Friday, August 31, 2012

Tech Dividends

Below are several articles on dividends. Most of  them are focused on technology sector dividends.

With sources of reliable income so tough to come by these days, investors seem to be chasing after yield. That has pushed up the valuations on many traditional dividend paying stocks. That trend is worth keeping an eye on.

Hopefully it will reverse sooner than later.

This article calls Southern Company (SO) and Verizon (VZ) the "poster children" of highly valued dividend payers.
(Though neither stock has performed all that well this year. In fact, Southern Co. stock is actually down slightly year to date. So these two came into 2012 rather pricey.)

Barron's: The Danger In Dividend Stocks

It's not just utility stocks like Southern Company and telecoms like Verizon (both sell for ~17x earnings).

Many stocks in the consumer staples sector are also no longer exactly cheap. They may not be late 1990s overvalued, but a bunch of them are hardly a bargain these days.

This article is focused on the fact that technology companies, historically not a big source of dividends, are now becoming meaningful payers. In fact, in terms of total dollars paid, the sector is now the biggest contributor of dividends to the index. That's hard to imagine when you consider how insignificant and rare dividends were among tech stocks around the time of the go-go technology bubble years.

Barron's: A New Approach to Income

Many dividend-oriented funds do not have a heavy weighting in tech stocks because the funds are based on indexes that require/favor a long dividend paying history. So it hasn't been easy to directly benefit from the increase in dividends without investing in the individual stocks.
(Though there's at least one fund that's trying to address this problem that's mentioned in the article. There will probably be more.)

While tech stocks may make the biggest dollar contribution of dividends to the S&P 500, the average yield for tech is still less than the average for the index itself.

Yet it's worth pointing out that the average masks the fact that some large cap tech stocks are now paying dividends approaching 3 percent and even more. More importantly, many of those dividends are backed by substantial free cash flows, pristine balance sheets, and dividend payout ratios that are relatively low.

So the capacity to increase dividends over time would seem to be there.

A comfortable dividend payout ratio is not an insignificant consideration. Utilities and telecom stocks may have higher dividends, but many have payout ratios that represent a substantial portion of earnings. Ultimately, it is the earning power that backs the dividend that matters.

Here's some more articles on tech stock dividends:

USA Today: Who Woulda Thunk It? Tech stocks new dividend leaders

The New York Times: Finding Dividends in Unusual Places

Wall Street Journal MarketBeat Blog: Dividends and Tech Stocks: Silicon Valley All Grown Up

Of course, what matters most is whether those dividends can be sustained and grown over a very long period of time. For most technology businesses, it's hardly easy to foresee what will happen to their core franchises many years from now.

That's the big advantage to stocks in the consumer staples sector. Hopefully they'll get cheap again sometime soon.

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.

Wednesday, August 29, 2012

The Cost of Complexity

I mentioned in my post on Monday that:

In [Donald] Yacktman's view, businesses with both low capital intensity and low cyclicality (Coke: KO, Pepsi: PEP, and P&G: PG are the specifics mentionedare likely to earn the highest returns.

The benefits owning shares in quality businesses long-term (especially if bought when occasionally selling at a fair or better than fair price) comes down to potential returns relative to risk.

Simple to understand? Certainly. Easy to implement as a core investing approach? A bit less so.  

The evidence to support the merits of owning shares in these kinds of businesses long-term isn't hard to find nor is it particularly complicated. A simple insight can sometimes trump details and complexity. When it occasionally does, use it. What's simple can beat the complex and, in fact, often does.

Yet simple isn't always better. It is just that what is used should be neither more simple nor more complicated than it need be.

It's possible, of course, to make things too simple.

Science views complexity as a cost. That additional complexity must be justified by the benefits. 

"In science complexity is considered a cost, which must be justified by a sufficiently rich set of new and (preferably) interesting predictions..." - From the book "Thinking, Fast and Slow" by Daniel Kahneman

Well, investors ought to view complexity in a similar way. 

Investing is always about getting the best possible returns, at the lowest possible risk, within one's own limits. Since it is already inherently enough of a challenge, there's no need to make it more so by adding unnecessary complexity. Don't use calculus when arithmetic will do the job. Save the more powerful tools for when they can actually add value (and especially avoid some of the worse-than-useless overly complex theories taught by modern finance).

Now, just because something is relatively simple doesn't mean lots of homework isn't necessary.

There absolutely is lots of hard work involved.

The reason for and advantage of owning shares in some of the quality franchises -- superior returns at less risk if bought well -- is clearly not all that difficult to understand. Having enough discipline, patience, and the right temperament to stick with it is the tougher part. 

Well, that and maybe not becoming distracted by the various forms of investing alchemy cloaked in incomprehensible faux sophistication: 

"...most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins'." - Warren Buffett in the 1987 Berkshire Hathaway Shareholder Letter

Quality stocks. Less drama. Little mystery. Effective. 

Think of them as the "two aspirins" of investing. 

I'm sure that many will still choose to own shares of the highest quality stocks primarily for "defensive" purposes. I doubt that changes anytime soon. Somehow, the thinking goes, they'll jump in and out while not having mistakes and frictional costs to subtract from total return. Sounds good in theory. I'm sure there are even some who can make that sort of thing work for them. There are likely even more who incorrectly think they can.

So, despite the evidence, investing in high quality businesses long-term remains an approach that's still not frequently employed.*
(I mentioned in the previous post that Jeremy Grantham has described these high quality businesses as the "one free lunch" in investing.)

It's a subject I've covered many times on this blog (okay...maybe too many times based upon the number of related posts I have listed below) because it just happens to have been and remains a cornerstone of investing for me.

Unfortunately, investors need more patience now compared to when valuations were quite attractive not too long ago (though at least it's not nearly as bad valuation-wise as it was a decade or so ago). Most of the best quality enterprises are rather fully valued right now.
(Over the shorter run -- less than five years -- anything can happen as far as relative performance goes. It's the longer time horizons -- more like twenty years or so -- that the "offensive" merits of high quality businesses become more obvious. A full business cycle or two. I realize that some, or maybe even many, market participants consider five years to be longer term these days.)

Still, it makes sense to embrace any simple, understandable, yet effective method of delivering above average risk-adjusted returns while generally avoiding the esoteric.**


Finally, the assessm
ent of risk is necessarily imprecise and is certainly not measured by something like beta. Real risks does not lend itself to the all too popular quantitative methods. What can be measured, should be, but much of the important stuff can't be measured all that well. 
It requires a mixture of both quantitative and qualitative.

"You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." - Charlie Munger in this speech at UC Santa Barbara

When it comes to managing risk (and many other things), it's often a mistake to allow the less important but easy to measure stuff to triumph over what's more meaningful if tougher to measure. 

Adam

Long positions in KO, PEP, and PG established at much lower than recent market prices. No intention to buy or sell shares near current valuations.

Related posts:
The Quality Enterprise, Part II - Aug 2012
The Quality Enterprise - Aug 2012
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Grantham: What to Buy? - Aug 2011
Defensive Stocks Revisited - Mar 2011
KO and JNJ: Defensive Stocks? - Jan 2011
Altria Outperforms...Again - Oct 2010
Grantham on Quality Stocks Revisited - Jul 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - Nov 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - Apr 2009
Best and Worst Performing DJIA Stock - Apr 2009
Defensive Stocks? - Apr 2009

* To me, the shares of many of these businesses are not especially cheap these days even if they have been at times over the past few years. It's worth waiting for a good price then acting decisively when valuation is attractive. Since each is unique, the necessary homework to build some depth of knowledge and understanding can be done while waiting for the right price. These may be lower risk but they're certainly not no risk. Margin of safety still matters. There's no way around the preparation and patience required in investing. 
After figuring out what's attractive at a certain price lots of waiting is inevitably necessary.
** Some may become bored by the straightforwardness. A few may even choose more complicated, high risk journeys just to enhance the challenge. Long-term Capital Management (LTCM) comes to mind. Charlie Munger said it best in this 1998 speech:

"...the hedge fund known as 'Long-Term Capital Management' recently collapsed, through overconfidence in its highly leveraged methods, despite IQ's of its principals that must have averaged 160. Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger's 1998 speech to the Foundation Financial Officers Group

Uncomplicated, understandable, yet effective ways to produce attractive risk-adjusted returns should be embraced. Sophisticated or esoteric methods, especially those involving leverage, should not. Best to be wary of overconfidence in any profession. It can get even the most talented into trouble.


Munger's Speech to Foundation Financial Officers - 1998
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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, August 27, 2012

Yacktman: Above Average Businesses, Below Average Prices

Here's a good GuruFocus interview with Donald Yacktman and Russell Wilkins of the Yacktman Funds. Check it out in its entirety. 

Some highlights (all excerpts below are Donald Yacktman quotes):

Above Average Businesses, Below Average Prices
"...one of my children said to me once, after dinner when we were talking about investing, 'Now let me see if I have this right, Dad. Basically what you're saying is if you buy above average businesses at below average prices, then on average it's going to work out?' I said, 'Yes, that's basically it.'"

So much for using complex formulas to boost returns.

On Patience
"So many people in this business think in terms of 10 minutes, or 10 hours, or 10 days, or 10 weeks, or 10 months, not 10 years. Very few people have the inner strength or patience to wait it out."

On Focus
"We are focused on a fairly narrow universe of companies we know well."

On Capital Intensity and Cyclicality
The interview includes a useful chart that Donald Yacktman used to demonstrate the business characteristics he and his team find attractive. On the y-axis is capital intensity and on the x-axis is cyclicality from high to low. It's a simple but useful way to think about businesses. As an example, they have consumer staples shown as low capital intensity and low cyclicality.

I'd add that greater cyclicality and capital intensity means that a strong balance sheet is a must. Too much financial leverage can get any business (anyone) in trouble, but excess financial leverage with highly cyclical and capital intensive businesses is just asking for it.

In Mr. Yacktman's view, businesses with both low capital intensity and low cyclicality (Coca-Cola: KO, Pepsi: PEP, and P&G: PG are the specifics mentionedare likely to earn the highest returns.*

Jeremy Grantham has previously described the higher quality stocks as the "one free lunch" in investing.
(Coca-Cola, Pepsi, and P&G are all in the top 25 of the GMO Quality portfolio)

I happen to think that sometimes, even if rarely, a simple insight can trump details and complexity. When it occasionally does, use it. A simpler approach can beat the complex and, in fact, often does.**

Back to the Yacktman interview:

On Valuation
The managers at the Yacktman funds have mentioned the following mantra on prior occasions:

"It's almost all about the price." 

Well, the chance to buy a good business cheap is usually when it is experiencing difficulties. During the interview, Russell Wilkins also points out sometimes a stock gets cheap when prospects for a business seem solid but unexciting.

On Growth
Yacktman points out that many businesses, especially the high growth ones, have difficult to project long-term prospects. That high growth doesn't generally last very long, yet valuations of fast-growers often assume growth will continue for an extended time. 

"...the problem is that the market has a central tendency to overprice things, and put very high multiples on companies that are growing quickly, even if it is for a short period."

Well, when high growth selling at a premium price disappoints, watch out below. 

On Hewlett-Packard, Microsoft, and Cisco
Hewlett Packard (HPQis cheap but its history of doing dumb things with cash (Yacktman specifically mentions the value destroying event that was the Autonomy purchase) and their relatively high net debt has kept it a smaller position for the Yacktman team.

The Yacktman team is more favorable toward Microsoft (MSFT) and Cisco (CSCOconsidering their also cheap valuations but much stronger balance sheets. As a result, both of those stocks are larger technology positions than Hewlett-Packard.

Special situations like Hewlett-Packard have been some of their biggest winners but they recognize that these have a higher probability of not working out. So they tend to keep positions like Hewlett-Packard on the smaller side.

Check out the full interview.

Adam

Long positions in all stocks mentioned

* To me, the shares of many of these businesses are not especially cheap these days even if they have been at times over the past few years. It's worth waiting for a good price then acting decisively when valuation is attractive. Since each is unique, the necessary homework to build some depth of knowledge and understanding can be done while waiting for the right price. These may be lower risk but they're certainly not no risk. Margin of safety still matters. There's no way around the preparation and patience required in investing. After figuring out what's attractive at a certain price lots of waiting is inevitably necessary.
** Some may become bored by the straightforwardness. A few may even choose more complicated, high risk journeys just to enhance the challenge. Long-term Capital Management (LTCM) comes to mind. Charlie Munger said it best in this 1998 speech:

"...the hedge fund known as "Long-Term Capital Management" recently collapsed, through overconfidence in its highly leveraged methods, despite IQ's of its principals that must have averaged 160. Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger's 1998 speech to the Foundation Financial Officers Group

Uncomplicated, understandable, yet effective ways to produce attractive risk-adjusted returns should be embraced. Sophisticated or esoteric methods, especially those involving leverage, should not.

Munger's speech to the Foundation Financial Officers Group - 1998
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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, August 24, 2012

eBay's Valuation

A follow up to this prior post on eBay (EBAY).

In that post, I contrasted how little eBay's free cash flow had changed in the past five years or so relative to what have been huge changes in enterprise value.

The story didn't sound great at the time (and headlines certainly weren't good) but the company's free cash flows were persistent even during the depths of the financial crisis.

Hardly a meaningful wobble in the scheme of things even if growth was unimpressive.

Free cash flow has hovered consistently at $ 2 billion or slightly above over the past five years. (Though, as I mentioned in the previous eBay post, free cash flow is reduced quite a bit when stock-based compensation is taken into account. I use the adjusted number to value the company.) Yet, since just 2010, the company's enterprise value has fluctuated from roughly $ 20 billion to, more recently, around $ 55 billion.*

Quite a range of values for similar free cash flows. The story itself sounds better now, and to an extent actually is.

Unfortunately, when the story sounds and feels good you can't usually buy an attractive business at a discount.

eBay's Free Cash Flow

In early 2010, I took a look at how little respect eBay was getting as far as valuation goes while Amazon (AMZN) certainly was. Both stocks are up substantially since then. In fact, eBay is now a rather expensive stock, at least by my criteria, while the already expensive Amazon has just become even more so.**

Then, like now, I had no idea what either stock would do. I just thought eBay was available at a discount to a conservative estimate of its intrinsic business value. Both remain businesses that seem to have good or better long run prospects.

I'm certainly not saying eBay isn't doing better these days. I'm just saying price matters and whatever the company has going for it now that it didn't have 2 to 3 years ago didn't make enterprise value nearly 3x higher. It was a good business then. It's a good business now. Real intrinsic values rarely change that quickly but perceptions of value certainly do. All a good story does is make an investor pay more for the privilege of ownership. Better to buy when the story sounds pretty horrible. A working assumption that eventually even good businesses will go through ups and downs (some of them more material than others) isn't a bad one to have at all. Buy shares of sound businesses when the headlines are unflattering (and the share price reflects it) then wait for the good times to return. This takes patience and an even temperament, not genius.
(And, well, at least decent judgment of business value.)

Stock prices will always fluctuate much more so than actual business value and a long-term investor can make those fluctuations work for them. Those with a shorter times horizon are slaves to price action.

"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

The word invest -- from the latin vestire -- means to wrap oneself up in something. Well, those willing to get wrapped up in owning part of a business for a long time improve their chances of really understanding it. A greater depth of knowledge about what one owns is likely to lead to better judgments over the long haul. It is tough for one person to truly understand the risks and prospects of lots of different businesses. Getting to know a smaller number very well and owning them a very long time seems, at least to me, much more doable.

The key, as always, is to avoid businesses that lack a sustainable moat. I mean, it's just as possible to wrap oneself up in something that will fail miserably. A business with a collapsing moat is no fun to own at all. What seems cheap is an illusion. Not exactly a recipe for outsized returns.

Successful long-term investments do not come down to whether a business runs into near-term difficulties. Missing a quarter of earnings or even several is no disaster. I know some will jump in and out of what they own based upon near term factors. They may even be very good at it. I suppose that's fine but, for most mortals, that's tough to do consistently well.

It naturally also triggers lots of unnecessary frictional costs.

It's not that eBay is one of my favorite businesses (and I would not even consider buying the stock near the current price), but I liked it well enough to buy when it had that nice margin of safety not too long ago.

The stock also remained cheap for an extended period so there were plenty of chances to buy it. So for what was a few years it was given little respect. Ugly headlines and unresolved very real business issues kept the buyers away. The best long-term investments will sometimes look and even feel pretty dumb at the time (and occasionally for an extended time). Cheap stocks often get even cheaper. That's no problem if intrinsic value isn't being destroyed.***

The focus needs to be on changes to the factors that determine value not price action. Hanging in there while the business issues, sometimes rather serious ones, are being resolved can be the toughest part.

Good times make it nearly impossible to buy any good business with enough margin of safety. Lacking that margin of safety, it's much more difficult for investors to ride out the inevitable storms and deal with unpredictable changing tides.

The most important thing, of course, is to distinguish between a business that may have stalled but will regain traction from those that will not. Easier said than done. Those not justifiably confident they can tell the difference will likely end up losing lots of money.

Otherwise, a business with stalled growth still producing an attractive return on capital that's sustainable can make for a sound long-term investment when bought at the right price.

Growth is often overrated.

Adam

I maintain a long position in eBay established at much lower than recent prices. No intention to buy or sell shares near the current price.

Related posts:
eBay's Free Cash Flow
Technology Stocks

In 2010 stock prices had rebounded substantially from the financial crisis lows. eBay's enterprise value actually briefly dropped to under $ 10 billion back in 2009. I've used the 2010 valuation because at least things had settled down a bit. Like many others, eBay's extremely low valuation in 2009 was heavily influenced by macro factors.
** I have very substantial respect for what Amazon seems to be trying to do long-term. I'm speaking strictly of market price relative to what I think is an extremely difficult to estimate (at least for me) intrinsic valuation.
*** A lower stock price is actually a good thing since more shares at a cheap price can be bought back by the company (and can be accumulated by long-term oriented owners).
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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, August 22, 2012

John Bogle: The Clash of the Cultures

John Bogle has written a new book with the title:

The Clash of the Cultures: Investment vs. Speculation

The book is his 11th and seems, at least in part, an expansion of this essay written by Bogle:

The Clash of the Cultures

The essay is well worth reading with lots of useful insights. I suspect that's the case for the book as well.

In the essay, Bogle argues that today's model of capitalism has lost the optimal balance between the two very different cultures of speculation and investment. It is, in his view, to the detriment of society. From the essay:

"As a member of the financial community, I'm concerned about these changes. I'm also concerned as a member of the community of investors, and as a citizen of this nation. The issue that concerns me is, simply put, today's ascendance of speculation over investment in our financial markets; or, if you will, the ascen­dance of the culture of science -- of instant measurement and quantification -- over the culture of the humanities of steady reason and rationality."

To me, it's partly an emerging preoccupation with measurement over meaning.

In no particular order, here's my take on some of John Bogle's notable lessons and insights (among many):

- In the book he 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 system now has more than 99 percent speculation for less than every 1 percent of actual capital formation. Keep in mind that this whirlwind of speculation is not limited to stocks. There's been an explosion of derivatives trading (to say the least) as well. We'd benefit from more focus on intelligent capital formation and less energy spent on the zero-sum (or worse) activities. It certainly would seem to be better use of our brightest minds (His essay compares slightly different numbers: Bogle 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.)

- There's a big difference between "value-creating" activities and "rent-seeking" activities. One adds value to society while the other subtracts value. Trading by definition subtracts from investor returns as a whole and the costs of all this trading creates a real economic drag. Some of those costs are easy to measure, some are not, but all are very real. This is really no different than what Warren Buffett separately referred to as Newton's 4th Law and The Invisible Foot. It's the "croupier's" take. As an investor, minimize those costs and you can end up way ahead in the long run. As Bogle points out:

"In investing, you get what you don't pay for."

- He also is leery of investors being charged excessive amounts for slickly marketed but overly complex advice or investing strategies. Buffett made a similar point:

"...most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins'." -Warren Buffett in the 1987 Berkshire Hathaway Shareholder Letter

- Bogle considers the proximate cause of our current predicament to be what he calls the "Double-Agency Society" that has evolved over the past several decades.* Essentially we now have large corporate manager/agents interacting with large investment manager/agents who focus excessively on near-term stock price fluctuation over long-term intrinsic value creation. Of course, there are very good corporate managers and investment managers. Yet, too much money is now engaged in speculation with little interest or concern for long term effects. If too many of those agents are primarily focused on the near-term price action and outcomes, who picks up the slack when it comes to building entities with enduring value? Who is really looking out for long-term shareholder interests?

More from Mr. Bogle's essay:

"If market participants demand short-term results and predictable earnings (even in an unpredictable world), corporations respond accordingly."

If you're likely selling the stock soon long-term outcomes aren't going to be front and center. Fixing poor corporate governance isn't going to be of primary importance. Nor is making sure the long-term interests of owners are served over the interests of management. In other words, the persistent effective application of capital (financial and intellectual) with some scale and a focus on long-term effects matters to civilization. We end up with much unrealized potential when so many participants are focused on what are really just narrow short-term oriented games.

As at least part of the solution, Bogle argues strongly in favor of a "fiduciary society" -- where manager/agents are required by federal statute to place the interests of owners first -- to replace the current "agency society".

I'm sure more than that needs to be done but it seems a pretty good place to start.

Bogle: A Crisis of Ethic Proportions

*****
My focus in investing happens to be on individual equities while Mr. Bogle's certainly is not.

In fact, he's very clear on this point. He thinks most investors should not be buying individual equities.

Despite this key difference, his wise advice (and conscience) has always been very useful to me and I suspect may be to just about any long-term investor.

In Mr. Bogle's view, investors should capture the growth in intrinsic value of corporations in a broad index using a vehicle that minimizes frictional costs. It's very hard to argue with that approach since the evidence is strong that too few investors actually do better than a broad equity index.**

Still, I don't follow his specific advice since I'm a buyer of individual stocks. I also prefer a more concentrated portfolio. Yet I own individual stocks with a similar set of principles and objectives in mind.

My results are similarly derived from the growth in intrinsic value of the businesses themselves over a very long time frame (that and consistently buying shares at a clear discount to my estimate of intrinsic value), not some special aptitude on my behalf to jump in and out of their shares at precisely the right time. My emphasis is always on long run compounding effects -- the growth in per share intrinsic value of good businesses -- while minimizing frictional costs.

I simply attempt to capture the long-term intrinsic value growth of a more limited number of businesses compared to a more broad-based index. The downside, of course, is if my judgment of individual companies and their long run prospects is not consistently sound.***

If I wasn't comfortable with buying individual stocks I'd certainly also use index funds. Either way, I'd never trade. It's a simple matter of knowing where one's limits lie and staying well within those limits.

Some final thoughts. I'm never trying to outguess or "play" market price action. It's my view that too many are involved in that sort of thing. The market is there to serve. If a stock I want more shares of gets cheap, I buy it with the intent to own for a very long time. Occasionally, the market in general or a specific stock goes to the other extreme and requires some action, but I rarely sell shares I like just because they've become a bit expensive. My reason for selling will usually be more along these lines:

The opportunity costs are high. In other words, capital from one long-term investment is needed to fund another long-term investment that has plainly superior prospects.

I think that buying/selling should be kept to a minimum and it's not just because of the associated frictional costs. It is because each move is just a chance to make a mistake, but the illusion of control sometimes masks this reality. So, at least to me, it's best to reduce the number of moves to those where the confidence level is very high.

Otherwise, the price action of markets and of individual securities is of little interest.

Adam

* In 1950, individual investors held 92 percent of equities while institutional investors held 8 percent. These days 70 percent is held by institutional investors.
** I realize it has been a tough decade for many equity indexes. The intrinsic value of corporations had to catch up to the extreme late 90s market valuation. That doesn't make Bogle's approach any less wise. It just means expectations need adjustment. Unfortunately, I doubt the next decade is going to be particularly wonderful for most indexes. It's a very real dilemma for investors.
*** It's a level of diversification consistent with Warren Buffett's and Charlie Munger's thinking:
"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

"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

Yet the right level of concentration depends on the individual investor and their specific circumstances. There's naturally just no one right generalized answer.

Press Release - The Clash of the Cultures
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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, August 20, 2012

Cisco Reports Earnings, Hikes Dividend

Cisco (CSCO) released it's fourth quarter and fiscal year 2012 earnings on Wednesday of last week.

The company earned $ 1.9 billion in the most recent quarter and $ 8 billion for the full fiscal year.

Cisco's free cash flow comfortably exceeded their earnings at $ 9.5 billion in the most recent fiscal year.*

So, at a minimum, it seems fair to say that the $ 8 billion that Cisco earned this past year is a conservative reflection of the company's current earning power.

Buyback activity during the past year reduced Cisco's shares outstanding from 5.496 to 5.354 billion shares. In fact, over the past five years Cisco has reduced their share count by nearly 1 billion shares.
(Since the beginning of their stock repurchase program, Cisco has bought back 3.7 billion shares at an average price of $ 20.36/share.)

Using Friday's close price, Cisco's market value is:

$ 19.06/shares*5.354 billion

= $ 102 billion

Net cash and investments on the balance sheet (cash and investments minus net debt):

= ~ 32 billion

Enterprise value (market value minus net cash and investments):

= $ 70 billion

So, as of last Friday, investors were willing to pay roughly $ 70 billion for a business that earned $ 8 billion or roughly 8.7x earnings. The multiple is more like 7.3x using the $ 9.5 billion free cash flow number.

Also, consider that the stock was selling at roughly $ 15/share as recently as July 25th, 2012. At that price investors were paying just 6x current earnings and 5x free cash flow.**

A multiple of 5-6x implies the expectation of real trouble for the business. At that kind of valuation, all long-term investors really need is for the company really has to prove is that the business is stabilizing -- show evidence that the moat is not collapsing -- while doing a reasonably good job allocating capital over time. No growth required.

Buffett said the following in the 2007 Berkshire Hathaway Shareholder Letter:

A truly great business must have an enduring "moat" that protects excellent returns on invested capital. 

Then later added...

A moat that must be continuously rebuilt will eventually be no moat at all.

Of course, the price action of any stock can be just about anything over the next few years. I'm simply saying that (at least at a 5x to 6x multiple) those with a true long-term investing time horizon simply need earnings to not fall off a cliff and management to not be wasteful of owner capital for the arithmetic to work.

With an earnings yield in the mid-to-high teens (the 5x to 6x multiple inverted) it would seem not much has to go right. At that valuation, the Cisco will naturally generate in cash every 5 to 6 years the company what investors paid up front. If the analysis were only as easy as that. The math is simple, of course, but the key is judging whether the excess cash is truly excess and that the earnings power is truly persistent. In other words, all or most of those earnings must not needed to continuously rebuild the moat.

How well long-term investors consistently judge this matters a bunch. Growth matters less but is a bonus if you can obtain it without paying too much.

Otherwise, buying cheap shares (those selling a plain discount to value) of businesses that have durable high returns on invested capital is the key driver of long-term returns.

A cheap multiple isn't enough.

An investor has to be confident the business can produce returns on invested capital that are both durable and attractive.

An investor has to be confident the excess capital will generally be put to good use.

Back to Cisco. The company's shares certainly don't appear expensive these days. The question that's tougher to answer is the long-term strength/durability of Cisco's moat and whether the company's excess capital will be put to good use going forward.

In a separate press release Cisco announced that it was hiking its quarterly dividend by 75%. As far as returning excess capital to shareholders goes, that would seem to be a meaningful step forward.

Cisco now has a nearly 3 percent annual dividend yield at the current price.

Adam

Established long position in CSCO just below the current price

* I do not include share-based compensation expense in my calculation of free cash flow. The dilutive effect of stock options is potentially very expensive in the long run for shareholders even if share-based compensation expense is also a rather imperfect estimate of what the real costs will be. Unfortunately, it's nearly impossible to gauge precisely what it will really cost so, as an investor, if a company is heavily reliant of stock options for its compensation, I prefer to assume something closer to the worst case. Nothing wrong with being pleasantly surprised if the actual costs to shareholders ends up being much lower. The non-GAAP results that Cisco reports back out share-based compensation expense so they're of little use to me.
** 5.354 shares multiplied by $ 15/share = $ 80 billion market value. Subtract the ~ $ 32 billion in net cash equals $ 48 billion in enterprise value. $ 48/$ 8 billion = 6x earnings. $ 48/$ 9.5 = ~ 5x free cash flow.
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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, August 17, 2012

Berkshire Hathaway's Derivatives Portfolio

A follow up to this recent post on Berkshire Hathaway's (BRKa) derivatives portfolio and its impact on the company's earnings.

Warren Buffett has said that Berkshire's derivatives now largely fall into two categories: Those tied to equity market indices and those tied to high-yield bond indices.

All these contracts provide lots of interest-free float to Berkshire.

So they are very insurance-like and crucially require that little or no collateral need to be posted. These have worked out for shareholders for the simple reason that they were priced right in the first place for the risk.

Buffett has explained, in some detail, the Berkshire derivative positions in past shareholder letters. Here's what he wrote in the most recent letter:

Our insurance-like derivatives contracts, whereby we pay if various issues included in high-yield bond indices default, are coming to a close. The contracts that most exposed us to losses have already expired, and the remainder will terminate soon. In 2011, we paid out $86 million on two losses, bringing our total payments to $2.6 billion. We are almost certain to realize a final "underwriting profit" on this portfolio because the premiums we received were $3.4 billion, and our future losses are apt to be minor. In addition, we will have averaged about $2 billion of float over the five-year life of these contracts. This successful result during a time of great credit stress underscores the importance of obtaining a premium that is commensurate with the risk.

Charlie and I continue to believe that our equity-put positions will produce a significant profit...

Buffett gave an example in the 2008 letter to help better understand the "equity-put" portfolio:

To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at, say, 1300. If the index is at 1170 – down 10% – on the day of maturity, we would pay $100 million. If it is above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to zero. In the meantime, the sale of the put would have delivered us a premium – perhaps $100 million to $150 million – that we would be free to invest as we wish. 

Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indices: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019 and our last on January 24, 2028. We have received premiums of $4.9 billion, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future.

So it's not just that all four equity market indices would have to go to zero for Berkshire to owe the full amount.

They'd also have to do so on the specific termination date of each contract.

When it comes to Berkshire's derivatives portfolio I'm not sure this is always fully appreciated.

What Berkshire ultimately pays, if anything, will be determined by where those indices are on those specific dates. It is then and only then that Berkshire could owe anything and experience more than just a "scorekeeping" loss.

There will certainly be lots of accounting gains and losses reported between now and then for these "equity-put" contracts. There just will be no additional cash paid (other than the already collected $ 4.9 billion in premiums) to or from Berkshire as a result of these so-called gains and losses.*

Let's say all these indices went to zero tomorrow.

Berkshire would, in fact, have a big accounting loss to report but the company would still owe nothing as a result. The only way Berkshire would have to eventually write a big check is if those indices for some reason happen to still be at zero between 2019 and 2028 on the right dates (well, the wrong dates from Berkshire's point of view). During all that time Berkshire will have had the $ 4.9 billion of cash to invest as they choose.

Of course, they don't have to go to zero for Berkshire to end up owing real money. Obviously, the indices may be instead down only somewhat on those future dates and, as a result, Berkshire would owe a proportional amount at that time.

It's also true is that the indices may be higher and Berkshire would owe nothing.

What's not in doubt is that Berkshire will have all that $ 4.9 billion at their disposal to invest during this time.

It all comes down to whether the premiums collected were priced right for the risks. An investor in Berkshire Hathaway has to decide whether Buffett is likely to misprice these contracts and, if so, what are the consequences.

I still think the Derivatives section (bottom of page 16) of 2008 letter does a good job on this subject but you have to read the updates on Berkshire's derivatives portfolio in more recent letters to have a complete picture.

Here's also a post that I did a while back on Berkshire derivatives, if interested.

Buffett also wrote in the latest letter that new requirements on collateral make establishing new derivatives positions less attractive. So expect fewer of them in the future.

I won't miss trying to understand them.

Adam

Related posts:
Berkshire Hathaway: Earnings and the Derivatives Portfolio
Buffett on Derivatives: The 'Chain Reaction' Threat
Munger on Derivatives
Buffett on Derivatives

* As I mentioned in the prior post, the problem stems more from the limitations of the Black-Scholes formula when it comes to very long-term options.
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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, August 15, 2012

Berkshire Hathaway 2nd Quarter 2012 13F-HR

The Berkshire Hathaway (BRKa2nd Quarter 2012 13F-HR was released yesterday. Below is a summary of the changes that were made to the Berkshire equity portfolio.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 1st Quarter 2012 13F-HR.)

As I noted in this post last week, Berkshire was a net seller of equities in the most recent quarter. Note 5 in the latest 10-Q made it fairly clear that a good portion of the selling was one or more of Berkshire's consumer stocks.
(The clue was the drop in cost basis of Berkshire's consumer products equity securities. See Note 5 of the most recent 10-Q then compare to the prior quarter's 10-Q.)

It just wasn't obvious which specific consumer stock (or stocks).

Well, thanks to this most recent 13F-HR, we now know. In addition to selling a large portion of their Johnson & Johnson (JNJ) stake, it turns out positions in Kraft (KFT), and Procter & Gamble (PG) were both cut meaningfully.

Those three stocks made up the bulk of the selling but quite a few other sales, even if relatively small in terms of total dollars, also happened this past quarter.

Details below.

There was also plenty of stocks being bought during the quarter. Some brand new positions were established while Buffett and his portfolio managers continued to build upon existing positions.

Here's what changed during the 2nd quarter:*

New Positions
Phillips 66 (PSX): Bought 27.2 million shares worth $ 1.08 billion
(some shares via spin-off from ConocoPhillips - COP)
National-Oilwell Varco (NOV): 2.8 million shares worth ~$ 214 million

Added to Existing Positions
Wells Fargo (WFC): Bought 16.7 million shares worth $ 567 million, total stake $ 14.0 billion
IBM (IBM):  2.2 million shares worth $ 444 million, total stake $ 13.2 billion
DaVita (DVA): 3.3 million shares worth $ 323 million, total stake $ 910 million
BNY Mellon (BK): 13.1 million shares worth $ 290 million, total stake $ 414 million
DirecTV (DTV): 5.4 million shares worth $ 281 million, total stake $ 1.47 billion
Viacom (VIA-B): 5.2 million shares worth $ 262 million, total stake $ 342 million
Liberty Media (LMCA): 2.5 million shares worth $ 247 million, total stake $ 544 million
Lee Enterprises (LEE): 1.6 million shares worth $ 2.1 million, total stake $ 4.3 million**

In the 2nd Quarter of 2012, there apparently was nothing purchased that was kept confidential. Their 13F-HR filings will often say: "Confidential information has been omitted from the Form 13F and filed separately with the Commission."

Not this time. Unlike the prior 13F-HR, all equity transactions have now been disclosed (the buying and selling in the latest 13F-HR then reflects what was actually bought in the 2nd quarter plus what had been held back). From time to time, the SEC allows Berkshire Hathaway to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

Reduced Positions
Johnson & Johnson (JNJ): Sold 18.7 million shares worth $ 1.28 billion, total stake now $ 707 million
Kraft (KFT): 19.2 million shares worth $ 785 million, total stake now $ 2.4 billion
Procter & Gamble (PG): 13.6 million shares worth $ 907 million, total stake now $ 4.0 billion

Other shares sold with roughly a $ 100 million portfolio impact or less include:
Visa (V) was reduced by ~$ 100 million (27% of shares)
U.S. Bancorp (USB) reduced by ~$ 100 million (4%)
UPS (UPS) reduced by $ 89 million (82%)
CVS (CVS) reduced by $ 79 million (25%)
General Electric (GE) reduce by $ 58 million (36%)
Ingersoll-Rand (IR) reduced by $ 28 million (97%)
Verisk (VRSK) reduced by $ 17 million (16%)
Dollar General (DG) reduced by $ 16 million (8%)
ConocoPhillips(COP) reduced by $ 13 million (1%)

Sold Positions
Intel (INTC) shares were sold outright.

Todd Combs and Ted Weschler are responsible for a portion of Berkshire's portfolio. Any changes involving smaller positions will generally be the work of the new portfolio managers.

Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities is made up of ~  35% financials, 29% consumer goods, 18% technology, and 9% consumer services.

It's certainly notable that consumer stocks have been sold lately but they still make up a substantial portion of the equity portfolio.

The remainder is primarily spread across healthcare, industrials, and energy.

1. Coca-Cola (KO) = $ 15.8 billion
2. Wells Fargo (WFC) = $ 14.0 billion
3. IBM (IBM) = $ 13.2 billion
4. American Express (AXP) = $ 8.6 billion
5. Procter and Gamble (PG) = $ 4.0 billion

As is almost always the case it's a very concentrated portfolio.

The top five often represent 60-70 percent and, at times, even more of the equity portfolio. In addition, Berkshire owns equity securities listed on exchanges outside the U.S.***, plus cash and cash equivalents, fixed income, and other investments that brings the total portfolio value to somewhere north of $ 175 billion (just slightly less than the prior quarter).

The portfolio, of course, excludes all the operating businesses that Berkshire owns outright with 270,000+ employees.

Here are some examples of the non-insurance businesses:

MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar Metalworking, and Lubrizol among others.

In addition, the insurance businesses (BH Reinsurance, General Re, GEICO etc.) owned by Berkshire have naturally provided plenty of "float" for their investments over time and continue to do so.

See page 101 of the annual report for a full list of Berkshire's businesses.

At the end of the quarter Berkshire's cash and cash equivalents alone now total more than $ 40 billion.

That's certainly enough to fund another major acquisition.

Adam

Long positions in BRKb, KO, WFC, AXP, PG, USB, JNJ, KFT, COP, PSX, and GE established at lower than recent market prices.

* All values based upon yesterday's closing price. Naturally, what was actually paid can't be known from the information disclosed.
** The initial Lee Enterprises stake wasn't reflected in the previous 13F-HR. It was instead later disclosed in an amended 13F-HR.
*** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside the United States. The status of those shares are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F-HR is if Berkshire happens to buy the ADR. Investments in things like preferred shares (and related warrants) are also not included in the 13F-HR.
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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, August 13, 2012

GMO's Ben Inker: Death of Equities Greatly Exaggerated

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - Warren Buffett in the 1992 Berkshire Hathaway (BRKa) Shareholder Letter

This should be my last post on growth and returns (a subject I've covered quite a bit in recent years) for a while, but Ben Inker's new white paper provides insights on the subject worth highlighting.

Inker does a good job of explaining the relationship between GDP growth and returns (or lack thereof).

Reports of the Death of Equities Have Been Greatly Exaggerated: Explaining Equity Returns

Two of my recent posts dealt with the relationship between growth and stock returns. The bottom line being that there really isn't one despite what seems to be an obsession with chasing growth often at a high price relative to near-term profitability.

It is the earlier part of Inker's new paper that covers the growth versus stock returns subject very well providing lots of useful charts and data.

From the paper:

"The first point to understand about stock returns is their relationship with GDP growth. In short, there isn't one. Stock returns do not require a particular level of GDP growth, nor does a particular level of GDP growth imply anything about stock market returns. This has been true empirically, as the Dimson-Marsh-Staunton data from 1900-2000 shows. Many investors are utterly convinced that strong GDP growth is the primary reason why one country's stock market will outperform another."

Later in the paper Ben Inker added...

"Insofar as there is any relationship here, it's a perverse one. All else equal, higher GDP growth seems to be associated with lower stock markets returns. How could this possibly be? Don't earnings grow with GDP and stock prices with earnings?"

Well, as it turns out, the answer is no.

Yes, aggregate profits should grow with GDP.

As should overall market cap grow along with those aggregate profits.

The problem is this doesn't reveal much about value on a per share basis. Companies may issue stock to fund growth. They may pay too much for growth or invest in growth that produces a low return on capital for shareholders even if it makes the company, in total, much bigger.

Also, high growth environments attract competition and shareholders, excited by the prospects for growth, tend to pay a premium for high growth prospects.

All this serves to cloud what otherwise would seem to be a much clearer picture.

Sometimes it's the counterintuitive stuff that's most profitable. I think it's worth taking some time to more completely understand the not always so obvious relationship between growth and returns.

Ben Inker's paper deals specifically with the relationship between GDP growth and stock returns yet at least some of the insights apply more broadly.
(ie. A high growth industry is not necessarily a high return industry for shareholders nor do necessarily high growth individual companies.)

"...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain." - Warren Buffett in the 1992 Berkshire Hathaway Shareholder Letter

In specific situations, growth can certainly be a good thing but it is just far less assured than some seem to think. Frequent readers of the blog with find none of this to be unfamiliar territory.

More from the paper:

"Total corporate profits and total stock market capitalization have very little to do with earnings per share or the compound return to shareholders because new companies, stock issuance by current companies, stock buybacks, and merger and acquisition activity can all place a wedge between the aggregate numbers and per share numbers."

Ben Inker's paper covers more than just the lack of correlation between GDP growth and stock returns. In fact, it makes four other major points in some useful detail.

Check it out in its entirety.

Certainly well worth reading.

Adam

Related posts:
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 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, August 10, 2012

Berkshire Hathaway: Earnings and the Derivatives Portfolio

Berkshire Hathaway's (BRKalatest quarterly results revealed that operating earnings grew to $ 3.7 billion from $ 2.7 billion in the same quarter a year ago.

On the surface looks pretty good, right?

Yet net earnings dropped to $ 3.1 billion from $ 3.4 billion.

Less impressive.

So what number better represents the economics of Berkshire?

Berkshire's operating earnings exclude gains/losses from derivatives and other investments. The generally non-cash gains/losses associated with derivatives mean little economically in the near term. It's "scorekeeping" where the "goals" are reversed time and time again. The gains and losses reveal practically nothing about the actual cash that is (or will) changing hands.

So these very lumpy, but economically pretty much meaningless, gains and losses are usually distractions at best.*

From Warren Buffett's 2007 Berkshire Hathaway shareholder letter:

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.

Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire's balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

The quarterly gains and losses may mean little, but the cash Berkshire is paid up front is a very useful source of "float". It's good to be aware of these contracts and understand what they may ultimately effect Berkshire economically (good or bad) a long time down the road, but otherwise is essentially worthless information.

Net earnings was reduced to $ 3.1 billion when including investment and derivative gains (losses) in the most recent quarter primarily because of a just under $ 700 million derivatives loss.

These one time gains and losses create lots of noise (on the upside and downside) that mask how Berkshire's operating businesses are really doing. So it is more useful to focus on the operating earnings while separately keeping an eye on the other stuff.

Buffett has said he believes Berkshire's derivatives position will ultimately be rather profitable (based upon recent shareholder letters it's difficult to not come to a similar conclusion).  If these work out for shareholders, it will be mostly because the contracts were priced right in the first place for the risk. They will also have worked out because little or no posting of collateral was required.

From the 2011 letter:

Though our existing contracts have very minor collateral requirements, the rules have changed for new positions. Consequently, we will not be initiating any major derivatives positions. We shun contracts of any type that could require the instant posting of collateral. The possibility of some sudden and huge posting requirement – arising from an out-of-the-blue event such as a worldwide financial panic or massive terrorist attack – is inconsistent with our primary objectives of redundant liquidity and unquestioned financial strength.

A small percentage of contracts in the past have called for posting of collateral but not anywhere near enough to matter in the context of Berkshire's resources.

To better understand what the derivatives portfolio really means (or may mean) economically for shareholders (as opposed to just the accounting treatment) check out some of the recent letters.**

The Derivatives section (bottom of page 16) of the 2008 letter isn't a bad place to start.

Here's also a post that I did a while back on Berkshire derivatives, if interested.

Given the arcane nature of derivatives it might be best to save that subject for another day. Obviously, it's important to understand this stuff as a shareholder. I'm just saying that it's Friday and there must be something more fun to read going into a weekend.

Related posts:
Buffett on Derivatives: The 'Chain Reaction' Threat
Munger on Derivatives
Buffett on Derivatives

In the end, the quarterly "scorekeeping" of Berkshire's derivatives portfolio doesn't mean much.

It creates noise but offers little perspective.

The derivatives positions held by Berkshire also make understanding the company's financial results more difficult even when Buffett does his best to explain the positions.

Berkshire's financial reporting isn't actually all that complex but certainly requires a bit more work than some other companies.

Adam

Long position in BRKb established at lower than recent market prices

* The problem here isn't so much with mark-to-market accounting. The problem stems more from the limitations of the Black-Scholes formula when it comes to very long-term options.
** Berkshire's largest derivatives positions are generally either tied to equity markets or high-yield bond indices.
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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.
 
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