Monday, April 30, 2012

Buybacks Take A Smarter Tack

Here's a Wall Street Journal article on the recent share buyback behavior of companies in the S&P 500 index. Apparently, companies did plenty of buying when the market was low then backing off as it rallied.

Wall Street Journal: Buybacks Take A Smarter Tack

The fact is companies do not always get this right. The article also points out that buybacks were at record levels as the market was peaking back in 2007. Yet, once stock prices fell dramatically, the buyback activity dropped off quite a bit.

Substantial corrections can happen (and have happened) where shares in general never fall to an unattractive valuation. So I'd be cautious about considering a large generalized drop in market prices, in combination with aggressive buyback activity, to be a reliable indication that shares are being bought back cheap.

A big drop certainly increases the probability that shares are at bargain valuations but hardly assures it.

For too many stocks, even near the bottom of some of the corrections (including larger ones in the past decade or so), the market price relative to intrinsic value provided insufficient or no margin of safety. Having said that, this most recent time there seemed to be quite a few bargains made available by market conditions in the third quarter of last year.

So, at least in this instance, many companies seemed to be getting it more right than wrong.

Effectively executed buyback programs usually have management (and a Board of Directors) who 1) provides a clear indication, through words and past actions, that they know what their shares are likely worth and 2) a track record of buying back shares more often than not when:
- the discount to intrinsic value is substantial,
- the business itself is in a comfortable financial position, and
- other more attractive investing opportunities are not on the horizon.

For long-term investors, large corrections in market prices are always a welcome thing to see. It often creates an environment where the price of individual shares become very attractive compared to intrinsic value.

Long-term investors can naturally take the opportunity to buy more shares when they're at a discount to value, but it's nice to know that management is likely to intelligently do the same with excess cash.

It's good to see the recent buyback pattern but, at least to me, it's not sufficient to look at what companies as a group are doing with buybacks. The track record is just too mixed. Instead, I'd rather look at the buyback behavior of a specific company, especially one that I happen to know its specific strength and challenges very well.

For frequent readers of the blog, of course, this is ground that's been covered on a number of previous occasions.

Adam

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

Friday, April 27, 2012

Yacktman 1st Quarter 2012 Update

Below is the 10-year performance through 03/31/12 of the funds that Donald Yacktman and his team manage:

The Yacktman Fund (YACKX) had a cumulative 10-year return of 180.24%.*

The Yacktman Focused Fund (YAFFX) did even better returning a cumulative 197.09% over the past 10 years.

For a comparison, the S&P 500 was up 49.72% over the same time frame.

These funds are very similar but the more concentrated of the two funds, as the name suggests, is the Yacktman Focused Fund.

Top 5 Holdings of The Yacktman Focused Fund
1 Procter & Gamble (PG)
2 News Corp (NWSA)
3 Pepsi (PEP)
4 Microsoft (MSFT)
5 Sysco (SYY)

Approximately 41 percent of the Yacktman Focused Fund portfolio is in the top 5 stocks. 

Top 5 Holdings of The Yacktman Fund
1 Pepsi (PEP)
2 News Corp (NWSA)
3 Procter & Gamble (PG)
4 Microsoft (MSFT)
5 Cisco (CSCO)

Approximately 34 percent of the Yacktman Fund portfolio is in the top 5 stocks.

From their 1st Quarter 2012 Letter:

Consumer Staples
We think the combination of predictability, quality, and valuation of companies like Procter & Gamble, PepsiCo, Clorox, and Coca Cola is especially important in a time when we perceive many significant risks in the world.   

Old Tech
Microsoft [was] the top contributor to fund results in the first quarter, appreciating more than 20%, though we believe the stock remains inexpensive at less than 10 times our expectation of 2012 earnings when adjusting for net of the cash on the balance sheet. While HP struggled, we think the shares are remarkably inexpensive and the management team has improved significantly since Meg Whitman became CEO.

In this Barron's interview from a little over a year ago, Donald Yacktman had this to say about the investing business:

This business boils down to what you buy and what you pay for it. The market level is incidental to us.

In the interview, he also talks about how inexpensive high-quality companies are compared to what he's seen over the years.

Unfortunately some (though certainly not all) of the high-quality companies he is referring to are much more expensive now.

I've mentioned this before, but it's worth noting again that the annual turnover of the portfolios managed by Yacktman and his team is typically under 10 percent.

In fact, they are often well under that 10 percent number.

According to Morningstar, lately it has been more like 2 to 3 percent.

Impressively low.

It's always good to see someone producing above average returns by paying the right price for sound businesses that compound over time in value.

I'll take that approach over some special aptitude for trading any day.

Adam

Established long positions in PG, PEP, KO, and MSFT at much lower prices. Have no intention to buy any of these near current prices. Also, have established a position in HPQ near its recent price.

* From the letter: The performance data quoted for The Yacktman Fund and The Yacktman Focused Fund represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that the investor's shares, when redeemed, may be worth more or less than their original cost. The current performance may be higher or lower than the performance data quoted.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, April 26, 2012

Buffett: Intrinsic Value vs Book Value

From Warren Buffett's 1998 Berkshire Hathaway (BRKa) shareholder letter:

Our stock sells at a large premium over book value, which means that any issuing of shares we do -- whether for cash or as consideration in a merger -- instantly increases our per-share book value figure, even though we've earned not a dime. What happens is that we get more per-share book value in such transactions than we give up. These transactions, however, do not deliver us any immediate gain in per-share intrinsic value...

It is gains in per-share intrinsic value that really matters. Here's how Buffett explains intrinsic value and book value in the Berkshire Hathaway owner's manual:

Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.

The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value.

Buffett later adds the following:

Inadequate though they are in telling the story, we give you Berkshire's book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire's intrinsic value. In other words, the percentage change in book value in any given year is likely to be reasonably close to that year's change in intrinsic value.

The per share book value of Berkshire Hathaway Class A shares at the end of 2011 was $99,860/share while the share price is at $ 119,756 (or a 19.9% premium). Now, Buffett consistently makes the point that it only makes sense to repurchase shares when a company is in a comfortable financial position and the shares are selling at a substantial discount to intrinsic value.

In September of last year, Buffett and the Board of Directors obviously believed that was the case for Berkshire and decided it made sense to establish a formal repurchase program:

Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares. In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise.

So that certainly provides some rough guidance as to when they think a sufficient enough discount to value exists that it warrants the repurchase of shares.

If the shares are selling at a 10% premium over the book value** or less, Buffett and the Board have now made it clear they think it represents quite a nice discount to what Berkshire's shares are worth intrinsically.***

When they announced the repurchase program, the prior trading day's closing price of Berkshire's Class A shares was $103,320 (or very close to dead even with book value).

Well, since the shares have rallied quite a bit since then, it would seem they are no longer low enough for repurchase.

Probably not, but it's worth keeping in mind that the book value is a moving target and has likely increased since the end of last year.

That makes the phrase "then-current book value" used by Buffett in the share repurchase announcement rather important. When Berkshire's results are released for the 1st quarter, we'll get to see if and by how much book value (Berkshire's inadequate yet useful tracking measure) has increased.

Check out page 99-100 of the 2011 annual report for a good explanation of how Buffett and Munger view Berkshire's intrinsic value.

Adam

Long position in BRKb established at lower than recent market prices

* From the letter: All figures used in this report apply to Berkshire's A shares, the successor to the only stock that the company had outstanding before 1996. The B shares have an economic interest equal to 1/30th that of the A. 
[Well, it was 1/30th back then but now is 1/1500th as explained in this memo.]
** 10% premium over the book value or 110% of the book value. It's been described both ways in different publications.
*** If selling at more than a 10% premium over book value, the stock may still sell at a discount to intrinsic value but not enough of one to warrant buying. How it competes with other investing alternatives also always comes into play and Buffett says as much in the share repurchase announcement.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, April 25, 2012

Apple's Quarterly Earnings

Apple's (AAPLquarterly earnings were released yesterday.

They didn't disappoint. From the earnings release:

The Company posted quarterly revenue of $39.2 billion and quarterly net profit of $11.6 billion, or $12.30 per diluted share. These results compare to revenue of $24.7 billion and net profit of $6.0 billion, or $6.40 per diluted share, in the year-ago quarter.

 Some other highlights:

- The company now has $ 110 billion in cash and investments (no debt). Cash on the balance sheet equals roughly 20% of Apple's market capitalization and is up from $ 97 billion in the prior quarter. Only 4 percent of the S&P 500 companies have a market capitalization that's higher than the cash Apple has laying around. In other words, Apple could go on one heck of an acquisition spree if they wanted to do so (though it's hard to imagine why they'd want the headache).

- Free cash flow was more than $ 28 billion over the past six months. So, give or take, the company has had average free cash flow of $ 1 billion per week over the past half year.

What Apple sold by key product this past quarter...
  • 35.1 million iPhones in the quarter, a 88 percent unit increase over the year-ago quarter.
  • 11.8 million iPads in the quarter, a 151 percent unit increase over the year-ago quarter.
  • 4 million Macs during the quarter, a 7 percent unit increase over the year-ago quarter.
  • 7.7 million iPods, a 15 percent unit decline from the year-ago quarter.
If Apple earns in the 2nd half of this fiscal year (their fiscal year ends in September) what it earned in the 1st half, its enterprise value/earnings is less than 9x based upon yesterday's closing price.

Unfortunately, the stock is up quite a bit this morning.

Adam

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

Tuesday, April 24, 2012

Facebook Profit Drops Ahead of IPO: 1st Quarter 2012 Results

Facebook yesterday released its 1st quarter results as part of an amended S-1 filing.

Some things of note:

- Net profit fell 12 percent from $233 million in the 1st quarter of 2011 to $205 million in the 1st quarter of 2012.

- Revenue was $ 1.06 billion in the 1st quarter, a 45 percent increase year over year. At first glance that seems just fine but revenue declined 6.5% sequentially in the first quarter of 2012 compared to Facebook's $ 1.13 billion in the 4th quarter of 2011.

Those results are certainly not the end of the world, but seem fairly weak for a company that's expected to go public with a monster valuation by any standard.

From this Reuters article:

"It was a faster slowdown than we would have guessed," said Brian Wieser, an analyst with Pivotal Research Group. "No matter how you slice it, for a company that is perceived as growing so rapidly, to slow so much on whatever basis - sequentially or annually - it will be somewhat concerning to investors if faced with a lofty valuation," Wieser said.

- Total expenses were up roughly 97 percent over the past 12 months far outpacing the 45 percent revenue growth.

- Monthly active users surpassed 900 million in the 1st quarter, up from 845 million in the last filing.

- Facebook is paying $ 300 million in cash for Instagram plus 23 million shares of its class B common stock. Since Facebook says that the fair value of the shares are $ 30.89, that means the 23 million shares are being valued at just over $ 700 million (obviously, anyone can say what they think their shares are worth...whether they are worth that much is another story).  So that brings the total deal value to roughly $ 1 billion for Instagram. Facebook also disclosed it will pay $ 200 million to Instagram if the company's recent deal to buy the photo-sharing start-up for about $1 billion falls through.

All stocks have a bunch of risk factors that must be listed. One risk factor that's listed in Facebook's S-1 is in the Our CEO has control over key decision making as a result of his control of a majority of our voting stock section. From the section:

As a stockholder, even a controlling stockholder, Mr. Zuckerberg is entitled to vote his shares, and shares over which he has voting control as a result of voting agreements, in his own interests, which may not always be in the interests of our stockholders generally.

Since CEO Mark Zuckerberg owns 58 percent of Facebook stock, anyone who invests has to feel confident that he'll mostly vote in the interest of all stockholders. Who knows, maybe that Instagram deal will make a lot of sense in hindsight. Then again, maybe not.

The initial public offering for Facebook is expected at around $ 100 billion. That looks like a full price to say the least. The New York Times noted yesterday in this article that Google (GOOG) looked stronger than Facebook prior to its initial public offering:

Before Its I.P.O., Google Looked Stronger Than Facebook

The article notes that Google's revenue grew 125 percent in the 2nd quarter of 2004, compared with the same period the previous year then added...

That was much faster than Facebook's 45 percent increase in the first quarter of this year. At the same time, Google increased its earnings by 146 percent as it headed into its I.P.O., not falling like Facebook's profit.

To be fair, Google had lower revenue and earnings compared to Facebook right before it went public (but also a market valuation that was roughly 1/4 what is expected for Facebook).

What I know is I'll never gain or lose no matter how good Facebook's future ends up being. It's just not something I can understand well enough (necessarily unique for each investor). Others no doubt can better judge what it's worth and future prospects. Considering the expected valuation it's not, at least for me, all that interesting though the company's business accomplishments to date are very impressive.

With the benefit of time and hindsight Facebook may prove to be an excellent business. In fact, with what are already formidable advantages in mind, the company won't surprise me at all if it performs very well over time. Yet, for a good long-term investment result (not simply a good trade over several years or less) to happen, it will necessarily depend upon outstanding and sustained business performance. Due to what appears to be a hefty upfront price, it's possible that the long-term investment result -- while not insignificant in an absolute sense -- will end up offering insufficient compensation for investors, considering the risks and compared to alternatives, even if the business itself does very well.
(i.e. Returns may be unsatisfactory considering the wide range of outcomes and unsatisfactory compared to much less risky investment alternatives that have a narrower range of outcomes. Investment performance ends up being not nearly as impressive as business performance simply because of the upfront price.)

My preference happens to be attractive results that can be achieved via merely solid (though maybe somewhat uneven) continued long run business performance.

Generally, that's going to be a rather boring but durable business -- possibly one experiencing some near-term difficulties but with otherwise sound core economics and sustainable competitive advantages -- bought at a very attractive price.

So Facebook may do more than just fine. It's just that there's a limit to the number of investments any one investor can understand.

Beyond that limit unnecessary mistakes end up being made.

Margin of safety must be obvious.

It comes down to opportunity costs. Choosing the best understood investment alternative, at the biggest possible discount, to protect against inevitable future uncertainties is all-important.

Adam

Long position in GOOG

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

Monday, April 23, 2012

American Express: 1st Quarter 2012 Results

From last week's American Express (AXP) 1st quarter earnings release:

"Higher cardmember spending, excellent credit metrics and disciplined expense management helped us to start 2012 with record first-quarter earnings and revenues," said Kenneth I. Chenault, chairman and chief executive officer. Spending on the American Express network rose 12 percent, remaining strong throughout the quarter, both in the U.S. and internationally. Credit quality continues to be among the best we have ever experienced, and our lending portfolio continued to grow at moderate levels.

Later in the release Chenault added...

"Our overall performance again underscored the advantages of our spend-centric business model, as did the results of a financial review, or stress test, of major financial companies that was completed by the Federal Reserve this quarter. American Express ranked among the highest in the group, and the Fed notified us that it had no objections to raising our quarterly dividend or repurchasing shares.

As a result, we increased our quarterly dividend by 11 percent to $0.20 per share, from the $0.18 level that we maintained throughout the financial crisis and recession. We are also moving ahead with plans to repurchase as much as $4 billion of outstanding shares this year and an additional $1 billion in the first quarter of 2013."

The company earned $ 1.07/share in the first quarter and will likely earn $ 4.30/share this year.

That $ 4.30/share will already 28% higher than the company's peak earnings before the financial crisis.

For a few months in early 2009, the shares were, at times, selling in the $ 10-15/share range (briefly, they actually hit single digits).

So just a modest multiple of normalized (and growing) earnings power. Mr. Market's terrible mood at that time didn't change the long run prospects for AmEx or the company's intrinsic value.

Instead, it just temporarily made shares of a good business available cheap for those with a reasonably long investing time horizon who liked the business.
(In contrast to those market participants who may be trying to figure out how bad news may move a stock in the short or even intermediate run.) 

As of this past Friday's close the shares were selling at $ 57.45 so, even if not necessarily expensive, they're no longer a bargain.

Adam

Long position in AXP at much lower than recent market prices. No intention to buy near the current prices but it's generally a long-term position. AXP has been part of the Six Stock Portfolio since it was established April of 2009.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, April 20, 2012

Jeremy Grantham's Latest Quarterly Letter: Tortured Logic of Rational Expectations

From Jeremy Grantham's latest quarterly letter:

"It is simple to see what is necessary, but not easy to be willing or able to do it. To repeat an old story: in 1998 and 1999 I got about 1100 full-time equity professionals to vote on two questions. Each and every one agreed that if the P/E on the S&P were to go back to 17 times earnings from its level then of 28 to 35 times, it would guarantee a major bear market. Much more remarkably, only 7 voted that it would not go back! Thus, more than 99% of the analysts and portfolio managers of the great, and the not so great, investment houses believed that there would indeed be 'a major bear market' even as their spokespeople, with a handful of honorable exceptions, reassured clients that there was no need to worry."

Price action in the short run (and even longer) will almost always be driven by the mood of the herd, not fundamentals. If price of something happens to be near fair value at any time it's likely mere coincidence.

I suppose no one is entirely immune to the influence of crowd behavior. Yet, it seems those who can mostly ignore what others are doing, judge value consistently well, buy what they understand at a discount (margin of safety or price versus value discipline), and have a bias toward owning what they like for a very long time seem to do more than okay.

Simple? Maybe.

Easy?

Not so much.

Check out the quarterly letter in its entirety.

Adam

* ...the efficient-market hypothesis requires that agents have rational expectations; that on average the population is correct (even if no one person is) and whenever new relevant information appears, the agents update their expectations appropriately. - Wikipedia

Thursday, April 19, 2012

Market Madness

MF Global is the new poster child for why thoughtful financial regulation is needed more than ever. - Bart Chilton

Some excerpts from this speech given by CFTC Commissioner Bart Chilton last month (in the midst of "March Madness"):

FCIC
The Financial Crisis Inquiry Commission (FCIC) was established to look at what happened. It concluded the Troubled Asset Relief Program or TARP was needed due to two culprits to the calamity.

One culprit: regulators and regulation. You see, in 1999, Congress and the president deregulated banks. Banks were no longer bound by that pesky Depression-era Glass-Steagall Act that cramped their style and limited what they could do with the money in their institutions. With the repeal of Glass-Steagall, regulators got the message to let the free markets roll. And, roll they did—right over the American people.

The second culprit: The captains of Wall Street. FCIC concluded that since they were allowed to do so much more without those annoying rules and regulations, they devised all sorts of creative, exotic and complex financial products. Some of these things were so multifaceted hardly anyone knew what was going on or how to place a value upon them.

Credit Default Swaps (CDS)
CDSs were a significant component of creating this ginormously humongous dark market with no oversight by regulators. When I say ginormously humongous, that's a technical term. You see, we at the CFTC currently oversee roughly $5 trillion in annualized trading on regulated exchanges, but the global over-the-counter (OTC) market is roughly—here it comes—$708 trillion. If you Google ginormously humongous, it should say, "See OTC markets."

In the speech, Chilton goes through what he views as four of the most critical rule changes needed but have yet to be approved or implemented. Speculative position limits is one of the four. He argues that position limits have been needed for years and are now needed more than ever.

The Commission passed a final position limits rule in October but, according to Chilton, implementation has been delayed by a lawsuit and some other unfinished business with the SEC. More excerpts from the speech:

Speculation and "Massive Passives"
I know we need speculators. I know I know I know—there are no markets without them. Speculators are good. But like a lot of good things, too much can be problematic. Therefore, it is the excessive speculation that can cause problems, contort markets, and result in consumers and businesses paying unfair prices and negatively impacting our economy.

Chilton then describes what he calls "Massive Passives":

Between 2005 and 2008 we saw over $200 billion come into futures markets from non-traditional investors. I call them "Massive Passives." They are the likes of pension funds, index funds, hedge funds and mutual funds. These funds are very large—massive—and have a fairly price-insensitive, passive trading strategy. 

Then went on to say...

I'm not suggesting that the Massive Passives, or speculators in general, are actually driving prices. Let me be clear. I’m not proposing they were all in cahoots and decided to raise oil prices. What I am saying is that they contribute to price swings, and have a proportional impact in markets based upon their size as a whole, and certainly individual traders can push prices around if they have a large enough concentration. When prices are on the rise, like now, and the Massive Passives and others get into markets, they can push prices to levels that may be uneconomic—certainly not tied directly to supply and demand—and the prices may stay higher longer than they normally would.

The Speculative Premium
...you don't have to take it from me, from Senators or U.S. Representatives, or from the President of the United States. In fact, you don’t have to take it at all. I know that many of you in this crowd won't. Nonetheless, let me lay one more piece of research on you with regard to speculation. This one doesn’t come from some lefty activist group. It comes from one of the big Wall Street banks. Its researchers said that each million barrels of net speculative length adds as much as 10 cents to the price of a barrel of crude oil. The speculative length is a known quantity. With a little math, you can determine that the "speculative premium" on oil these days is around $23 a barrel—and that translates into about an extra 56 cents for a gallon of gas.

Considering the interests involved and the dollars at stake, I'm not surprised it has taken this long to address these kind of things. Still, we'd be smart to not wait too long. The most critical changes ought to be thoughtfully implemented well before the next financial crisis is upon us.

Not doing so is just asking for largely unnecessary self-inflicted economic pain at some unknowable point in the future.

Adam

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

Wednesday, April 18, 2012

Buffett Reveals 'Not Remotely Life-Threatening' Cancer Diagnosis

Warren Buffett disclosed that he has been diagnosed with stage I prostate cancer in this news release:

The good news is that I've been told by my doctors that my condition is not remotely life-threatening or even debilitating in any meaningful way. I received my diagnosis last Wednesday. I then had a CAT scan and a bone scan on Thursday, followed by an MRI today. These tests showed no incidence of cancer elsewhere in my body.

This CNBC article added some perspective on Buffett's health.

Buffett Moves Quickly to Disclose 'Not Life Threatening' Cancer

This inevitably will bring Berkshire's succession planning to the forefront. It is almost certain that lots of time will be dedicated to the issue at the the 2012 Berkshire Hathaway annual shareholder meeting that's happening at the beginning of next month.

Who will be taking Buffett's job when he no longer can do it is obviously an important subject for Berkshire shareholders. It would be nice to know the successor (though there's plenty of downside to revealing who it is).

Having said that, the meeting need not become too narrowly focused on this one important issue. The meeting generally covers a wide range of subjects and hopefully this year will be no different.

I'd certainly like it to remain that way as long as Buffett is on the job.

In the latest Berkshire Hathaway (BRKashareholder letter, after emphasizing the Board's enthusiasm for the two new investment managers (Todd Combs and Ted Weschler), here's what Buffett said about his chosen successor:

Your Board is equally enthusiastic about my successor as CEO, an individual to whom they have had a great deal of exposure and whose managerial and human qualities they admire. (We have two superb back-up candidates as well.) When a transfer of responsibility is required, it will be seamless, and Berkshire’s prospects will remain bright. More than 98% of my net worth is in Berkshire stock, all of which will go to various philanthropies. Being so heavily concentrated in one stock defies conventional wisdom. But I’m fine with this arrangement, knowing both the quality and diversity of the businesses we own and the caliber of the people who manage them. With these assets, my successor will enjoy a running start. Do not, however, infer from this discussion that Charlie [Munger] and I are going anywhere; we continue to be in excellent health, and we love what we do.

Despite his new illness, from what is known it seems there's a good chance Buffett will be in his current job for a very long time. I, like many others, wish him the best possible health.

The next shareholder meeting certainly needs to have enough time (subjective, of course) spent on succession. Yet, I'm hoping the meeting doesn't become dedicated to (or obsessed with) anticipating the inevitable transition ahead that's ultimately unknowable at this time.

There's plenty of other worthwhile ground to cover. For whatever number of years may be left where Buffett and Munger take questions at the annual meeting, to me it should be used to learn as much as possible from them.

Adam

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

Tuesday, April 17, 2012

U.S. Bancorp's 1st Quarter 2012 Results

From this post on the WSJ's Deal Journal blog:

If U.S. Bancorp's results were any more consistent, the bank might be able to stop reporting quarterly data.

It just keeps posting solid growth that generally outpaces most other lenders. Earnings jumped 27% as average total loans increased 6.4% amid a 17% jump in commercial borrowing and 26% surge in commercial and commercial-real-estate commitments.

Not many domestic banks performed like U.S. Bancorp (USB) during the financial crisis or are now positioned as well.

From the U.S Bancorp's earnings release:

U.S. Bancorp Chairman, President and Chief Executive Officer Richard K. Davis said, "U.S. Bancorp's first quarter 2012 financial results clearly demonstrate that the momentum the Company has established and built over the past several years is continuing to drive performance in 2012. The Company's first quarter diluted earnings per common share of $.67 were 28.8 percent higher than the prior year and the increase was driven by revenue growth and improving credit costs. Our key performance ratios of return on average assets, return on average common equity and efficiency were 1.60 percent, 16.2 percent and 51.9 percent, respectively, in the first quarter. All of these performance ratios are among the best in the industry and at the top of our peer group.

"Average total loans and deposits were higher in the first quarter, posting year-over-year growth of 6.4 percent and 11.7 percent, respectively, as all of our balance sheet businesses benefited from growth initiatives and continued to capitalize on the flight to quality."

That kind of loan growth or source of inexpensive funds has the potential to drive healthy future profit growth as long as U.S. Bancorp continues, as it has historically, to intelligently underwrite the loans.

Like most good banks, their above average returns on capital seems to begin with having sound practices and culture that's reinforced by capable management.

It certainly shows up in the numbers.

Relative to many peers, U.S. Bancorp has exceptional net interest margins (at 3.6 percent, it doesn't match the 3.91% of Wells Fargo: WFC, but handily beats most others) and the capacity for fee generation.*

As one of the stronger domestic banks going into the financial crisis, U.S. Bancorp was in a position to acquire some fine assets while weaker ones could not.

That certainly also hasn't hurt their current results and future prospects.

Adam

Established a long position in USB at much lower than the recent market prices

* Payments processing, credit/debit cards, trust/investment management, mortgage banking, loan syndication and bond underwriting among other things.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, April 16, 2012

Buffett on Commodity Businesses - Part II

A follow-up to this post.

Warren Buffett, in the 1985 Berkshire Hathaway (BRKa) shareholder letter, explained his thinking about commodity businesses:

"For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries, by far the largest U.S. textile company both 21 years ago and now. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours. Its stock sold at 60 at the end of 1964; ours was 13.

Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington's basic commitment to stay in textiles, I would also surmise that the company’s capital decisions were quite rational.

Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at 34 -- on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid but they, too, have shrunk significantly in purchasing power.

This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise. The situation is suggestive of Samuel Johnson's horse: 'A horse that can count to ten is a remarkable horse - not a remarkable mathematician.' Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company - but not a remarkable business.

My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row..."

Then later in the letter Buffett added...

"Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."

Since businesses with commodity-like economic characteristics by definition have little or no pricing power, a sustainable cost advantage ends up being the crucial factor for investors.

Now, it's one thing to understand the importance of owning shares of low cost producers (or, at the very least, among the lowest cost producers), but sometimes figuring out who that actually is and why the advantage they have is sustainable isn't all that easy.

Adam

Long position in BRKb established at lower prices

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, April 13, 2012

Wells Fargo Reports 1st Quarter 2012 Earnings

From the Wells Fargo (WFC) quarterly earnings release:

Wells Fargo & Company (NYSE: WFC) reported record net income of $4.2 billion, or $0.75 per diluted common share, for first quarter 2012, compared with $3.8 billion, or $0.67 per share, for first quarter 2011...

Net interest income after provision for credit losses did grow to $ 8.89 billion from $ 8.44 in 1st quarter of 2011 but was basically flat compared to 4th quarter of 2011.

The bank's net interest margin increased to 3.91 percent from 3.89 percent in the 4th quarter of 2011. On that key measure, Wells continues to have a big advantage over most peers. Over the long haul, it should provide a big boost to returns on capital if combined with smart credit underwriting.

In the 1st quarter, the key driver of earnings growth was noninterest income:

Noninterest Income
Noninterest income was $10.7 billion, up from $9.7 billion in fourth quarter 2011. The $1.0 billion increase was driven by increases of $506 million in mortgage banking, $458 million in market sensitive revenue, and $181 million in trust and investment fees.

In the 1st quarter of 2011, noninterest income was just under $ 9.7 billion.

Wells Fargo will likely earn roughly $ 3.20/share this year. That compares to peak earnings prior to the financial crisis of $ 2.47/share. The fact that they are already displaying relatively strong earnings power in a still somewhat fragile economic environment would seem to imply they'll do just fine as conditions improve.

Yesterday's closing price was within 2% of a 52-week high yet, using the $ 3.20/share estimate, the stock currently sells for under 11x earnings.

Adam

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

Thursday, April 12, 2012

Yacktman on PepsiCo

Donald Yacktman and his team recently responded to GuruFocus readers' questions. Here's a short excerpt of what he had to say about PepsiCo (PEP):

We believe the company will need to show improved results from several of the key areas of strategic focus or there may be a new management team in place in the near future. The potential for the stock is less about the growth, which we think is mid-to high single-digit per year, and more about the combination of valuation and quality of business. - Donald Yacktman

Donald Yacktman has liked PepsiCo for some time but that seems a slightly less favorable assessment compared to previous ones by him and his team.

PepsiCo has some high quality businesses, but the execution on some fronts lately has been somewhat disappointing.

Earnings is expected to be down this year compared to last year. Using this year's number, PepsiCo is selling for nearly 16x earnings.

So, while not expensive (especially if an investor believes those earnings will begin to bounce back next year), it hardly seems like a bargain near the current valuation considering some of their recent difficulties.

A larger discount until they prove some things to shareholders seems warranted.

Check out the full article. In it, the co-managers at Yacktman Funds respond to a bunch of  readers' questions.

Adam

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

Wednesday, April 11, 2012

Buffett's $ 50 Billion Decision

Some comments of interest by Warren Buffett regarding his early days from this recent ForbesLife magazine article:

On Retiring
...when I got out of college, I had $9,800, but by the end of 1955, I was up to $127,000. I thought, I'll go back to Omaha, take some college classes, and read a lot—I was going to retire! I figured we could live on $12,000 a year, and off my $127,000 asset base, I could easily make that. I told my wife, Compound interest guarantees I'm going to get rich.

On Buying A House
I told my wife, "I'd be glad to buy a house, but that's like a carpenter selling his toolkit." I didn't want to use up my capital.

In the article, he adds that he had no plans to start a partnership or even get a job.

He also didn't want to sell securities to others again.

On Forming A Partnership
"You used to sell stocks, and we want you to tell us what to do with our money." I replied, "I'm not going to do that again, but I'll form a partnership...and if you want to join me, you can." ...That was the beginning—totally accidental.

Five decades plus later that simple start became what is effectively a partnership (although the form is technically corporate) with a combined value of $ 200 billion and roughly 270,000 employees.

Buffett certainly views it as a partnership. From the Berkshire Hathaway (BRKaowners manual:

Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we are also, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.

He was certainly right about compound interest making him rich, though I'm guessing he couldn't have imagined the partnership would become anything like its current size and form.

Adam

Tuesday, April 10, 2012

Buffett on Commodity Businesses

"...when a company is selling a product with commodity-like economic characteristics, being the low-cost producer is all-important." - Warren Buffett in the 2000 Berkshire Hathaway (BRKa) shareholder letter

In his 1985 letter, Warren Buffett focuses on a mistake he made with Berkshire's textile operations.

From the letter:

"Our Vice Chairman, Charlie Munger, has always emphasized the study of mistakes rather than successes, both in business and other aspects of life. He does so in the spirit of the man who said: 'All I want to know is where I'm going to die so I'll never go there.' You'll immediately see why we make a good team: Charlie likes to study errors and I have generated ample material for him, particularly in our textile and insurance businesses."

Early on, the cash generated by the textile business had funded Berkshire's entry into insurance. It was a crucial move since the textile business never earned much even in a good year.

Smart capital allocation led to further diversification and, over time, the textile operation became a relatively small portion of Berkshire. Excess capital was consistently put to more attractive alternative uses. If that capital had been instead invested back into the textile operation Berkshire would be a shadow of itself.

In the 1978 letter, Buffett listed the four reasons why they were staying in the textile business despite its relatively unattractive economics. The last of the 4 reasons listed by Buffett was that:

"...the business should average modest cash returns relative to investment."

He also said:

"As long as these conditions prevail - and we expect that they will - we intend to continue to support our textile business despite more attractive alternative uses for capital."

By the mid-80s there was overwhelming evidence Buffett's thinking in 1978 was incorrect.  For the most part, the textile business continued to be a consumer of cash. He admits as much in the 1985 letter saying:

"It turned out that I was very wrong...Though 1979 was moderately profitable, the business thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue. Could we have found a buyer who would continue operations, I would have certainly preferred to sell the business rather than liquidate it, even if that meant somewhat lower proceeds for us. But the economics that were finally obvious to me were also obvious to others, and interest was nil.

I won't close down businesses of sub-normal profitability merely to add a fraction of a point to our corporate rate of return. However, I also feel it inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with my first proposition, and Karl Marx would disagree with my second; the middle ground is the only position that leaves me comfortable."

So the textile business was largely shut down during 1985. Buffett later added...

"Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.

But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company's capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.

Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital."

Unless a commodity business has a clear and sustainable built in cost advantage over competitors, capital expenditures will likely not produce a great return for long-term owners.*

Returns of these businesses, at least as a general rule, will be subpar.

The Appendix to the 1983 Berkshire Hathaway shareholder letter is relevant here. In it, Buffett explains economic Goodwill.**

"It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.

Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill."

Yet economic Goodwill can also exist in non-consumer businesses...

"Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry."

Otherwise, lacking a sustainable advantage, large amounts of capital investment aren't likely to work out well in the long-run for owners.

There are exceptions but most commodity businesses (excl. things like governmental franchises or a monopoly-like position) need to have a sustainable cost advantage to produce above average returns.

The lessons from Berkshire's textile business experience may be useful background for those considering an investment in a commodity-like business. 

Adam

Long position in BRKb established at lower prices

Related post:
Buffett on Commodity Businesses - Part II (follow-up)

* Government interference can subsidize or support what otherwise is a commodity business. Well, at least enough help that there is less competition and no overbearing profit regulation.  Eliminate the natural competing forces or provide subsidies and the underlying economics may no longer seem like that of a commodity business. Yet, if proper competition existed it would. In contrast, it is the reputation and brand of successful consumer franchises create their pricing power. No government support or monopoly required.
** Economic Goodwill is very different animal from accounting Goodwill. Buffett does a good job of describing the differences in the Appendix to the 1983 letter.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, April 9, 2012

The Illusion of Skill

This article is adapted from the book "Thinking, Fast and Slow" by Professor Daniel Kahneman that was published last year. The Princeton professor is known for research on how quirks in human behavior lead to illogical decision-making and outcomes.

In the 2nd half of the article, Professor Kahneman focuses on results from studies of active traders, professional fund managers, and wealth advisers.

Active Traders, Take a Nap
According to the article, an analysis of trading records by Professor Terrance Odean* revealed that individual investors lose consistently by actively trading:

"On average, the shares investors sold did better than those they bought, by a very substantial margin: 3.3 percentage points per year..."

This doesn't include the not insignificant costs of trading. The article later added:

"...the large majority of individual investors would have done better by taking a nap rather than by acting on their ideas."

I've covered this "illusion of control" in a prior post:

The Illusion of Control

Later in the article, Professor Kahneman examines a somewhat different illusion but, before looking at that, here's some more evidence from the article that less activity produces superior results.**

"Odean and his colleague Brad Barber showed that, on average, the most active traders had the poorest results, while those who traded the least earned the highest returns."

The Illusion of Skill
While professional investors and traders may have (or at least would be expected to  have) the skill needed to outperform the market compared to amateurs, the evidence from 50 plus years of research suggests:

"...for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. At least two out of every three mutual funds underperform the overall market in any given year."

Now, what about wealth advisors? Kahneman looked at data for some anonymous wealth advisers to figure out whether the same advisers consistently achieved better returns for clients and display more skill than others. Once again...

"The results resembled what you would expect from a dice-rolling contest, not a game of skill."

So what was the response from the directors when they heard of the findings? Kahneman says he and Richard Thaler told the directors the following:

"What we told the directors of the firm was that, at least when it came to building portfolios, the firm was rewarding luck as if it were skill. This should have been shocking news to them, but it was not. There was no sign that they disbelieved us. How could they? After all, we had analyzed their own results, and they were certainly sophisticated enough to appreciate their implications, which we politely refrained from spelling out."

Then later Kahneman added:

"...I am quite sure that both our findings and their implications were quickly swept under the rug and that life in the firm went on just as before. The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions — and thereby threaten people's livelihood and self-esteem — are simply not absorbed."

Not surprisingly, when they reported the finding to the wealth advisers themselves the response was similar. Kahneman closed with the following:

"...overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion."

In the 1970s, the work of Kahneman (in collaboration with Amos Tversky) challenged the flawed but once prevailing wisdom in social science that people generally acted rationally and selfishly (in some ways still alive and well even if to a lesser extent). First, they showed that mental shortcuts (heuristics) are useful but "lead to severe and systematic errors." Experiments they did revealed "cognitive biases" or unconscious errors of reasoning. Later, their prospect theory exposed flaws in the dominant models in economics at the time. The basic assumption that people will always act rationally and in their own interests was wrong.

For Kahneman and Tversky, it was obvious that people are not fully rational nor selfish.

In 2002, Kahneman won the Nobel in economic science. What's at least notable about winning such an award is that Kahneman is a Professor of Psychology.

I am currently reading Kahneman's "Thinking, Fast and Slow". The book covers, along with much else, the many forms of cognitive bias. It does a good job of explaining why the assumption embedded in traditional economic models that humans are coldly rational actors is flawed. I've found it insightful and useful for investing and beyond. It is a comprehensive (and, though accessible, I mean comprehensive!) look at the reasons why we sometimes act just a bit less than rational.

To me, Kahneman seems most interested in allowing the implications of the better ideas in his field to speak for themselves, while recognizing their limitations, and noting some of the key disagreements among colleagues, where applicable.

To me, it's a refreshingly humble approach.

Adam

Related posts:
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* Terrance Odean is the Professor of Finance at the University of California, Berkeley.
** Based upon Terrance Odean's and Brad Barber's paper: "Trading Is Hazardous To Your Wealth".
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, April 5, 2012

Jamie Dimon's 2011 Annual Shareholder Letter

In his latest letter to the shareholders of Berkshire Hathaway (BRKa), Warren Buffett had this to say about the CEO of J.P. Morgan ((JPM), Jamie Dimon:

One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; I recommend that you read his annual letter.

Recently on CNBC, he also was very complimentary of Jamie Dimon's annual letter and said he owns some J.P. Morgan shares personally.

Well, Jamie Dimon's 2011 letter to J.P. Morgan shareholders was just released and it is a very good one.

Some excerpts from Dimon's latest letter:

$ 1.8 Trillion of Capital and Credit
During 2011, the firm raised capital and provided credit of over $1.8 trillion for our commercial and consumer clients, up 18% from the prior year.

On Buybacks and Dividends
We also bought back $9 billion of stock and recently received permission to buy back an additional $15 billion of stock during the remainder of 2012 and the first quarter of 2013. We reinstated our annual dividend to $1.00 a share in April 2011 and recently announced that we are increasing it to $1.20 a share in April 2012.

J.P Morgan's Stock
Normally, we don't comment on the stock price. However, we make an exception in Section VIII of this letter because we are buying back a substantial amount of stock and because there are many concerns about investing in bank stocks.

It Could Have Been Much Better
Recently, we have begun to achieve modest economic growth around the globe, somewhat held back by certain natural disasters such as the tsunami in Japan. But I have no doubt that our own actions – from the debt ceiling fiasco to bad and uncoordinated policy, including the somewhat dramatic restraining of bank leverage in the United States and Europe at precisely the wrong time – made the recovery worse than it otherwise would have been. You cannot prove this in real time, but when economists 20 years from now write the book on the recovery, it may well be entitled, It Could Have Been Much Better.

A Stronger System
There also should be recognition that the whole system is stronger. Accounting and disclosure are better, most off-balance sheet vehicles are gone, underwriting standards are higher, there is much less leverage in the system, many of the bad actors are gone and, last but not least, each remaining bank is individually stronger.

Best and Highest Use of Capital
Our best and highest use of capital (after the dividend) is always to build our business organically – particularly where we have significant competitive advantages and good returns. We already have described many of those opportunities in this letter, and I won’t repeat them here. The second-highest use would be great acquisitions, but, as I also have indicated, it is unlikely that we will do one that requires substantial amounts of capital.

More on Buybacks
If you like our businesses, buying back stock at tangible book value is a very good deal. So you can assume that we are a buyer in size around tangible book value. Unfortunately, we were restricted from buying back more stock when it was cheap – below tangible book value – and we did not get permission to buy back stock until it was selling at $45 a share.

Our appetite for buying back stock is not as great (of course) at higher prices.

Dimon does also say that they plan to buy back the amount of stock that we issue every year for employee compensation because "we think this is just good discipline".  I find that to be a bit disappointing but the statement that follows provides some reassurance they won't do that kind of thing at any price:

Rest assured, the Board will continuously reevaluate our capital plans and make changes as appropriate but will authorize a buyback of stock only when we think it is a great deal for you, our shareholders.

The statements "our appetite for buying back stock is not as great" and "will authorize a buyback of stock only when we think it is a great deal" should be the norm among CEOs but that kind of discipline is far from a given.

Adam

Established long positions in BRKb and JPM at less than recent market prices

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, April 4, 2012

Is a $ 1 Trillion Market Cap in Apple's Future?

There have been some recent headlines made by analysts who are predicting that Apple (AAPL) stock will hit $ 1,000/share.

Brian White of Topeka Capital Markets said he expected it to happen within 12 months while Gene Munster of Piper Jaffrey said it would be more like by 2014.

Apple May Be World's First Trillion Dollar Company

Are these predictions at all similar to the kind of price targets that happened during the tech bubble?

Well, I doubt we are there yet but I readily admit to not being a fan of the whole price target game. Never have been and never will be. I also realize the price target folly that goes on is not going away anytime soon.

So I'll leave the guessing what a stock will do over a shorter time frame like 2 or 3 years to others.

To me, it has always made more sense to to buy what I understand at a discount to a conservative estimate of hopefully well-judged worth, then let it compound for years to come.

Other than that, just monitor the strength of the core franchise and sell only if something fundamental materially breaks (and occasionally, if reluctantly, when it gets extremely expensive or the capital is needed for a clearly superior alternative).

Well, that's true for most investments I've made but, as I'll get to later in this post, it's not easy to do with something like Apple (at least not easy for me).

So will Apple soon be intrinsically worth $ 1 trillion? More importantly, will it be able sustain and increase that value for a long time?

Let's look, somewhat simplistically, at the kind of assumptions that are needed to get Apple to a $ 1 trillion valuation.

Assumptions
15% earnings growth in 2013 and 2014 (I think many are expecting more than that)
Dividends and buyback plan is executed as announced
15x enterprise value/earnings
Shares outstanding remain roughly the same (per Apple's recent announcement, buybacks are to neutralize share dilution)

With 15% growth in earnings through 2014, by my math Apple will have over $ 200 billion in cash after paying the dividends and executing the buyback. That 15% level of growth suggests Apple will be earning roughly $ 55 billion in 2014.

15x that amount of earnings results in an enterprise value/earnings of $ 825 billion.

Add in the $ 200 billion of cash and you get a $ 1 trillion market cap.

For those willing to buy the above assumptions the stock may not seem expensive now. Yet, while I own shares of Apple (disclosure: purchased at less than 1/3 of yesterday's closing price), the risk/reward of buying near what it sells at now is far less comfortable for me.

It's not that the stock is expensive compared to current earnings. Certainly not at roughly 12x enterprise value to 2012 earnings even after this most recent run up in the stock price.

It's that, unlike most other things I own, it's difficult to judge what Apple's normalized earnings are likely to be longer term. There is a wide range of outcomes (seemingly now more on the upside than downside these days, but that's often the time to start being skeptical) and the safety margin seems either too small or not knowable.

I can see why others will likely still see the stock as still a good opportunity and they may turn out to be right. Apple's near term prospects are hard to argue with and, considering their track record, will probably even continue to surprise on the upside.

I just have no idea and I'm not willing to risk additional capital based upon the assumption that $ 50 billion plus in earnings, if achieved in 2014, will be a sustainable number that can be built upon for years to come. (Apple very well may prove it is more than sustainable, but no one gets to invest in retrospect.)

In other words, I'm being conservative in my estimate of intrinsic value by not assuming that $ 50 billion plus will be sustainable.*

What's the normalized earnings for a company like Apple that has seen its recent earnings explode higher?

Maybe still a lot higher but who knows in an industry as dynamic as the one Apple competes in. Among other scenarios, it's also possible this is a temporary explosive spike in earnings that, as competition pressure margins somewhat, eventually settles in at a lower level and then Apple grows from there. Apple would remain a terrific business if that happened, but the stock would seem a whole lot less cheap.
(Of course, this was also a possibility a few years back. It's just worth considering that Apple has gone from earning just under $ 5 billion in 2008 to a current estimate of ~$ 40 billion this year. So while, with the benefit of hindsight, this concern may also prove to be too early at least some caution seems warranted considering how dramatically the earnings picture has changed in a short time.)

When earnings capacity changes this much in a relatively small window of time (both a large percentage change and a large absolute number by any measure), it seems wise to at least start considering some of the less desirable scenarios instead of blindly extrapolating into what now seems a blissful future.

I don't doubt the stock could go up from here but eventually an investment gets to the point where, at least near the current price, it's not clear to the owner (me) what the longer run downside risk is (again, even if it turns out to be a wrong judgment after the fact).

So, while I may not be selling the shares I already own anytime soon, what seemed a clear margin of safety when I initially purchased Apple's stock is, to me, much harder to see.

Can Apple can become worth $ 1 trillion and make it stick longer term? As good as Apple is, that's still too hard to figure out. I mean, the durability of any company that resides in a dynamic industry is difficult to figure out but, of course, Apple is not just any company.

Over the next five years or so, Apple's upside is or at least seems just fine compared to just about any large cap. I don't doubt they may get to $ 1 trillion or more in market value. They may even seem worth it for a while (Or end up actually being worth it. Remember: I'm not selling yet...I'm just not buying!).

The math required to get there isn't aggressive.

Having said that, I know of some great (if far more boring) business franchises in less dynamic industries that, if bought at the right price, still have a far easier to gauge long-term risk/reward for my money.

That's my comfort zone.

Apple's business is not. As I've explained here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment.

Of course, few can probably match Apple's potential near-term (and possibly even longer-term) term prospects. 

I have owned Apple's stock the past three years or so for the simple reason that the price became ludicrously low compared to its rapidly growing intrinsic value. Its cash generation and net cash on the balance sheet provided a margin of safety. That margin of safety seemed large and turned out to be even larger than could have been known at the time (at least by me). As always, the price paid relative to likely value dictates the risk one takes on an investment.

Eventually, the discount to value gets so low that something I normally would not like to own becomes attractive.

Apple's business has a far wider range of outcomes than I usually like so it's kept on a shorter leash than most other things I own. The underlying economics are terrific now, but the durability of it's economics over many years will never be easy to judge. In contrast, selling something like Coca-Cola  (KO) would never be a consideration just because it became somewhat expensive (Though if it ever becomes late 1990s expensive again I certainly will be selling some shares!)

The fact is, I never will be the best candidate to own Apple's shares long-term (others are more qualified), but I wouldn't want to be betting against the company's future prospects either.

It's always about price versus value and I've just decided to think more conservatively about Apple's likely intrinsic value. As more evidence comes in, I will adjust accordingly.

Adam

Established a long position in AAPL at much lower than recent market prices

Related post:
Technology Stocks

* Others, of course, can do whatever they want but, for me, capital preservation is paramount. Apple may continue to do very well but missing that kind of opportunity doesn't bother me. I like certain attractive returns...not risky ones. It's not difficult to understand why value-oriented investors sometimes buy "too early" and sell "too early". What seems to be a bargain becomes an even bigger one. When something becomes expensive it ends getting even more so.
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