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.

Adam

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.
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