Friday, September 28, 2012

High-frequency Trading & Capital Formation

From this article on high-frequency trading:

High-frequency trading insanity

...the high-frequency trader, deploys massive computer capacity and complex algorithms to buy and sell individual stocks multiple times in a fraction of a second, all in search of micro-profits with each trade. This trader cares not a whit about a stock's fundamentals.

In a sane world, high-frequency trading would be a minor specialty at best. But in the bizarro world that Wall Street has become, such activity now makes up the majority of all trades. It is manufacturing risk while siphoning money and talent that growth-producing sectors of the economy need.

Then a bit later in the article:

...these practices undermine the core purpose of markets, which is to raise capital in pursuit of enterprise, profit and economic growth.

In his latest book, John Bogle points out that there are more than $ 30 trillion worth of trades each year, yet fresh investment of capital into things like businesses, new technology, medical breakthroughs, plant and equipment is less than 1/100th that amount (~ $ 250 billion). So our equity market system now has more than 99 percent speculation for less than every 1 percent of actual capital formation.*

With those numbers in mind, I don't think it's unfair to say we have more than enough liquidity. These traders, not surprisingly, don't quite see it that way.

The traders argue that they add liquidity to markets that lowers transaction costs and eases dealing in thinly traded shares. There is some truth to this. But the negatives far outweigh the positives.

It's certainly the case that markets need enough liquidity. I think it's safe to say we're well beyond having a shortage of liquidity when pieces of businesses are being bought and sold in fractions of a second over and over again.

We need an optimal amount, not an unlimited amount.

Eventually, more isn't better.

Once there's enough liquidity, the focus ought to be reducing the cost of capital and improving capital formation. Getting capital to where it is needed most to fund crucial investments.

Those who buy/sell in high volumes obviously benefit greatly when the cost of each transaction goes down. Those with a longer term horizon who trade infrequently the absolute minimization of transaction costs matters less. So the lowest possible transaction costs is naturally a top priority of a highly active trader. Yet market's don't exist to serve traders.

They exist to support the formation and development of enterprise in the real economy.

Equity markets are there (or should be) to help fund the creation and expansion of businesses. Naturally, low transaction costs and enough liquidity matters to a varying extent to all participants, but that focus is too narrow.

For businesses in pursuit of opportunity, lowering the cost of capital and enhancing access to capital is far more important.

My vote is for more emphasis on whether markets are structured to increase the probability that capital is directed to its highest and best use.

That dollars in enough scale are meeting up with good ideas and talent.

After all, that's the reason the equity markets exist in the first place. At the present time, there's more than enough liquidity. Transaction costs are hardly at levels that hinder progress in the real economy.

If all this added liquidity is actually lowering the cost of capital then it's a useful thing. If, instead, it is creating added volatility, as it surely seems to be, and instability (perceived, real, or a little of both...fear of the next flash crash when some unforeseen scary macro event inevitably occurs), then it has the potential to raise the cost of capital if participants who might otherwise put their capital at risk are less willing to do so.

Liquidity is also a good thing as it helps to generally set market prices closer to the per share intrinsic value of the underlying businesses. Frequent and substantial mispricing ultimately leads to capital misallocation. Well, if as the article above suggests, the high-frequency variety of trader "cares not a whit about a stock's fundamentals," and that their activity "now makes up the majority of all trades," it seems unlikely they'll make a useful contribution to the discovery of a fundamentally rational market price relative to per share intrinsic business value.**
(Realistically, it would always be more a range of prices. It's not like wide fluctuations could ever be eliminated in the equity markets. The simple reason being that there's no way to ever perfectly judge what intrinsic per share business value actually is. The range is necessarily especially wide for shares of certain more speculative businesses.)

So, at least in today's market, apparently the bulk of all trading comes from those basically uninterested in underlying business fundamentals.

With so few interested in underlying fundamentals, how do we not end up with stocks becoming mispriced more often in that environment? How do you not end up with a market environment where capital is frequently misallocated?

Most answers to those two questions seem destined to be, at best, rather contorted.
(Though those with enough creativity, motivation, and vested interest in the status quo could no doubt come up with a good way to answer these questions.)

The markets exist to help facilitate capital formation for businesses so they can more ably pursue productive enterprise. Markets operate below their potential when they become a hyperactive, casino-like, atmosphere more interested in serving its active participants (those primary interest is near-term price action) instead of the entities that need capital to fund their opportunities.

I'd like to see some evidence that high-frequency trading makes it easier for corporations to efficiently raise capital and/or that it lowers the cost of that capital. It seems likely that all this added hyperactivity does little in that regard and, instead, mostly just adds a bunch of frictional costs to the system as a whole (even if it happens to lower the cost for certain participants.)

Those costs are effectively a tax on capital formation. Yet the biggest cost might be all the talent high-frequency trading takes away from more value added endeavors.

Here's a report by the Federal Reserve Bank of Chicago for more background on the concerns surrounding high-speed trading and keeping markets safe. Also, last week a senate panel looked into this.

Washington Post: Senate panel looks into high-frequency stock trades

According to this article, the Federal Reserve has concerns about how market structure is impacting their easing policies. Programs like quantitative easing depend on the markets functioning well.

Finally, the SEC is supposed to hold a meeting next week on this in an attempt to figure out just what to do about it.

I'd prefer to think otherwise but it doesn't seem likely much of this will be fixed anytime soon.


* In this essay, John Bogle cites slightly different numbers. He says that annual stock trading volume is $ 30 trillion while average annual new issues of common stock is $ 145 billion. So trading represents more than 200x the amount of equity capital that's provided to businesses.
** I personally like it when stocks get mispriced but frequent and substantial mispricing ultimately leads to capital misallocation. So I'm speaking in terms of what's the best way for equity markets to promote enterprise not how to make life easier for participants who seek out mispricing in the equity markets.
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, September 26, 2012

Second Quarter Stock Buybacks Rise

This recent S&P Dow Jones Indices press release summarizes share repurchases for the second quarter among the companies that make up the S&P 500.

According to the press release, there have been $ 788 billion in buybacks by the following 20 companies since the 4th quarter of 2004. In fact, there has been $ 2.81 trillion in buybacks by all the companies in the S&P 500 over that same time frame.

A rather impressively large number to say the least.*

Here's the twenty largest 2nd quarter buybacks:

- Johnson & Johnson (JNJ) $12.85 billion

- Exxon Mobil (XOM) $5.01 billion

- ConocoPhillips (COP) $3.05 billion

- Intl Business Machines (IBM)  $2.99 billion

- AT&T (T) $2.56 billion

- Oracle (ORCL) $2.40 billion

- Wells Fargo & Company (WFC) $2.04 billion

- American International Group (AIG) $2.00 billion

- Cisco Systems (CSCO) $1.89 billion

- Wal-Mart Stores (WMT) $1.84

- American Express (AXP) $1.78 billion

- Philip Morris International (PM) $1.63 billion

- The Coca-Cola Company (KO) $1.53 billion

- The Goldman Sachs Group (GS) $1.50 billion

- The Home Depot (HD) $1.50 billion

- JP Morgan Chase & Co (JPM) $1.44 billion

- Intel Corporation (INTC) $1.40 billion

- DIRECTV (DTV) $1.35 billion

- Pfizer (PFE) $1.34 billion

- News Corporation (NWSA) $1.30 billion

During the quarter, the top 20 bought back $51.39 billion while all companies in the S&P 500 combined bought back $ 111.75 billion.

J&J's buyback comes as part of a deal to buy Synthes for roughly $ 20 billion that is summarized here. It's the biggest deal in the company's 126 year history and was financed with roughly 65 percent stock and 35 percent cash.

This 8-K filing provides more details. Essentially, they are using foreign cash held at an Irish subsidiary (Janssen Pharmaceutical) to buy back $ 12.9 billion of J&J's shares.

This J&J press release to announce U.S. regulatory clearance for the deal also explains the financing of this transaction.

Janssen Pharmaceutical, a wholly owned Irish subsidiary of Johnson & Johnson, has entered into accelerated share repurchase (ASR) agreements with Goldman, Sachs & Co. and JPMorgan Chase Bank, N.A. to purchase a combined total of 203.7 million shares of Johnson & Johnson common stock for an initial purchase price of $12.9 billion.

Here's how the deal is financed. Those shares bought via the ASR agreements along with cash on hand at the subsidiary will then be given as merger consideration to Synthes shareholders. So, unlike most other buybacks, it's not as if this one by J&J is going to result in a reduction in share count. It's simply going to prevent the share count from going up as a result of the transaction.

The reason for the financial gymnastics is to prevent a big U.S. tax bill.

The ConocoPhillips buyback may not have been the biggest in dollar terms but, if their buyback rate continued for an entire year, it would amount to 17 percent of Conoco's current market value. In fact, DIRECTV, AIG, AmEx, and Goldman Sachs all were buying back at an annualized rate that, if continued for a full year, would represent 10 percent or more of their current market value.**

Obviously, these companies may not necessarily continue to buy back at the same rates (nor should they if the share price doesn't represent a nice discount to value) but these actions do represent impressive proportions of total market value. Naturally, when the price drops a larger number of shares can be bought back for the same amount of cash. Unfortunately, these stocks are not nearly as cheap as they were not all that long ago. The inevitable, arithmetically certain, outcome being that these buybacks would be even more effective if they were still at or near those lower valuations.

So a long-term investor shouldn't generally want shares of a sound business they own to go up in the near-term. What's an exception to this? Here's one scenario to consider. Unfortunately, there's the very real risk that a buyout offer comes in at a premium to market value but a discount to intrinsic value. If enough owners are okay with the gain that will have occurred compared to the recent price action, the deal may be approved. If too few have conviction about longer run prospects, the deal may get approved. When too many owners of shares are in it for the short-term or, at least, primarily to profit from price action, the chance of this happening increases. Well, those that became owners because of the plain discount to intrinsic value and the company's long run prospects will likely get hurt in this scenario.

Otherwise, a long-term investor (who judges intrinsic value well, of course) should generally want the price to go down in the near-term or even longer. Warren Buffett provides a useful explanation of this using IBM as an example in the 2011 Berkshire Hathaway (BRKaShareholder Letter. Also, here's a prior post on the same subject: 

Why Buffett Wants IBM's Shares "To Languish"

That's why it matters a whole lot for a high proportion of the board, management, and other owners (especially those who are influential) of the stock have potential long-term value creation over short-term gains in mind. 

That's why it matters if there are fewer traders and more true long-term owners controlling the shares outstanding.

It's also why it matters that long-term prospects are well understood by the board, management, and owners even if real short-term challenges have pressured the stock price. All of this must be carefully considered by an investor.


* Unfortunately a disproportionate amount was done throughout 2007 and early 2008 when the market was at or near its peak. So the fact that buybacks have risen recently hardly says much about where stocks are going in the near-term and even longer. Buybacks only makes sense when shares sell below intrinsic value, the company is otherwise well-financed, and the investments needed to maintain/increase competitiveness can still be made. Ideally, buybacks should (and actually would) mostly occur when the discount to value is clear and substantial. 
** The annualized buy back rate for DIRECTV would be equal to 16 percent of current market value. AIG = ~ 14 percent. AmEx = ~ 11 percent. Goldman Sachs = ~ 10 percent. AIG's buybacks, of course, follow the massive dilution that occurred to the company's share count during the financial crisis.

Johnson & Johnson and Synthes Announce Definitive Merger Agreement - 8-K Filing

Johnson & Johnson Announces Completion of Synthes Acquisition - 8-K Filing

Keywords: Buyout below value, going private below value, premium to market value but discount to intrinsic value.
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, September 24, 2012

Sheila Bair: Former FDIC Chair on the Bank Bailouts

Sheila Bair, chairman of the FDIC throughout the financial crisis, has a new book with the following title:

Bull by the Horns: Fighting to Save Main Street From Wall Street and Wall Street From Itself

She led the FDIC from June 2006 through July 2011 and has a uniquely close up view of what actually happened. Fortune recently published an excerpt from the new book. There's some rather interesting and blunt insights in the excerpt. Well worth reading in its entirety.

In the excerpt, Bair describes the meeting with bankers that occurred at the Treasury Department back in October of 2008. In that meeting, Treasury Secretary Hank Paulson convinced a roomful of bank CEOs to go along with the TARP bailout.

Here's some examples of Sheila Bair's insights about the meeting:

On Richard Kovacevich, Chairman*, at the time, of Wells Fargo (WFC)
He [Kovacevich] was eager to give me an update on his bank's acquisition of Wachovia, which...I had helped facilitate. Kovacevich could be rude and abrupt, but he and his bank were very good at managing their business and executing on deals. I had no doubt that their acquisition of Wachovia would be completed smoothly and without disruption...

At the time, Wells Fargo had recently come in with a deal for Wachovia that derailed Citigroup's (C) plans to buy the troubled bank. Citigroup needed help from the FDIC to pull it off. Wells Fargo did not. Citigroup's CEO Vikram Pandit naturally didn't appreciate what Wells had done and was not happy with the fact that Bair had been supportive of their deal over Citigroup's.**

Bair says she didn't have much choice.

Wells was a much stronger, better-managed bank and could buy Wachovia without help from us.

Basically, the FDIC didn't need two troubled banks to merge when a relatively healthy and well run bank like Wells Fargo was more than capable of doing it, and could handle the job on its own.

On Vikram Pandit, CEO of Citigroup
Pandit looked nervous, and no wonder. More than any other institution represented in that room, his bank was in trouble. Frankly, I doubted that he was up to the job.

On Kenneth Lewis, CEO (at the time) of Bank of America (BAC)
He was viewed somewhat as a country bumpkin by the CEOs of the big New York banks, and not completely without justification. He was a decent traditional banker, but as a dealmaker his skills were clearly wanting...

By doing expensive dumb deals for two very sick financial institutions, Merrill Lynch and Countrywide, he took BofA, a bank that was healthy going into the crisis, and turned it into one that was very much less so.

Bair goes on to say that the actions of others were smarter with the smartest being Jamie Dimon...

On Jamie Dimon, CEO of J.P. Morgan Chase (JPM)
Dimon was a towering figure in height as well as leadership ability.

She says that Dimon had warned of troubles in subprime early on and protected his bank via preemptive actions prior to the crisis:

As a consequence, while other institutions were reeling, mighty J.P. Morgan Chase had scooped up weaker institutions at bargain prices.

The purpose of this meeting at the Treasury Department was for Paulson to tell this group of bankers they had to, at least temporarily, accept government capital. In addition to the capital injection, the FDIC was asked to temporarily guarantee the debt of these institutions, while the Fed would be opening up special lending programs measured in trillions of dollars.

Here's some other noteworthy insights of what occurred during the meeting:

- John Thain, the CEO of Merrill Lynch (who Bair earlier in the excerpt described as insolvent), apparently was concerned about executive compensation.

Sheila Bair: I couldn't believe it. Where were the guy's priorities?

- BofA's Kenneth Lewis agreed to participate in the program and thought talking about compensation wasn't appropriate.

- Vikram Pandit apparently scribbled some numbers down then said "This is cheap capital".
(Treasury was only asking for a 5 percent dividend on the capital. Citi would likely not have been able to get anything like that kind of cheap funding elsewhere.)

Sheila Bair: I wondered what kind of calculations he needed to make to figure that out.

- Richard Kovacevich complained, rightfully in Bair's view, that Wells Fargo didn't need the capital.

Sheila Bair: I was astonished when Hank shot back that his regulator might have something to say about whether Wells' capital was adequate if he didn't take the money.

- Jamie Dimon also said J.P. Morgan Chase didn't need the money but accepted it for the sake of system stability. Other CEOs apparently followed with similar sentiments.

By the end of the day each bank had agreed to accept the money.

Sheila Bair says that Citigroup probably needed the government assistance. Otherwise, she seems to think that the capital levels at the other large commercial banks were adequate. So the capital injections into those firms, at least according to her, were largely unnecessary.

The investment banks were in trouble but she also questions whether they needed the capital injections.

Yet, since Merrill was to be acquired by Bank of America (who paid a generous price to say the least), while Goldman and Morgan had been able to raise capital privately (and she thinks were capable of raising more as needed), she also questions whether the capital was actually needed.

It was, of course, a chaotic environment during the crisis.

Decisions without all the necessary information had to be made.

Bair admits that these actions collectively were a success in the sense that the system didn't fall apart, but wonders what the real costs of not imposing more discipline on the worst actors might be down the road.

Check out the entire excerpt in Fortune.


* John Stumpf became Chairman of Well Fargo in January of 2010.
** Nor did Timothy Geithner who was the head of the New York Federal Reserve Bank and Citigroup's primary regulator. Bair says that both Pandit and Geithner were angry with her for not objecting to the Wells acquisition.
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, September 21, 2012

Mason Hawkins: Competitively Advantaged Businesses Selling at a Discount to Value

Mason Hawkins, chairman and CEO of Southeastern Asset Management, the advisor to Longleaf Partner Funds, recently answered questions from GuruFocus readers.

Here is a quick summary of just a few of the noteworthy things he had to say:

- They look for financially strong, competitively entrenched/advantaged businesses selling at a significant discount to intrinsic value.

- They like to limit their portfolio to 20 investments and consider that number of securities adequate diversification. In fact, Mason Hawkins says statistical evidence shows there is little incremental benefit of additional holdings beyond 14 different stocks in different industries.

- They like owning businesses run by management that is competent both operationally and in terms of capital allocation.

Check out the Q&A in its entirety.

An excerpt:

"We view quality through the lens of a business owner. We want to own companies with the following qualitative characteristics. 1) Unique assets having distinct and sustainable competitive advantages that enable pricing power, long-term earnings growth, and stable or increasing profit margins. 2) High returns on capital and on equity as measured by free cash flow rather than earnings. 3) Capable management teams with operating skills, capital allocation prowess, and properly aligned, ownership-based incentives."

Hawkins also said that that their long-term horizon allows them to buy quality businesses at large discounts to value when earnings, for any number of reasons, happen to be reduced short-term. It's not a small advantage to be thinking a number of years out when so many market participants are focused on very near-term price dynamics.

In The Superinvestors of Graham-and-Doddsville, Warren Buffett made the following point about the "intellectual origin" of "superinvestors":*

"In addition to geographical origins, there can be what I call an intellectual origin."

He then adds that, in the world of investing, you'll find that a disproportionate number of successful investors...

"...came from a very small intellectual village that could be called Graham-and-Doddsville."

Buffett considers Ben Graham the "intellectual patriarch" with each successful investor applying or building upon the the theory in his own manner. Yet, while each may put the fundamental ideas of Graham-and-Dodd to work in somewhat different ways, they have a crucial thing in common:

"The patriarch has merely set forth the intellectual theory...but each student has decided on his own manner of applying the theory.

The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market."

Many market participants expend lots of energy figuring out (or attempting to) what direction a stock price might move in the near-term (or even the intermediate-term) and try to profit from it. It's fine and even necessary that some participants are involved in that sort of thing (though I do think the proportion who speculative versus invest longer term has become a bit extreme in favor of speculation).

The emphasis of a speculator is the correct judgment of relatively near-term price action.

The emphasis of an investor is judging value and how compounding effects will impact that value -- generally over a much longer time horizon -- then paying a price now that will produce a good result if that judgment turns out to be sound.

The price paid also must provide a margin of safety for the unforeseen and unforeseeable.

I think it is safe to say that those who primarily focus on making correct judgments about price action, especially those with an average holding period shorter than 3 to 5 years, are probably less influenced by Graham and Dodd and the many investors that have since built upon their theoretical framework.

There are exceptions, of course, but discrepancies between business value and price mostly need to play out over many years. Near-term price action are just votes that, in the near-term, reveal not much about how the price/value discrepancy will be resolved.

The hard work for those heavily influenced by Graham and Dodd is in figuring out what something is worth not trying to figure out what the stock will do. The stock will generally do just fine in the long run if business value was judged well.

Buffett later went on to say...

"Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value."

Well, Mason Hawkins and his team seem also very much focused on the variables of price and value. In one of his answers, Hawkins mentioned that they have...

"...a master list of appraisals for 600+ good businesses that we would like to own at the right price."

That's a rather expansive "master list" yet they still end up with a nicely concentrated portfolio when it's all said and done. In my view, owning shares in fewer businesses for a very long time means that big surprises become less likely over time as familiarity with the business and industry grows. So, as a result, there's less chance of getting the valuation very wrong. So my own preference happens to be owning fewer quality businesses for a very long time.***

While that may work for me it is just one of many ways to go about it.

Searching for discrepancies between price and value is the common theme but the specific approach for each investor is necessarily not one size fits all.

There's a wide range of effective ways to get results. For example, Walter Schloss, one of the 'superinvestors", often had a rather large number of stocks in his portfolio. His style is very much unlike Warren Buffett's and Charlie Munger's strong preference for portfolio concentration. It's not unusual for the Berkshire Hathaway (BRKa) equity portfolio to have 60-70 percent and, at times, even more allocated to just five stocks.

Like anything else, the best approach is consistent with individual limits and capabilities, realistically assessed, instead of wishful thinking or overconfidence.

"The first principle is that you must not fool yourself -- and you are the easiest person to fool." - Richard Feynman

Some might prefer more or less diversification.

Others may be a bit more or less active.

Maybe a particular knowledge or expertise lends itself to investing in certain types of businesses or industries.

The list goes on.

There are many variations always come back to the common theme of a focus on two variables: price and value.


* The "superinvestors" mentioned by Warren Buffett include: Walter Scloss, Tom Knapp (Tweedy Browne), Ed Anderson (Tweedy Browne), Bill Ruane (Sequoia Fund) , Rick Guerin, Stan Perlmeter and, of course, Charlie Munger (plus two funds managed by multiple managers).
** That doesn't mean those participants who may be generally more price action conscious don't, at times, use valuation as part of the justification for their trades. Market participants of all kinds draw from a variety of influences.
*** It's an approach that starts and ends with recognition of my own limits. Lower portfolio turnover, higher portfolio concentration, and generating returns primarily from increases to per share intrinsic value of the businesses themselves over time is what has worked best. Beyond the benefits of lower frictional costs, less moves means fewer mistakes. So, as a result, I buy the shares of a limited number of high quality businesses -- those I find understandable that are run by capable owner-oriented executives -- whenever they sell at a plain discount to my estimate of value. From there it is mostly about waiting as long as necessary for the right price then, when the price is right, buying a meaningful amount with the intent to hold long-term.

The Superinvestors of Graham-and-Doddsville
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, September 19, 2012

Apple's iOS vs Google's Android: Who's Winning?

According to this article, Google's (GOOGAndroid is Winning. At a minimum, the latest worldwide market share numbers for the Android operating system were rather impressive during the 2nd quarter.

But is Android really winning?

According to Gartner, mobile devices using Android captured roughly 64 percent of worldwide market share.

Apple's (AAPL) iOS-based iPhone captured more like a bit under 19 percent. 

Now, as this article points out, consider that it was a quarter where Apple's iPhone purchases had "paused" in anticipation of the iPhone 5. Of course, that's not going to close the huge market share gap but is still relevant.

There's also a huge difference in economics.

This article compares Apple's profit share to competitors and also provides a useful chart.

It turns out that Apple had 77 percent of the mobile industry profits in the 2nd quarter. Who wins from here? I don't know but you have to define what winning is. If market share is your objective, then Android seems to be winning. If profit share is the objective, then it's iOS that's winning.

In my book it's whoever has an approach that ends up sustaining high return long-term profitability.
(As opposed to chasing low return market share, indefinitely. Going after market share for a while can be a smart, but only ultimately makes sense if it ends up generating high returns on capital for shareholders.)

Naturally, the current numbers can't reveal what's going to happen over the long haul, but Apple's profit share is rather exceptional. That doesn't mean Google (and competitors that rely on Android) aren't also doing what's right for themselves.

So the company's fortunes is now firmly driven by that phone more so than other other products. It's not just because it makes up such a large percentage of revenue. It's also because the margins on the iPhone come in something like 2x that of the iPad. According to this article, the iPhone has had gross margins in the 49 to 58 percent range while the iPad is more like 23 to 32 percent going back to 2010 (April 2010 for the iPhone and October 2010 for the iPad).

Healthy margins in both cases, at least for now, though still difficult to gauge just how that might change over time.
(Also, consider that the iPhone was likely held back by the anticipation of a new release.)

Nearly 80 percent of Apple's total revenue during the quarter was from products based upon iOS. Products based on iOS include the iPhone, iPad, and iPod Touch. What's worth noting is just how much of Apple's revenue and profits come from just the iPhone. According to this 8-K, revenue from products based on iOS was $ 30.5 billion for the quarter with $ 22.7 billion coming from iPhone. Based upon the gross margins noted above and the revenue mix, the iPhone likely makes up a bit less than two-thirds of Apple's profits.

Apple's blended gross margin were 42.8 percent and net margin more like 25.2 percent.

All very impressive especially since the company's return on capital is currently just spectacular by any measure (though it'd be nice if they'd do something more productive with all their cash and investments).

What happens to those margins over time is worth watching closely. There's enough moving parts to make it not easy, at least for me, to judge what Apple's likely to be worth several years from now.

I invested in Apple quite a while back and continue to own it. I did that because of its extreme low valuation then and an incredible balance sheet. Well, it still has an incredible balance sheet and, in fact, it has become only stronger. Valuation is a different story. It's certainly not plainly expensive. Not at all. Still, unlike some other investments, it's just not easy to judge what its intrinsic value is likely going to be over a longer time horizon.

I'm not going to be surprised if the stock does just fine. As always, I never have an opinion about near term or even longer term price action of any stock. The company could easily continue to roll like nothing else ever has.

Tough to bet that they will not.

Whether there really is sufficient margin of safety to buy it for the long-term near the current valuation is a whole different question.

Though I admire the company (and Google for that matter), all I know is I won't be buying more shares anytime soon.


Long positions in Apple and Google established at much lower than recent prices.

Reuters: Apple margins for iPad about half of iPhone
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, September 17, 2012

Klarman & Graham: The Margin of Safety Principle

From the introduction section of Seth Klarman's book Margin of Safety:

"If investors could predict the future direction of the market, they would certainly not choose to be value investors all the time. 

Indeed, when securities prices are steadily increasing, a value approach is usually a handicap; out-of-favor securities tend to rise less than the public's favorites."

In rising markets, it's the favored stocks that have captured the imagination of active participants that tend to do better than what, at least in the near term, might be out of favor (cheap or otherwise). In the book Seth Klarman points out that those with a value focus tend to sell "too soon" as equities, in general, go from becoming fully valued to just being plain overvalued.

I'd add that, for similar reasons, a value approach also often leads to buying and selling "too soon".*

More from Margin of Safety:

"The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism. Value investors invest with a margin of safety that protects them from large losses in declining markets.

Those who can predict the future should participate fully...when the market is about to rise and get out of the market before it declines. Unfortunately, many more investors claim the ability to foresee the market's direction than actually possess that ability. (I myself have not met a single one.) Those of us who know that we cannot accurately forecast security prices are well advised to consider value investing, a safe and successful strategy in all investment environments."

Some might be tempted to adjust investing styles and strategies to the environment.

In other words, in addition to a value focus, why not try to learn how to predict the direction of price action of a particular security or for the market as a whole?

Why suffer the consequences of selling or buying too early, right?

Well, best of luck with that.

Maybe more than a few can actually predict the future direction of the market effectively. Yet consider me skeptical that a methodology, whatever it might be, can be applied by a large number of market participants in a way that reliably produces above average results.

It just doesn't seem very likely this can be done reliably well. My guess is the result would be costly mistakes leading to sub-par returns over the long haul for most who try.

At a minimum, identifying examples of those that can reliably foresee the future direction of the market, and have a proven track record, isn't easy.
(I suspect this won't deter those who seem to try!)

By comparison, finding examples of capable value investors with proven long-term track records is rather easy.

There's plenty of evidence that any number of variations of disciplined value investing can produce attractive long-term results. The primary driver of returns is intrinsic business value and how it changes over time and no real need to know what direction the market might be headed near term. The market is simply there to serve the investor.

Value investing only works over the long haul if securities are purchased with an appropriate margin of safety (even if in the short run price action implies otherwise) and value is consistently well-judged. The benefits of a well-executed value approach is particularly significant when viewed through a risk-adjusted prism.

One serious mistake that gets made is as follows: projecting forward the earnings a business has produced under recent favorable economic conditions. In other words, not enough consideration of what they'll look like under much less than optimal conditions. The end result ends up being an insufficient margin of safety. For all but the highest quality businesses earnings needs to be normalized over at least a full business cycle.

For some lower quality businesses -- particularly those that are capital intensive, highly cyclical, and in fiercely competitive industries -- a full business cycle may not even enough.

Benjamin Graham had the following to say in Chapter 20 of The Intelligent Investor.** 

"...the risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to 'earning power' and assume that prosperity is synonymous with safety."

Earning power under favorable business conditions is usually insufficient. It is especially the case for the lower quality variety of enterprise. Understanding how earning power might vary over a full business cycle (again, and sometimes even longer) matters a bunch.

As does balance sheet strength. Weaker franchises require the most balance sheet flexibility.

The higher quality enterprises (and I'm generally NOT talking about fast-growers or highly dynamic industries), those that sometimes even seem just a little expensive, will often suffer rather modest drops in earnings during periods of severely unfavorable business conditions.

Judging their normalized earning power, and how it may increase over the long haul, is more straightforward than most.

The benefits of their relative earnings persistence shouldn't be underestimated but frequently is.

The lower quality enterprises, those that may even appear cheap but in reality are anything but, will sometimes see near catastrophic drops in earnings capacity during severely unfavorable business conditions.

Judging their normalized earning power is far from straightforward.

For these, it is more likely that a substantial misjudgment by the investor will end up being made. So, inevitably, they demand a much larger margin of safety and, more often than not, they should just be avoided due to the wide range of possible outcomes.

The most vulnerable businesses, especially those that don't prepare operationally and financially for the next severe drop in economic activity, will leave common equity shareholders wondering what happened to what once appeared to be a nice margin of safety.


* It seems not exactly surprising those with a value focus (and less interested in playing near-term price action) would be early sellers and buyers. There are many reasons why what's cheap just gets cheaper and vice versa in the near-term and, yes, sometimes for a bit longer. It seems inevitable that those who invest primarily with value in mind will, at times, act too early in either situation. If something is plainly cheap accumulation has to begin at some point and it's likely not at the eventual lowest price. Yet selling and buying early is anything but a big problem long-term if you're mostly getting business value right and clearly paying a nice discount. Only if the investing time horizon is short is it a real issue. So it's learning to not be annoyed by, or pay much attention to, near term price action. Not always easy. It's a necessary trained response considering how much loss aversion can impact investing behavior. I mean, a value focus should lead logically to the hope that what is cheap does get even cheaper in the near or even intermediate term. This is especially true during the share accumulation process but not limited to it. A stock that gets cheaper -- and I've covered this many times -- also allows the benefits per dollar spent on a buyback to be even more potent for long-term owners. The important thing is, of course, that shares are actually selling below intrinsic value. So if value has been judged generally well, then a temporarily lower stock price is a very good thing. Learning to manage the innate influence of loss aversion is probably the toughest part for most. Attempts to buy at the lowest price creates its own problems. One being possibly owning few shares (or no shares) when an investor wants to own a meaningful amount (a partial or complete error of omission). What if the stock happens to unexpectedly reverse course? Some may not consider this but it is a real risk. Maybe the window of opportunity closes, maybe it doesn't. What's worse, staring at temporary paper losses for some time, or permanently missing the chance to own a meaningful amount of something for the long-haul? When highly confident that an attractive long-term investment is selling plainly below what it's worth, it's important to buy it in some quantity when the chance is there. It's difficult enough to find something one understands and wants to own for the long haul. Why worry about some near term price fluctuations in those cases?
** Margin of safety is the principle focus of Chapter 20.

Intro. 12
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, September 14, 2012

Grantham & Buffett: "Career Risk" & "The Institutional Imperative"

Jeremy Grantham had this to say about what he calls "career risk" in his April 2012 letter:

"The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples' money. The prime directive, as [John Maynard] Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority 'go with the flow,' either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest."

He also talked about "career risk" in part 2 of his January 2011 letter:

"Career risk drives the institutional world. Basically,everyone behaves as if their job description is 'keep it.' Keynes explains perfectly how to keep your job: never, ever be wrong on your own. You can be wrong in company; that's okay."

Investment professionals certainly had to wrestle with
"career risk" head on during the dot-com bubble. At the time, more than a little conviction and willingness to appear very wrong for quite a long time was necessary. Some pros rightly resisted the herd and were promptly rewarded with client redemptions.

Unceremoniously dumped as investors chased the "new paradigm".

Supposedly, those that weren't buying the hottest tech stocks just didn't "get it" or at least that's what much of the herd seemed to be thinking. Well, there was no new valuation paradigm. Many transformative companies were created (and plenty less so) but, either way, valuations went to ludicrous extremes. Only after the fact (and, unfortunately for some money managers, after the money had left) is it usually clear who really "gets it".*

This likely helps to explain something Warren Buffett pointed out in the 1978 Berkshire Hathaway (BRKa) shareholder letter:

" 1971, pension fund managers invested a record 122% of net funds available in equities - at full prices they couldn't buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks."

Jeremy Grantham happens to be describing a specific investment industry dynamic but, even if not precisely the same, it is not unlike something more generalized that Warren Buffett has covered from time to time.

What he calls
"the institutional imperative".**

From the 1989 Berkshire shareholder letter:

"My most surprising discovery: the overwhelming importance in business of an unseen force that we might call "the institutional imperative."

Basically, in Buffett's view, the imperative is a powerful tendency to imitate peer companies, at times rather foolishly, on things like acquisitions, executive compensation, expansion plans or whatever else.**

He described it in the 1990 Berkshire shareholder letter this way:

"...the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so."

Buffett makes it clear he considers the power of "the institutional imperative" to be rather substantial. In fact, so much so that Berkshire Hathaway has been deliberately set up to minimize its influence. Also, he prefers to invest in companies that seem to have an awareness of the problem.


Long position in BRKb established at lower prices

Related posts:

Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline

* And it's not like having money drain out of a fund (or funds) doesn't create its own return sapping headaches for a professional money manager. Part of the brilliance of Berkshire Hathaway is how it is designed to prevent this problem and, in fact, benefit from it.
** Check out the Mistakes of the First Twenty-five Years section of the 1989 Berkshire shareholder letter (the section is near the end of that letter) for more background on this.
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, September 12, 2012

Why Buffett Prefers Using Cash Over Stock in Acquisitions

Both stock and cash was used for the merger of Burlington Northern Santa Fe (BNSF) into a subsidiary of Berkshire Hathaway (BRKa) back in early 2010. Yet, whenever possible, Warren Buffett has made it very clear he prefers using cash instead of stock in mergers/acquisitions.

In the 1997 letter, Buffett said the following about prior deals involving Berkshire's stock up to that point:

"If you aggregate all of our stock-only mergers (excluding those we did with two affiliated companies, Diversified Retailing and Blue Chip Stamps), you will find that our shareholders are slightly worse off than they would have been had I not done the transactions. Though it hurts me to say it, when I've issued stock, I've cost you money."

The problem wasn't that the businesses they did deals for ended up being poor performers or that they were somehow misled by the sellers.

Not at all.

"Instead, our problem has been that we own a truly marvelous collection of businesses, which means that trading away a portion of them for something new almost never makes sense. When we issue shares in a merger, we reduce your ownership in all of our businesses -- partly-owned companies such as Coca-Cola, Gillette and American Express, and all of our terrific operating companies as well. An example from sports will illustrate the difficulty we face: For a baseball team, acquiring a player who can be expected to bat .350 is almost always a wonderful event -- except when the team must trade a .380 hitter to make the deal.

Because our roster is filled with .380 hitters, we have tried to pay cash for acquisitions, and here our record has been far better."

Buffett later added...

"These acquisitions have delivered Berkshire tremendous value -- indeed, far more than I anticipated when we made our purchases."

In 1998, not long after the 1997 letter was written, Berkshire would go on to use its stock to merge with General Re for roughly $ 22 billion. It was a deal that added meaningfully to Berkshire's share count (it was a more than 20 percent increase in shares outstanding).

The far more recent BNSF deal was structured to be roughly 60 percent cash and 40 percent stock. Buffett explained it this way in the 2010 Berkshire letter:

"It now appears that owning this railroad will increase Berkshire's 'normal' earning power by nearly 40% pre-tax and by well over 30% after-tax. Making this purchase increased our share count by 6% and used $22 billion of cash. Since we've quickly replenished the cash, the economics of this transaction have turned out very well."

In a perfect world he'd have not used stock but this BNSF deal had a much smaller impact on shares outstanding. Buffett said this to CNBC just after the deal was announced:

"I don't like to use stock, but on this one, because of the size and because they wanted a tax-free option for shareholders..."

The deal was structured (along with the 50-1 split of the 'B' shares) to enable even those with a small number a shares of BNSF to exchange their shares tax-free for Berkshire stock.

At least compared to prior occasions, it's pretty clear that the BNSF deal was a reasonably good use of the stock. It was certainly a great use of their cash. Using some Berkshire stock to make this happen was also consistent with Buffett's preference to always have lots of cash around. Making sure Berkshire's liquidity remained ample has always been a priority for them (and, I might add, should be for any well run enterprise). After the deal was done there was more than $ 20 billion of cash on the balance sheet. From the CNBC interview:

"...after doing it we will be left with over 20 billion of consolidated cash. So, we like to have a lot of cash around and we'll have a lot of cash around straight through this."

Still, I don't doubt they'd still have rather not used stock in the deal. Yet the opportunity arose to buy a very good large business and they did the deal that made sense consistent with their principles but within real world constraints. If they waited until they could do the deal with all cash who knows if the opportunity would have been there to buy the business at an attractive valuation.

So Buffett doesn't like to use Berkshire's stock but, under the right circumstances, it happens. There was 1.23 million Class A equivalent common shares outstanding at the end of 1997. These days, there's more like 1.65 million.

That increase in share count over 15 years or so comes mostly down to the General Re and BNSF deals.


Long BRKb

Berkshire Hathaway To Acquire Burlington Northern Santa Fe - Nov. 2009
Berkshire and BNSF Close Merger - Feb. 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.

Monday, September 10, 2012

Investors Are Often Their Own Worst Enemies, Part II

A follow up to this post.

Investors Are Often Their Own Worst Enemies

This paper*, created by Professor Terrance Odean and Professor Brad Barber, asserts the following:

" investment strategies will not outperform passive investment strategies. Both the theoretical and empirical work on efficiency supporting this view have led to a rise of passive investment strategies that simply buy and hold diversified portfolios (Fama (1991)).

Behavioral finance models that incorporate investor overconfidence (e.g., Odean (1998b)) provide an even stronger prediction: Active investment strategies will underperform passive investment strategies. Overconfident investors will overestimate the value of their private information, causing them to trade too actively and, consequently, to earn below-average returns. Consistent with these behavioral models of investor overconfidence, we provide empirical evidence that households, which hold about half of U.S. equities, trade too much, on average. Those who trade the most are hurt the most."

Odean and Barber don't really attempt to address how valuation fits into the equation.** The paper is mostly about just how much investor overconfidence and trading hyperactivity meaningfully subtracts from returns.

This Forbes article makes the point that most would be better off just buying index funds while minimizing trading and, based upon the evidence, it's hard to argue with that.***

Buying and holding index funds (and ideally having at least some sense of when the market is selling at valuation extremes) for anyone that does not have the background to effectively evaluate the shares of individual companies. The paper doesn't address, understandably given its focus, buying shares of the great durable business franchises and owning them for a very long time. Yet, owning high quality individual stocks for a very long time (ie. extremely low portfolio turnover much like an index fund), carefully evaluated and bought cheap, is a legitimate alternative to indexation for some and ought to be considered on its own merits.

One of the papers key conclusions is that less trading activity produces better results.

Well, owning long-term a basket of high quality individual stocks, minimally traded, would seem to fit that description. In any case, I'm suggesting it shouldn't be lumped in with all other active investment strategies just because an infrequently traded stock portfolio (quality shares bought with a margin of safety, of course) is not part of an actual index fund. It's fairly obvious, at least it would seem to be, that not all forms of "active" investment management are equivalent. An investor with an individual stock portfolio with turnover of 2 percent is technically "active" but shouldn't be put in the same category as those with 200 percent.
(An average holding period of 50 years versus just 6 months...just think of the difference in frictional costs that have to be overcome!)

With low expenses (fewer frictional costs) and minimal turnover (likelihood of fewer mistakes) there is, much like an index fund, substantial long-term advantages to owning a portfolio of well chosen individual stocks.

The ability to judge individual business value consistently well is, of course, essential.

In addition, this approach may help to mitigate though doesn't eliminate the many reasons investors can be their own worst enemies.

Otherwise, like owning a broad-based index fund, the returns are driven by growth in per share intrinsic value of the businesses themselves, not unusual trading skills. It is, naturally, a necessarily more concentrated approach than most index funds. So diversification is certainly lost but:

"We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter

"Diversification is protection against ignorance. It makes little sense if you know what you are doing." - Warren Buffett

"I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken." - Charlie Munger in this 1998 speech to the Foundation Financial Officers Group

Those not comfortable judging the risks associated with individual stocks clearly require more diversification will find indexation make more sense. Knowing one's own limits, as always, is the key before a penny of capital is put at risk. Choose the approach that fits real (not imagined or hoped for) capabilities.

Index funds tend to outperform (not traded excessively) many active participants. They do so, at least in part, because of the low frictional costs and the fact that value creation comes from the increase in per share intrinsic value of the businesses themselves over time. If traded minimally, it's a convenient way to avoid the pitfalls like the illusion of control and, more generally, the overconfidence that hurt investor returns. Those who know how to judge businesses well (and what to pay per share) but otherwise take a rather passive approach can gain a similar advantage by owning individual stocks.

No matter what approach is chosen, the potential adverse effects of overconfidence never completely disappear. Some might dismiss or underestimate overconfidence as being a minor factor when it comes to producing attractive risk-adjusted returns. That's a mistake. It's a big factor for most and the paper does a nice job of revealing this. The temptation to sell or buy too frequently -- causing investors to trade excessively -- leads many to make costly mistakes.

Individual stocks can be owned long-term with returns primarily driven by the the performance of the businesses themselves. The approach has little need for extraordinary trading skills and by its nature minimizes frictional costs.

Both index funds and purchasing individual stocks -- with the intent to own long-term -- can be wise alternatives to the many all too popular casino-oriented approaches. There's just so much focus on near term price action with them.

"Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide." - Peter Lynch

Compare the ratio of advertisements on the various business media outlets that emphasize generating returns via passive strategies (i.e. primarily generating returns via the per share intrinsic value created by businesses over the long haul) to those that emphasize active strategies (i.e. primarily generating returns via bets on near-term price action). That ratio reveals much about the current extremely short-term oriented culture of speculation in lieu of investment.

It simply plays into the worst instincts of investors.

An overly confident view can lead to excessive trading but the downside is hardly just the explicit additional frictional costs. There's evidence that, at least for many participants, the added moves are just an opportunity to make (and frequently become) additional mistakes.
(Though it's not easy to convince a highly confident participant of this.)

To me, it's folly to allow excessive trading costs, and a too optimistic assessment of near-term informational advantages, to be the wind in your face. Better to allow the long-term effects -- the compounding of business value over time -- to be the wind at your back.

The returns derived from a good businesses bought when Mr. Market happens to offer shares at a discount to value doesn't require exceptional trading skill or something like a near-term informational advantage. Instead, it requires understanding long-term prospects, what those prospects are worth, and yes, at least a reasonably even temperament.

In fact, whether passively an owner of individual stocks or index fund, the intrinsic value created by the businesses themselves does the heavy lifting as far as generating long-term returns.

The price paid versus value (buying with margin of safety) naturally always matters.

The key is really just having a long time horizon, the patience to wait for a good price, and, again, reasonably good judgment of what businesses are worth (and how that worth is likely to change intrinsically over time).

Not everyone buys a stock or an index fund with the idea that they have a near term informational advantage or extraordinary trading skills. Nor is every participant is trying to outsmart the market near-term (though I think fewer should be trying to do so and instead be focused on long-term values). As the paper maintains:

"Active investment strategies will underperform passive investment strategies."

I believe the evidence to support that is substantial. Yet it sometimes seems to be assumed that an index fund is the only passive strategy available to investors. It isn't.

Investors sometimes underestimate how much investor overconfidence, excessive trading, and other frictional costs subtract from returns.

The illusion of control is just one of many good examples how overly optimistic appraisals of prospects and abilities actually hurts long-term performance. If one enjoys creating additional activity for its own sake I suppose that's fine, otherwise, it's extra effort that's often less than fruitless.


Related posts:
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

"Trading Is Hazardous To Your Wealth"
** Clearly, whether you are buying an individual stock or an index fund, what's a smart buy at one valuation is rather less so at another. (See what Warren Buffett calls "The first law of capital allocation" in the Share Repurchases section of the 2011 Berkshire letter.) Buying with the idea of holding long-term when a quality stock (or basket of stocks) is selling at ~ 30 times earnings or more, in all but the exceptional case, likely doesn't make much sense. Some may even be able to reliably find those exceptional cases without making big mistakes along the way. Just watch out for overconfidence. It wrecks returns. Now, when shares of good businesses (those with durable advantages, high return on capital, reasonable debt levels, etc.) can be found at 10 times earnings or less...
*** Many index funds were tough to own this past decade plus but that's mostly the result of extreme valuations that were prevalent across many sectors. Many indexes were a decade and more ahead of themselves in terms of valuation (though plenty individual stocks were not). 30 to 40 times earnings and more was all too frequently the norm. In the late 1990s, valuations for many stocks (not just tech) were just plain silly. In more recent times...much less so. 
(Even if today's market indexes aren't particularly cheap, more than a few individual stocks have been cheap often enough to make buying shares of good businesses to be held long-term more doable.)

Buffett and Munger Writings & Speeches
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, September 6, 2012

Facebook's Shares Outstanding

Facebook (FB) took action earlier this week that effectively reduced their shares outstanding by 101 million.

Prior to January 1, 2011, Facebook granted restricted stock units (Pre-2011 RSUs) to employees (including executive officers), and members of their board of directors. From the latest Facebook 8-K:

...we anticipate that we will net settle the awards by delivering an aggregate of approximately 124 million shares of common stock to holders of Pre-2011 RSUs and withholding an aggregate of approximately 101 million shares of common stock. Pre-2011 RSUs will no longer be considered for accounting purposes to be issued and outstanding, thereby reducing our shares outstanding used to calculate earnings per share.

In the 8-K filing, they added that the 101 million shares will be eligible to be granted as new awards (future dilution) under their 2012 Equity Incentive Plan. The company also said that assuming the price of their common stock at the time of settlement was equal to the August 30th closing price...

...we estimate that the aggregate tax obligation for the settlement of these RSUs would be approximately $1.9 billion.

The filing also says...

We intend to fund these tax withholding and remittance obligations by using our existing cash and borrowings from our credit facilities.

Once this action is complete, Facebook should have approximately 2.64 billion shares outstanding based upon the filing.*
(This will not necessarily be the same as what is reported as fully diluted shares outstanding though, over time, it should end up being a pretty decent estimate. See Treasury Stock Method.)

Some of the more popular finance sites show shares outstanding for Facebook to be much lower than this 2.64 billion number. The confusion is somewhat understandable. For now, these sites appear to be using a share count that's not fully diluted. I'm sure it will be sorted out as we get further from the IPO.

The fully diluted share count -- which accounts for stock options, RSUs, and shares issuable upon completion of the Instagram acquisition -- is the one to use in order to get market valuation and per share measures right. Facebook's relatively complicated capital structure (different classes of stock, stock options, and RSUs) is at least part of the reason for the mix-up.

In effect, Facebook is buying back stock even if the proceeds they'll be paying (to "buyback") just happens to be in the form of a tax. So it functions like a buyback even if the cash doesn't end up in the hands of selling shareholders. In other words, it's not like the reduction in shares outstanding is coming at no cost. As is true with any buyback, the most important thing is whether they're buying those shares back comfortably below per share intrinsic value.

Multiply the 2.64 billion shares outstanding by the current price of $ 19 per share gets you to the ~$ 50 billion market value. The company is making money but their earnings are not yet backed by quality free cash flow (FCF).

In fact, FCF in the 1st half of 2012 was negative. We'll see if that improves over time but it's worth keeping an eye on.

Use of the not fully diluted shares outstanding is making Facebook's market value appear lower than it actually is. The difference isn't inconsequential. Some sites now still show Facebook as having a ~$ 40 billion market value near current prices instead of the ~ $ 50 billion.

I won't be surprised if Facebook is going to be worth quite a lot someday. Maybe even much more than it's current valuation. That doesn't mean at today's valuation it will provide acceptable compensation for investors or a sufficient risk-adjusted return. There seems, at least to me, many other more attractive risk-adjusted alternatives with a narrower range of outcomes.

Judging how valuable something this dynamic is (and how valuable it is likely to become) and the appropriate price to pay TODAY isn't easy. Personally, I simply don't buy anything unless I can gauge the risk of permanent capital loss (both in terms of size and likelihood). I think it is fair to say the range of outcomes for a business like Facebook is relatively wide. Figuring out the appropriate margin of safety seems to me difficult at best.

In any case, plenty has to go right for the current valuation to make sense.

Even though Facebook's stock has fallen hard since the IPO, the company still has more than twice the market valuation that Google (GOOG) had when it went public. The question is whether Facebook's business will have anything like the kind the trajectory that Google's business has had.

I certainly have no idea.

Google earned nearly $ 1.5 billion the first full year after its IPO (not so unlike the current expectations for Facebook) and should earn nearly $ 11 billion or so this year. If Facebook has anything like that ahead of it then the current seemingly high valuation won't turn out to be so elevated after all.


Long position in Google

Related posts:
Is One Apple Really Worth Less Than Four Facebooks
Facebook Drops Ahead of IPO: 1st Quarter 2012 Results
Facebook Files for IPO: What the S-1 Reveals
Facebook's IPO: $ 100 Billion Valuation?
Facebook's 1st Half Revenue Doubles to $ 1.6 Billion
Is Facebook Worth $ 100 Billion?
Technology Stocks

* Prior to the action taken earlier this week, 2.74 billion was roughly the correct share count (confirmed by Facebook). At the time of the IPO, many seemed to be using something close to that number. 
(In fact, one can't get near the reported ~ $ 100 billion plus valuation multiplying the share price at the time of the IPO by the number of shares currently being reported on some finance websites.)
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.