a system this large and complex when under stress (what Rickards describes in the paper as the supercritical state) cannot be expected to behave predictably in any meaningful way.

Rickards makes that point very clear.

More limits and safeguards that protect the system (not the participants) seem inevitable. The question is whether we'll make sure this gets done proactively or not.

Rickards explains why complex systems by their nature behave unpredictably and are prone to collapse. He also seems to think that regulators and bankers are still not using the right tools or metrics to assure system stability.

In any case, the time to put up the firewalls is before there's another fire.


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.

Thursday, January 19, 2012

Bank Earnings: Traditional Banking Doing Just Fine, Investment Banking Is Not

Bank of America reported earnings this morning reinforcing a clear pattern that has emerged this earnings season among the bigger banks. Investment banking and capital markets results have been weak while more traditional banking* is much stronger.

That has meant the those with a more traditional banking mix, like U.S. Bancorp (USB) and Wells Fargo (WFC), are doing just fine while the likes of Citigroup (C), J.P. Morgan (JPM), and Bank of America (BAC) have been hurt by their sizable investment banking and capital markets operations.

Below are some excerpts from recent articles commenting on bank earnings results (each bank below has at least some traditional banking in its mix). It's clear that, while the traditional banking world still has its problems, the environment continues to improve in a meaningful way.

In contrast, Wall Street businesses continue to struggle.

BofAThe Big Surprise in Bank of America's Earnings
What is clear is Bank of America followed a trend seen at its peers Citigroup and J.P. Morgan. Fourth-quarter results were ugly in its stock-and-bond trading and other Wall Street businesses, but BofA's traditional banking businesses – making loans to businesses and consumers — were stronger.

U.S. BancorpU.S. Bancorp Continues Solid Earnings Generation in 4Q'11
Fitch Ratings notes that U.S. Bancorp's (USB) results continue to outpace those of many of its rivals. USB reported net income of $1.35 billion in fourth quarter 2011 (4Q'11), a solid 6.0% increase from net income of $1.27 billion in the sequential quarter. These earnings equated to a strong 1.62% return on assets and 16.8% return on common equity.

Wells FargoWells Fargo Net Up 20%
Wells Fargo & Co.'s fourth-quarter earnings jumped 20% as the banking giant sold more commercial loans and saw a surge in mortgage creation.

It's traditional banking is doing well differentiating itself from those banks more reliant on investment banking.

CitigroupCitigroup Earnings Fall Short of Expectations
...Citigroup reported fourth-quarter results that fell far short of what analysts were forecasting, despite a pickup in lending and a drop in losses on bad loans. The culprit was the banking giant's capital markets division, where revenue fell 10 percent last quarter as traders headed for the sidelines, hurting businesses like stock and bond trading as well as investment banking.

J.P. MorganJ.P. Morgan Earnings Miss Wall Street Expectations
The big disappointment at J.P. Morgan was the investment bank, and its slide allowed J.P. Morgan's Main Street businesses to take command. J.P. Morgan's division made up of credit cards and auto lending overtook the investment bank in revenue and profit in the fourth quarter.

The net interest margin of Wells Fargo is 3.89% while the net interest margin of U.S. Bancorp is a bit lower but a still impressive 3.6%. On this important measure, both banks have a big advantage over most peers.

Consider that Wells Fargo has typically had a roughly 1% (and even greater) net interest margin advantage compared to other big banks. That may not sound like much but consider this: If Wells Fargo's net interest margin was more like its competitors (something like 1% lower...2.89% instead of 3.89%), the bank would earn $ 11.3 billion less pretax!**

Now, even the best large banks a susceptible to systemic risk. There's no getting around that. The complexity and interconnectedness of large banks making gauging the risks difficult at best (though U.S Bancorp is not exposed to global systemic risk in the same way as someone like Citigroup. It is a much more straightforward banking business). Considering the many other attractive investing alternatives, I can see why an investor would not want to bother with any of these larger banks.

Having said that, banks with higher net interest margins (low cost deposits combined with loans intelligently priced) and other reliable sources of noninterest income can produce above average return on equity (ROE). Banks with relatively high ROE (mid-teens or higher) that maintain a disciplined credit culture throughout the business cycle have a better likelihood of producing above average long-term returns for shareholders.

J.P. Morgan is considered by many to be one of the stronger large banks yet, while the two banks are of course nothing alike, U.S. Bancorp's 16.8% return on equity is more than 2x that of J.P. Morgan. If sustained, that advantage should benefit long-term U.S. Bancorp shareholders in a measurable way.

Even though J.P. Morgan is far larger and certainly more complex (it has a balance sheet that is roughly 7x larger in terms of assets), U.S. Bancorp can hardly be considering small with its $ 340 billion in assets.
(So I'm not really a fan of J.P Morgan due mainly to its complexity, but its shares did seem to get very cheap very recently. It has rallied since but continues to sell at a lower multiple than Wells Fargo or U.S. Bancorp. Still, I'd not be interested in it as a long-term investment. My preference is for less complexity and a bigger emphasis on a more traditional banking model.)

The bad news is, for those that still want to bother investing in one of better large banks, they're much more expensive now. On many occasions these past few years there were opportunities to buy the better banks at very attractive prices (They've gone from being 4 or 5x my estimate of normalized earnings in 2009 to more like 10 or 11x more recently). For my money, an acceptable margin of safety has all but disappeared near current prices.

Of course, as we've seen quite a few times in recent years, that can change pretty fast.

Cheap stocks and good news rarely coincide.


Long WFC, USB, and JPM bought at much lower prices

* Accumulating deposits then making loans (net interest income) and providing related services (noninterest income) to businesses/consumers.
** Here's another way to look at it. On the same amount of earning assets, the 1% net interest margin advantage enables Wells Fargo to absorb an additional $ 11.3 billion per year of losses before putting a dent in their capital (actually, first it would hit loan loss reserves then equity capital) during times of economic and/or financial stress. So there's a defensive angle to this advantage as well. Some may look at a bank more statically and give less weight to this important dynamic. 

Of course, the loans that go bad are accounted for with a provision for loan losses (a non-cash charge to earnings) that serves to build loan loss reserves on the balance sheet. Then, once a bank is convinced there's no hope of getting paid all or part of what is contractually obligated, loan charge-offs deplete the reserve. No matter how the accounting works, the important point here is that there is an additional $ 11.3 billion available per year to absorb losses on the same amount of earning assets. Finally, a bank can have above average net interest margins but, if it tends to make a lot of dumb loans, at some point this extra capacity to absorb won't be enough. A bank still has to know how to put their money to work intelligently and that means consistently providing credit to borrowers who can handle it.
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, January 18, 2012

An Interview with Markel's Tom Gayner: On Hedging, Intrinsic Value, Banks, and Investing in Europe

Tom Gayner is president and chief investment officer of Markel Corporation (MKL) and president of Markel Gayner Asset Management (the investment subsidiary of Markel Corporation).  He's been investing their since 1990 and manages roughly $ 2 billion.

Over the past twenty years the book value* of Markel has compounded in the high teens.

As of September 30, 2011, the top holdings in the Markel portfolio included: Carmax (KMX), Berkshire Hathaway A & B shares (BRK.a, BRK.b), Fairfax Financial Ltd (FRFHF) and Diageo (DEO). Gayner doesn't sell stocks in the Markel portfolio all that often.

Some excerpts from this recent GuruFocus interview with the value investor:

On Hedging
...the costs of hedging are substantial, so we try not to incur those. We don't assume that we have a more accurate view of the future than others. So in general we try to avoid incurring those costs, which helps the returns.

In the interview, Gayner also explains how he'd estimate Markel's intrinsic value. Gayner's answer on intrinsic value is not unlike the way Berkshire Hathaway's intrinsic value can be estimated.

On Large Bank Stocks
...I have decided that they're beyond my circle of competence to invest in them.

In the interview, Gayner was asked about Fairfax Financial (and, as noted above, one of Markel's top holdings) saying:

"...we have a lot of respect for what they're doing and how they've compounded value over the years." 

He was also asked about Prem Watsa, the founder, chairman, and chief executive of Fairfax Financial calling him "a very talented and honest businessman."

A Solution to Investing in Europe?
If you look at Nestle (NSGRY) and Diageo (DEO) whether Europe goes up, down, sideways, whether they solve the problem in one month, or one year, or ten years, the economics of those companies are likely to do pretty darn well.

Successful investors generally know their own own limits well and Gayner sure seems to be a good example of someone with that quality.

Check out the full GuruFocus interview here.


* An imperfect measure but can still be a useful gauge.
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 17, 2012

Wells Fargo Reports 4Q and Full Year 2011 Net Income

Almost all bank stocks did poorly during the crisis.

Most of the stocks, yes. Yet, at least in some cases, the best in the banking business came out the crisis just fine.

Telling the strong from the weak at the height of the crisis wasn't easy but, now that some time has passed, it's become more clear where the quality was and is.

Some of the best banks are intrinsically more valuable now per share than before the crisis occurred. Short of another financial crisis, the better ones are in a solid position to continue building on that value.

Wells Fargo (WFC) seems a good example. The bank just reported 4th quarter and full year net income.

From the earnings release:

Wells Fargo & Company (NYSE:  WFC) reported record net income of $4.1 billion, or $0.73 per diluted common share, for fourth quarter 2011, compared with $3.4 billion, or $0.61 per share, for fourth quarter 2010, and $4.1 billion, or $0.72 per share, for third quarter 2011. Full year 2011 Wells Fargo net income was $15.9 billion, or $2.82 per share, up 28 percent from 2010.

"I'm extremely pleased with Wells Fargo's performance in 2011 – including strong deposit and loan growth,  record cross-sell and record earnings," said Chairman and CEO John Stumpf. "We achieved these results while completing the conversion of Wachovia's retail banking stores – the largest such conversion in banking  history – and now all of our 6,239 retail banking stores are on a single platform serving customers coast to coast. At the time of the merger, we said the integration of Wachovia would take three years and we are right on track."

Wells Fargo certainly made their fair share of mistakes during the crisis but, compared to most peers, they've come through it just fine to say the very least.

In what is still a very challenging bank environment, Wells Fargo is now already earning more per share than it ever did pre-crisis.

That may or may not seem like a huge deal but, in contrast, other less well run banks are still having a tough time earning even a fraction (if they're even still around) of what they earned pre-crisis.

Citigroup (C) is as good an example of this as any. The bank may be getting its house in order now, but that doesn't change what it looks like from a long-term equity investors point of view.

At its pre-crisis peak, Citigroup earned more than $ 48/share (apples to apples accounting for the 10-1 reverse stock split) but earned less than $ 4/share during all of 2011 (as just reported).

Even when things begin to fully normalize for Citigroup, the amount of wealth destruction for shareholders has been extensive. Much of that value destruction, of course, is due to extreme share dilution and the need to sell off valuable assets to clean up the balance sheet. As a result, as far as the common stock goes, it is a shadow of its former self.

Not so at Well Fargo, the bank is intrinsically more valuable absolutely and, most importantly for an investor, on a per share basis. There is also plenty of reasons to think they'll compound that value at a higher than average rate for a bank going forward.

In its peak earnings year prior to the crisis, Wells Fargo earned $ 2.47/share.

For the just reported 2011 full year, the bank earned $ 2.82/share (Wells share dilution during the crisis was more than offset by increases to earning power).

So, at a time when Citigroup still can't even earn 1/10th per share of what it did pre-crisis, Wells Fargo is already earning more than its best pre-crisis year (earnings are expected to be higher in 2012...we'll see).

In what is still a rough environment for any bank, Wells Fargo has figured out a way to earn more than it ever did previously while building a healthy balance sheet (and also absorbing the not-so-healthy and very large Wachovia).

When a more healthy economic expansion begins to kick in, the deposit and loan growth should lead to much more earning power and eventually more capital being returned to shareholders.

In addition, compared to peers, Wells is less complex and requires a much smaller balance sheet to produce a similar amount of net income.* Unlike the other large banks, Wells Fargo never really focused on investment banking and its many pitfalls. Not a small advantage. The result is a cleaner model focused primarily on commercial banking. The bank has a substantial advantage over most peers in terms of net interest margin. If sustainable, in combination with their credit culture and other qualities, should lead to higher than average return on equity (ROE) over time (for a bank, a sometimes useful if imperfect proxy for investor returns given the limits of accounting) and, ultimately, superior long-term investor returns (increases to intrinsic value).

When it comes to banks, investors should tread carefully with what looks like a "bargain". The better bank stocks sometimes look relatively expensive compared to book value** and/or earnings per share, but that's often because the best are capable of increasing intrinsic value at a higher rate.
(Wells Fargo has been very cheap, at times, for several years but that's no longer the case as of today. It's selling at slightly more than 10x earnings. Expensive? No, but not cheap either. Many banks sell at a far lower earnings multiple or discount to book value but watch out for those that are cheap and, well, worth it.)

As always, you've got to pay an appropriate discount to value. For most banks, the analysis of what it's worth should start with balance sheet health and net interest margin performance but credit and selling culture, complexity, compensation systems, and attitudes toward accounting practices are crucial. Having a simpler business model and a management team that prioritizes balance sheet health over short-term income statement performance likely wins in the long run. All these characteristics contribute to the robustness of the franchise and help an investor gauge, though never precisely, how rapidly intrinsic value is likely to increase over multiple business cycles.***
(It's how these many different moving parts play out in combination over time that determines returns...not just one or two of these things.)

Evidence of sustainable and high return on equity (book value) relative to peers is a useful if insufficient measure.

Paying a reasonable multiple of normalized earnings always makes sense to protect, at least somewhat, against the unforeseen and unforeseeable.

Still, in the long run, if you don't gauge things like culture and the effectiveness of compensation systems reasonably well, the rest likely won't matter much.

Also worth consideration: Is the the culture, practices, and competitive advantages that produced prior results still mostly in place?

It is one thing for a bank like Wells Fargo to temporarily have reduced earning capacity per share as it absorbs credit losses. With even the best bank that kind of goes with the territory. For shareholders, the key thing is that those earnings are substantially restored (and then eventually begin climbing again) after the worst of a credit cycle passes.

It's a whole different ballgame, as is the case with Citigroup, to have so much earning power per share (and, of course, intrinsic value) permanently destroyed. Some of the wealth destruction comes down to dilution and asset sales but there is another disadvantage: It's a lower return business than Wells. Even when things begin to more fully normalize Citigroup will continue to be a shadow of itself on a per share basis.

In general, I can think of easier ways to produce solid long-term risk-adjusted returns other than investing in financials. Wells Fargo may be "less complex" than other large banks but that's not really saying much. Any large bank, including Wells Fargo, is not at all simple and ends up being a bigger leap than most other investments.

There's more room for error with businesses in other sectors.

It's worth remembering that during the worst of the financial crisis, very few distinctions were being made between quality financial institutions and those that behaved the worst. The downward price action was awful for just about all of them and that action always has the potential to become self-fulfilling, at least to some extent, under times of stress.

The situation is very different for a business like Coca-Cola (KO). The beverage company doesn't much depend on the kindness of the capital markets to fund itself.

The difference in possible outcomes is night and day.

A long track record of producing returns and protecting wealth, especially through difficult periods, is one way to begin judging the quality of any financial institution. The benefit of the recent financial crisis is it provided a good real world stress test. No bank came through 2008-9 without real financial pain though it is much more clear now who avoided the excesses.

That should count for a lot, and inform any analysis, but will always be insufficient.


Long WFC

* Example: J.P. Morgan (JPM) has ~$ 2.3 trillion in assets compared to $ 1.3 trillion for Wells Fargo yet earned only $ 17.6 billion compared $ 15 billion. So almost $ 1 trillion more in assets (73% more than Wells) produced just $ 2.6 billion more in earnings (17% more than Wells) for common shareholders. One way to look at it is this: JPMorgan is on the hook -- in an economic downturn -- for the losses associated with a relatively large chunk of additional assets (~$ 1 trillion and the associated risks of potential loss/other liabilities) but produces a relatively small ($ 2.6 billion) amount of incremental earnings with those assets.
** Book value is a sometimes useful, but mostly limited proxy for real business worth given the limits of accounting. Intrinsic value (itself a necessarily imperfect measure that, using the John Burr Williams definition, is primarily the present value of future cash flows) can be much higher or lower than book value. A bank that has higher sustainable net interest income, noninterest income, similar expense levels as a percent of revenue, and fewer credit losses over a complete business cycle is naturally worth more intrinsically. The return it will generate on that book equity (more importantly, the economic returns) will be superior resulting in more intrinsic value creation over time. The opposite, of course, is also true.
*** Things like balance sheet strength, net interest margin, return on equity, and other quantifiable measures are not difficult to understand. These things, of course, matter but only up to a point. Yet, a culture that chooses balance sheet strength over short-run income statement performance, with conservative accounting practices, and smart credit standard are harder to see in an SEC filing but those characteristics often determine durability. Those who have compensation systems that reward short-run outcomes will inevitably lead to a gaming of the system. It's best to view bank performance over a full business cycle or even longer. None of this is exactly easy to judge.
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 13, 2012

Microsoft: A Gem In Plain Sight?

So is Microsoft (MSFT) a gem in plain sight? According to Brad Hinton, a portfolio manager with Weitz Funds, it certainly is.

During a recent Barron's interview, the value investor explained why he likes Microsoft, calling it a "hidden gem in plain sight."

Loading Up on Cash-Rich Value Stocks

The company sells at roughly 9x earnings but Hinton later in the interview pointed out that multiple is pre-cash. It's even cheaper if you back out net cash.

Here's the top ten holdings of the fund family's flagship Weitz Value Fund (WVALX) as of September 30, 2011:

1) Microsoft (MSFT)
2) AON (AON)
3) Berkshire Hathaway (BRK.b)
4) Google (GOOG)
5) Dell (DELL)
6) Wells Fargo (WFC)
7) Texas Instruments (TXN)
8) Conoco Phillips (COP)
9) United Parcel Service (UPS)
10) Tyco International (TYC)

Morningstar: Weitz Value Fund Portfolio

Microsoft has more than $ 5/share of net cash and investments (cash and investments minus debt) on the balance sheet. Taking that into account, the company is selling at less than an 8x multiple of earnings.

Certainly not expensive but, as I explained here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment.


Long positions in MSFT, BRKb, GOOG, DELL, WFC, and COP

Related post:
Technology Stocks

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.

Thursday, January 12, 2012

Five Dow Stocks with the Highest Earnings Yield

Here is the five Dow stocks with the highest earnings yield (inverse price to earnings) based upon consensus earnings:

Dow Industrials Consensus Earnings

Stock                                     | Earnings Yield
Hewlett-Packard (HPQ) | 16%
Bank of America (BAC)  | 15%
JPMorgan (JPM)              | 14%
Chevron (CVX)                 | 12%
Pfizer (PFE)                        | 11%

Some things to consider:

- Chevron may seem cheap but, there are other large, integrated oil companies that appear even cheaper. These happen to be located in economically dismal Europe yet derive their economics globally. Examples include BP (BP) and Total (TOT). Considering the capital intensiveness of these businesses they should have low multiples in my view.

- If you adjust for net cash and investments* on the balance sheet, Microsoft (MSFT) and Cisco (CSCO) would displace Chevron and Pfizer in the top five.
(Many estimates of Cisco's earnings are non-GAAP. In my view, it creates an optimistic view of the company's true earnings power. This inflated earnings picture is primarily the result of stock-based compensation.)

- Earnings season is just ahead so what is revealed in each earnings report may change the consensus (up or down) meaningfully in the coming weeks. To be clear, I NEVER use another analyst's estimate to figure out intrinsic value. Personally, I don't think any investor should use someone else's numbers or assumptions. It's also why I do not believe in making stock recommendations (something I'd never do). I think the work has to be done by the owner so that person really knows, in a substantive way, why they want to own a specific stock.

- Instead of using someone else's estimate, I come up with my own calculation of current intrinsic value** (and how it may change over time) using conservative future earnings power (and return on capital). I weigh heavily how the business performed over the previous business cycle. If I think the price paid produces a nice long-term risk-adjusted return based upon these conservative estimates, I'm certainly not going to mind if the business ends up having even more earnings power than I assumed. I also make subjective judgments on whether management can be trusted to allocate capital intelligently and, ultimately, how confident I am the business has a sustainable economic moat. There are many other subjective judgments to be made so spreadsheets matter less than some may think. An investor that doesn't take the time to get their arms around these things shouldn't really be buying an individual stock in my view.

- I own shares of some banks but my view continues to be that most banks are not really worth the trouble. The larger ones, for the most part, are just too complex to really understand.

- While some of the banks appear very cheap, most have rallied substantially in recent weeks. Bank of America has a wide range of estimates among analysts so the so-called consensus earnings are really anything but a consensus. On the other hand, Bank of America is not yet producing the kind of profits it likely can once its house in order. The question is will material dilution end up happening, especially at a low stock price (making the dilution even more painful), hurting the shareholders who already own it. A tough call that doesn't seem worth the risk to me considering alternatives (something I've said on a prior occasion).

A double digit earnings yield implies an expectation for earnings to shrink, in some cases substantially, proving these estimates to be too optimistic. It would seem that, near recent market prices, most of these just have to prove that their business is not in some kind of secular decline or near a cyclical peak (revealing true earnings power to be much lower than it now seems). Watch out for highly cyclical businesses. Low P/Es turn out to be anything but sometimes.

Otherwise, eventually the earnings yield gets high enough to compensate an owner for the risks even if no meaningful growth is in the cards.*** Now, if it turns out these businesses do begin to profitably grow in a sustained way again, even if modestly, long-term owners of the shares can do quite well at a double digit earnings yield entry point.

Still, on a risk-adjusted basis, these five stocks seem less attractive near recent prices than some other higher quality alternatives.


I've either already established long positions in the above stocks or have the intention to accumulate shares slowly over time if, as I hope, they continue to get cheaper.

* Cash and investments minus debt.
** Estimates of intrinsic value is actually more a range of likely values and certainly is not a precise number. There's no need for false precision when it comes to estimating value.
*** As long as management makes intelligent, shareholder-friendly, use of the capital. Not exactly guaranteed.
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