Wednesday, July 31, 2013

FPA Crescent Fund Commentary: Steve Romick on Microsoft, Oracle, and Cisco

Steve Romick, a managing partner at First Pacific Advisors, LLC, said the following about Microsoft (MSFT), Oracle (ORCL), and Cisco (CSCO) in his 2Q 2013 FPA Crescent Fund (FPACX) commentary:

"These three companies all face real challenges, including poor management and/or competition from new technologies. But we feel, in each case, the prices adequately discount those fears."

Some businesses -- especially those that reside in dynamic industries, with lots of potential competitive threats, and/or frequent technology shifts that can change fundamental business economics -- are wise to have minimal debt and carry lots of cash for defensive reasons. Those that possess a wide economic moat -- large and sustainable competitive advantages -- need no such rainy day fund.

"...all else equal, we prefer companies with strong balance sheets and this group has those. Moreover, even though cash is akin to a lead weight that depresses a company's return on capital calculation, these companies offer a much higher return on capital than the S&P 500."

Whether it makes sense for these businesses to hold on to so much cash or not, it's a mathematical certainty that return on capital is reduced by all the net cash on the balance sheet. The fact these have more than respectable return on capital while carrying all that cash says a lot about their current core business economics. Unfortunately, it says little about what those economics might look like down the road. With the best businesses this is generally not the case. The long run future economic prospects of the highest quality business -- within a range of outcomes, of course -- are far less uncertain and unknowable.

Still, in Romick's view, the three stocks remain far from expensive:

"Our three tech musketeers now trade less expensively than they have versus the S&P 500 median on a historical basis..."

Enterprise Value/Earning Before Interest & Tax (EV/EBIT) and price/earnings ratio (P/E) are the metrics Romick uses to compare the valuation of these tech stocks to the S&P 500.

"These companies had not historically offered a dividend yield, but now with cash flow exceeding internal investment opportunities, they each now pay a dividend and offer yields in excess of the market.

With certain tech stocks an adjustment to earnings (or free cash flow) needs to be made in order to understand the business economics and estimate intrinsic value.

"...our earnings (and revenue) estimates are less than that of Wall Street. We consider "owner earnings" when establishing our base case, rather than GAAP (General Accepted Accounting Principles) earnings. We, therefore, reduce net income by cash used for stock options and further ding earnings for "required" M&A (Mergers & Acquisitions) that we view as imperative to remain relevant and to sustain earnings on a going forward basis."

Adjusting earnings or free cash flow for the cost of options is certainly very important. Some choose to ignore stock-based compensation because it's a non-cash expense.*

Also, what a company spends on M&A sometimes needs to be treated a bit like necessary capital expenditures (required investments to remain competitive and deal with threats to core economics). The problem is that, at times, it's difficult to judge from the outside how necessary the target investment really is and whether management is overpaying for it. In fact, sometimes it's pretty clear they're overpaying. A tendency to overpay for acquisitions has to be subtracted from any useful estimate of intrinsic value. The amount that should be subtracted is necessarily a difficult and imprecise judgment call but very important.**

These points can easily be overlooked. If so, earning power can be made to look more attractive than it actually is. As I've said previously and more than a few times, I'm not a fan of technology businesses though I'll buy shares in them, reluctantly and in small doses, when they're very very cheap.

Romick also added this:

"We can't tell you what the world will look like tomorrow or when Bernanke will raise rates, but we will borrow a line from the investment strategist, Dylan Grice, who said it best when he quipped, 'I'm interested in the possibility of building a profitable portfolio which is robust to my ignorance.'"

Check out the commentary in its entirety. It includes lots of good charts, graphs, and other insights.


Long positions in MSFT and CSCO established at much lower than recent prices

* I
t's worth noting that adding back stock-based compensation (as is done in cash flows from operating activities section of the cash flow statement) boosts free cash flow but, for certain companies, is potentially a material source of future dilution and likely quite expensive for continuing shareholders over the long haul. Yes, it's a non-cash expense but, unlike some other non-cash expenses, it shouldn't be ignored. One way to think of this is to calculate how much net cash would be needed to keep share count stable over time. Well, that incremental cash expended is a very real cost to shareholders and should be subtracted from free cash flow for a better understanding of the business economics. It's, at the very least, a rather big stretch to consider economically meaningful any free cash flow calculation that doesn't attempt to account for the cost of stock-based compensation. For those companies that make heavy use of stock for compensation the cost is very real even if difficult to estimate. The reality is that these potentially material costs are generally rather difficult to pin down with any precision. Unfortunately, with stock-based compensation, the best case that can usually be expected is an estimated range of costs (the economic costs...not the accounting costs). A bit messy? No doubt, but that messiness doesn't mean the costs can be ignored to make it seem more neat than it is. Not everything that matters economically can be precisely quantified. In fact, some of the most important things can't be quantified at all.
** See the end of the Intrinsic Value - Today and Tommorrow section from Berkshire's 2010 letter on the "'what-will-they-do-with-the-money' factor" for more on this. This explanation can also be found toward the end of the past two Berkshire annual reports.)
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, July 26, 2013

Investor Overconfidence Revisited

According to Dalbar, a financial analytics firm, the average stock mutual fund investor had an annual return of 3.83% from 1990 to 2010.

Over that same time frame the S&P 500 had a return of 9.14%.

A 5.31% gap.

This more recent report by the same firm showed a somewhat narrower gap but, not surprisingly, what otherwise was a similar result.

Why Your Investment Returns Could Be Lower Than You Think

This unfortunate outcome is consistent with what their earlier reports have shown.

Though a factor, it's not just high fees that account for the difference.

It's also not necessarily due to poor average mutual fund performance.

A bunch of the gap comes down to investor behavior. For example, buying when the world seems more certain* and the outlook appears to be the rosiest. Selling when it is less so. This pattern tends to result in buying assets when they're not cheap (or worse, rather expensive) and selling when the opposite is true.

That's a tough way to achieve even satisfactory results as an investor.
(Never mind very good results.)

It also results in unnecessary mistakes -- some of which are related to the illusion of control -- while incurring additional and unnecessary frictional costs. Some might expect that market participants would be becoming more aware of this pattern of behavior by now then make the necessary adjustments. Maybe behavior is slowly changing and it just isn't yet being reflected in the numbers. If not, then apparently too many still conclude that it only applies to the other guy.

Basically, investors are generally way more confident in their investment skills than they should be.

Lake Wobegon is the fictional town where "all the children are above average." Well, this article from The Motley Fool mentions the Lake Wobegon effect as it applies to drivers.

Fighting Investors' Greatest Enemy: Overconfidence

It turns out that the vast majority of drivers think they are above average. Those that don't consider themselves better than average being more the exception.

Amazingly, as the article points out, this optimistic self-appraisal persists even when the survey is done of drivers that have just caused an accident serious enough to put them in a hospital.

Charlie Munger has previously referred to a study of Swedish drivers to make a similar point.**

Overconfidence is a dangerous thing for a driver. The same, of course, is true for an investor.

It gets worse. Not only do they tend to believe they outperform the average investor, they overestimate their actual returns. In other words, investors convince themselves they've performed better than they have when a careful look at actual results would reveal otherwise.

From The Motley Fool article:

"...researchers asked investors to estimate their annual returns, and then compared those estimates to the investors' actual returns by checking their brokerage statements. Investors were quite literally clueless about how their investments performed, overestimating their returns by more than 11 percentage points per year. The average investor painfully lags an index fund and thinks he's Warren Buffett, basically."

According to Jason Zweig, one explanation for this tendency comes down to "positive illusions" that may serve to boost self-esteem.

"By fibbing ourselves, we can give a needed boost to our self-esteem."

If results aren't great, and lots of effort has been expended, I guess it's easier to just ignore the reality.

Another explanation comes from hindsight bias that leads to too much confidence in forecasts and predictions. The following Daniel Kahneman quote is used in the same article to further explain:

"Our tendency to construct and believe coherent narratives of the past makes it difficult for us to accept the limits of our forecasting ability. The illusion that we understand the past fosters overconfidence in our ability to predict the future."

Not surprisingly, it turns out the most confident forecasters are the worst forecasters.

Excessive confidence leads to a reduction in perceived risk but, of course, not the actual risk.

Think Long-Term Capital Management (LTCM).

LTCM might be the best example among many of what happens when high IQ meets overconfidence.
(As an aside: Could there be any more perfect name for an entity that couldn't survive beyond just over 4 years?)

Charlie Munger on LTCM & Overconfidence

Charlie Munger once said: "If you totally divorce economics from psychology, you've gone a long way toward divorcing it from reality."

Well, it seems clear that the same can be said about investing.

Munger also added this about the importance of knowing the edge of one's own competency:

"Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It's not a competency if you don't know the edge of it. And Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error."

Investor overconfidence isn't easy to combat but it starts with an awareness of limits and respect for the psychological factors that reinforce it.

Warren Buffett explained it this way in the 1999 Berkshire Hathaway (BRKa) shareholder letter:

"If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter."

More think they know the edge of their competency than actually do know the edge of it. Being vaguely familiar isn't enough. It's truly knowing one's own circle of competence, staying well within that circle, while learning to appreciate the various, sometimes subtle, cognitive illusions and biases that get investors into trouble.

Some will no doubt conclude that it's not terribly important to seriously consider the psychological factors that contribute to lower returns and greater than necessary risk-taking.

They'll decide it somehow doesn't really apply to them.

Those same investors might then, as a result, decide the psychological stuff deserves nothing more than a passing glance.

That's a mistake.


Long position in BRKb established at much lower than recent market prices

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

* I say "seems more certain" because the world is effectively always uncertain even when it doesn't seem to be. Mostly, it is just the perception of certainty that changes. Big surprises should be considered inevitable 
but there's nothing new about that for investors.
** Charlie Munger speaking to the Foundation Financial Officers Group in 1998: "...a careful survey in Sweden showed that 90% of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert's public assessment is that he is above average, no matter what is the evidence to the contrary."
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, July 24, 2013

Apple's Buyback

Back in April of this year, Apple (AAPL) increased its share repurchase authorization to $ 60 billion.

Apple More Than Doubles Capital Return Program

Well, that naturally meant the company's fiscal 2013 third quarter financial results yesterday was going to be the first chance to see how aggressively it is being implemented.

It turns out they bought back $ 16 billion worth of their shares during the most recent quarter alone.

Quite a lot by just about any standard.

Under an earlier buyback authorization, they had bought back much less ($ 1.95 billion) during their fiscal first quarter (that ended on December 29th, 2012) but none in their fiscal second quarter.

Otherwise, meaningful buybacks really haven't been part of the Apple capital allocation plan (even as their free cash flow and cash on the balance sheet have been dramatically increasing over the past decade).

Even if there's less instant gratification, anyone who's invested in Apple for the longer haul should hope the share price continues to remain low as they carry out this repurchase program (and maybe even follow on programs). That way their cash gets more bang for the buck as they repurchase and the share count is reduced by a greater amount for a given amount of funds.

What matters, if the business needs are being appropriately funded and there's lots of financial strength, is that the shares are only repurchased when they sell at a nice discount to per share intrinsic value. As always, what's smart to buy at one price is rather less so at some price that's higher than what an asset is intrinsically worth. That, in just about any real world scenario, ends up being an approximate range of estimated value.

Since the value of any asset is always a necessarily imprecise thing to estimate -- and likely even more so for a business like Apple with the rapid changes that occur where it competes -- the discount should be a meaningful one.*

This $ 16 billion in repurchased shares was far in excess of quarterly free cash flow. Since Apple borrowed roughly $ 17 billion dollars during the quarter, as was announced a few months ago, that means the buyback was more than fully funded by their debt offering.

From here, without additional debt, any sizable buyback will have to be funded by their huge pile of cash (now $146.6 billion but after subtracting the debt they've taken on their net cash is more like $ 129.7 billion) or via free cash flow.

According to their latest reported results, this reduced average shares outstanding from 946 million at the end of the second quarter to just over 924 million in the current quarter. That roughly 22 million reduction in share count represents a 2.3% reduction.

Now, this is based upon the diluted weighted-average number of shares of common stock outstanding.

Yet, the end-of-quarter impact of the $ 16 billion in repurchased shares would clearly be greater than the weighted-average number would indicate.

In other words, it's not difficult to roughly calculate that the direct impact of the buyback on share count reduction -- based upon a reasonable assumption of average price paid -- would be greater than 22 million shares by quarter-end.**

The company also paid out roughly $ 2.8 billion in dividends during the most recent quarter.

So at least they're finally starting to do something material with all their cash.


Long position in AAPL established at much lower than recent prices

Related post:
Technology Stocks

* A more unpredictable range of possible outcomes requires a bigger margin of safety. In fact, sometimes no margin of safety is sufficient. As I have said before, there's really no technology business I'm comfortable with as a long-term investment. Most are involved in exciting, dynamic, and highly competitive industries. That's precisely what makes them unattractive long-term investments. For me, a very large discount is needed for them to be worth the trouble (i.e. an obvious and substantial mispricing) and positions remain on the small side. Otherwise, they're mostly just not worth the trouble. As always, I offer no view (and never will) on what's right for someone else. That's necessarily a unique thing. As a rule I believe no marketable stock should be purchased or sold based upon what someone else says (good or bad) about it. To me, that is a fundamental principle. Stocks should be bought or sold based on one's own sound analysis, conclusions, level of conviction, and within the limits of what the investor uniquely finds understandable. Satisfactory results aren't likely unless an investor is able to consistently and correctly judge the future prospects of a well understood business. Good outcomes aren't likely unless the investor can figure out what something is conservatively worth and always pays a nice discount to that estimate.
** For example, by dividing the $ 16 billion in buybacks by the average market price of AAPL during the quarter. Based on that the share count reduction directly attributable to the buyback would be much greater than 22 million. In fact, even if the shares were purchased at the highest quoted price during the quarter (not plausible, of course) the share count would be lessened by more than 34 million. This is offset, in part, by common stock that is issued under stock plans (employee shares issuances) over time, of course. The $ 16 billion was accomplished via both an accelerated share repurchase (ASR) program and repurchases in the open market. Apple entered into an ASR program with two different financial institutions to purchase as much as $12 billion of its common stock. The total number of shares repurchased (and the average price paid per share) won't be finalized until the program is settled up at the end of the purchase period (which goes beyond the quarter that just ended). Initially, 23.5 million shares were delivered to Apple and retired but that does not represent the final number of shares to be delivered and retired under the ASR program. The other $ 4 billion in repurchases was achieved via the open market. Apple repurchased and retired 9.0 million shares of its common stock in the open market at an average price of $446.74 per share for a total of $4 billion. A further explanation of this can be found under Note 6 in the latest 10-Q. The bottom line is that all of this buyback activity -- especially once the ASR is settled per contract -- will cause the shares outstanding impact to be greater than what's reflected in the weighted-average shares outstanding.
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, July 19, 2013

John Kay on Equity Markets: Exit, Voice, and Short-termism

A year ago, John Kay produced what can only be described as a rather long report focused on, among other things, the reduction in long-term oriented behavior among UK equity market participants and corporate decision-makers.

Kay's work more than implies that the fault lies both with shareholders and company decision-makers alike. Naturally, the behavior of owners (and, too often, what amounts to "renters" of stock) influence how the board and senior management behaves and vice versa.

The Kay Review of UK Equity Markets and Long-Term Decision Making

Increasingly, business executives, for a variety of reasons, too often end up focused on shorter term outcomes and quick fixes.

From the report:

"Short-termism, or myopic behaviour, is the natural human tendency to make decisions in search of immediate gratification at the expense of future returns..."

Longer tenure among competent senior executives and the right kind of compensation systems would certainly help. The CEO with a short tenure and lots of pressure to perform quarter-to-quarter is less likely think and act longer term. Few would seem likely to focus on long-term effects if the prevailing pay systems, in combination with shorter in duration tenure, frequently reward the next person who gets the job.

A system that tends to reward the next CEO for the long-term decision-making of the current CEO is a system destined to fail.

As far as short-termism goes it's not just executives, of course.

Corporate boards, regulators, and market participants all play a role.

John Kay makes it rather clear nothing short of a major cultural shift is required. That's unlikely to happen quickly under the best of circumstances.

Market participants have shorter time horizons by almost any standard these days; and it is not just the high frequency trading types.

It's an increased number fund managers and other participants who increasingly emphasize shorter term price action and outcomes in markets (w/holding periods maybe not measured in seconds or less but still hardly investing with long-term effects mostly in mind).

Also, the layers of middle men -- investment consultants and financial advisors among others -- not only tend to add frictional costs, but also increasingly create a buffer between those who've invested the capital at some risk and the companies they partially own.

This reduces shareholder engagement.

"Short-termism can also manifest itself in hyperactivity."

Well, as the report points out, individuals that are hyperactive generally "fail to give sustained attention to tasks" but what does this hyperactivity mean for the corporate sector?

"In the corporate sector, hyperactivity can be seen in frequent internal reorganisation, corporate strategies designed around extensive mergers and acquisitions, and financial re-engineering which may preoccupy senior management but have little relevance to the capabilities of the underlying business."

The civilized world has for a very long time attempted "to construct devices and institutions to combat our instinctive short-termism. The central question for this Review is whether capital markets in Britain today dissuade or stimulate the search for instant gratification in the corporate sector."

 In fact, as Kay notes, attempts to combat this instinct can even be found in the epic story of Ulysses.

"The outcome, not the process, is what matters, and that perspective has been central to this Review. From the outset, we have emphasised that the goals of equity markets are to operate and sustain high performing companies and to earn good returns..."

It's important to note that the report is focused on the more established relatively large public companies that are traded in London (see bottom of page 15). Of course, smaller, less mature, and not quite as established businesses will require very different things from the capital markets. Many will need efficient access to capital to build their businesses and generally have had more difficulty accessing funding since the financial crisis. Yet, much like the more established businesses, they'd still benefit from a reduced culture of short-termism.

Larger and smaller businesses have that in common even if their needs are otherwise rather different.

Business investment has declined in the past decade in the UK, but it's not because the larger companies are lacking funds.

"Quoted companies, both taken as a whole and in most individual cases, generate more cash from operations than they use for investment. They are not short of cash; they are awash with it. The value of the cash holdings of British business today is larger than the value of its plant and machinery."

And it's not necessarily just about encouraging more shareholder engagement...

"Shareholder engagement is neither good nor bad in itself: it is the character and quality of that engagement that matters."

Exit and Voice
The report also refers to "economist Albert Hirschman's famous distinction between the courses of action available to buyers when the quality of a relationship is inadequate: 'voice' – attempting to improve outcomes within the context of the market relationship; and 'exit' – withdrawal from the market relationship*. These alternatives apply just as much to a shareholder concerned with corporate governance or company performance as to a customer dissatisfied with the produce at the local supermarket. The unhappy shopper can complain to the management, or go elsewhere. And so can the contemporary shareholder."

The problem is that structure and regulation have the emphasis wrong.

"...the structure and regulation of equity markets today overwhelmingly emphasise exit over voice and this has often led to shareholder engagement of superficial character and low quality. We believe equity markets will function more effectively if there are more trust relationships which are based on voice and fewer trading relationships emphasising exit.

The focus of the report is on the UK equity markets but the problems, as well as potential solutions, seem likely to be more similar than different for the United States.

Kay rightly criticizes the hyperactive behavior of senior management and market participants who pursue "immediate gratification". Well, behavior that is longer term oriented is more likely to follow if the right incentives are put in place and enough conflicts of interest can be eliminated.

Considering this apparent attention deficit for anything but what can deliver the quickest rewards, it seems unlikely that this not at all short report will even reach enough of its target audience in the first place (never mind get the focused attention it deserves).

This report -- and the subject more generally -- certainly requires that the reader not have such a deficit.

So, in contrast to short-termism, no quick payback or reward will be found in reading Kay's report. It's certainly a worthwhile read for those who'd like to see long run systemic improvements; it's a worthwhile read for those less conflicted (or, at least those who can mostly set conflicts of interest aside for the bigger picture), less susceptible to short-termism, and willing to invest some time to seriously consider what really needs to be changed.
(Though, of course, it's not as if Kay's work could possibly provide all the answers.)

Changes that might make equity markets better serve their purpose for existing in the first place. In reality, nothing appears likely to be fixed anytime soon. The conflicts of interest, wrong incentives, and embedded industry cultural forces are just too powerful.

It's still worth better understanding how the status quo might be failing us.


Related post:
Buffett & Bogle: Overcoming Short-termism

* Hirschman, A. (1970), Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States, Harvard University Press
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, July 17, 2013

Charlie Munger: Gresham's Law (In Its New Form)

Gresham's Law - A monetary principle stating that "bad money drives out good." - Investopedia

If someone wants to better understand how Charlie Munger and Warren Buffett think about the insurance business, this turns out to be a useful principle to understand.

Gresham's Law in its original form, according to Charlie Munger, is a "non-starter" for today's world. It just isn't terribly relevant these days.

Yet it is extremely relevant in the newer form that Munger describes below:

"Nobody cares what the melt-down value of the quarter is in relationship to the dime, so Gresham's Law is a non-starter in the modern world. Bad money drives out good. But the new form of Gresham's Law is ungodly important. The new form of Gresham's Law is brought into play - in economic thought, anyway - in the savings and loans crisis, when it was perfectly obvious that bad lending drives out good. Think of how powerful that model is. Think of the disaster that it creates for everybody. You sit there in your little institution. All of the builders [are not good credits anymore], and you are in the business of lending money to builders. Unless you do the same idiotic thing [as] Joe Blow is doing down the street. Pete Johnson up the street wants to do something a little dumber and the thing just goes to a mighty tide. You've got to shrink the business that you love and maybe lay off the employees who have trusted you their careers and so forth or [make] a lot of dumb loans. At Berkshire Hathaway we try and let the place shrink. We never fire anybody, we tell them to go out and play golf. We sure as hell don't want to make any dumb loans. But that is very hard to do if you sit in a leadership position in society with people you helped recruit, you meet their wives and children and so forth. The bad loans drive out the good. 

It isn't just bad loans. Bad morals drive out the good." - Charlie Munger at Harvard-Westlake School in 2010

This doesn't just apply to making loans.

It just as comfortably applies to the insurance business.

To understand Berkshire's willingness to shrink a business with Gresham's Law (in its new form) in mind, consider the example of National Indemnity (NICO) -- a property and casualty insurance company.

Here's how Buffett explained it in the 2004 Berkshire Hathaway (BRKashareholder letter:

"Insurers have generally earned poor returns for a simple reason: They sell a commodity-like product."

NICO is fundamentally a commodity business.

"Customers by the millions say 'I need some Gillette blades' or 'I'll have a Coke' but we wait in vain for 'I'd like a National Indemnity policy, please.' Consequently, price competition in insurance is usually fierce. Think airline seats.

So, you may ask, how do Berkshire's insurance operations overcome the dismal economics of the industry and achieve some measure of enduring competitive advantage?"

How does this relate to Munger's version of Gresham's Law? Well, for starters Buffett asserts:

"Nevertheless, for almost all of the past 38 years, NICO has been a star performer. Indeed, had we not made this acquisition, Berkshire would be lucky to be worth half of what it is today."

In the letter, there is a table that shows NICO allowed written premiums to drop from $ 366 million in 1986 to $ 54 million in 1999.

An 85 percent decline.

So Munger wasn't kidding when he says they are willing to let the business shrink to combat Gresham's Law in its new form.

How did this challenging business contribute so much value to Berkshire when the industry overall, excluding Berkshire, mostly operates at an underwriting loss?

How does so much value get created when a business is allowed to shrink that much for such a long period of time?

Again, as Buffett pointed out, this has contributed roughly half of Berkshire's total.

I'd say this all qualifies as just a bit counterintuitive.

It comes from a kind of discipline that many find difficult to emulate considering real world pressures and other behavioral tendencies. More from the letter:

"Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999?  That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.

Most American businesses harbor an 'institutional imperative' that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract last year but that it will continue to drop?  In insurance, the urge to keep writing business is also intensified because the consequences of foolishly-priced policies may not become apparent for some time. If an insurer is optimistic in its reserving, reported earnings will be overstated, and years may pass before true loss costs are revealed (a form of self-deception that nearly destroyed GEICO in the early 1970s)."

As I said in this previous post:

Shareholders of many commodity-like businesses that are run with the Berkshire mindset have a much better chance of being served well in the long run. For example, the next time a banker is promising consistently high earnings growth it would be wise to remember the above because it generally applies.

That is not a bank I'd want to own.

For some commodity-like businesses, at times the smartest thing to do is intelligently shrink, even if less dramatically than the NICO example above, until the competitive landscape produces a pricing environment supportive of high returns.

Finding a business leadership team who not only understands but acts in accordance with this isn't easy.

Self-interest, and other powerful psychological factors (subconscious and conscious) can lead to cognitive errors that adversely affect even the very brightest (this includes those who might be quite admirable in other ways). There just are aspects of human nature that can lead to less than optimal outcomes.

It has little to do with how smart those involved happen to be.

I happen to think this aspect of Berkshire's overall success frequently goes underappreciated. I also happen to think, if internalized, this way of thinking can be both useful to long-term investors and corporate executives alike.


Long position in BRKb established at much lower than recent market prices

Related posts:
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline
Buffett on Bold & Imaginative Accounting
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.

Charlie Munger at Harvard-Westlake 2010

Friday, July 12, 2013

Wells Fargo's 2nd Quarter 2013 Results

Some highlights from Wells Fargo's (WFC) latest quarterly earnings:

- The bank earned $ 5.52 billion in the second quarter, up from $ 4.62 billion. Revenue was $ 21.4 billion, up from $ 21.3 billion. Quarterly per share profit increased 20 percent in second quarter to 98 cents per common share from 82 cents per common share in the same period a year earlier.

- Net interest margin decreased to 3.46 percent from 3.91 percent. Not really surprising considering interest rate trends this past year or so. Though net interest margin is lower, the bank continues to have a meaningful advantage compared to other big banks.

- Return on equity was 14.02 percent, up from 12.86 percent a year earlier.

- Total average deposits is now at $ 1 trillion, up 9 percent from a year ago.

- Net loan charge-offs were $ 1.2 billion in the second quarter of 2013 compared to $ 2.2 billion in the second quarter of 2012.

- Average loans grew to $ 800 billion from $ 768 billion a year ago.

From the Wells Fargo quarterly release:

"Our results reflected the strength of our diversified business model. Compared with the prior quarter, we grew loans, deposits, and net interest income, and both our efficiency ratio and credit quality improved." - Chairman and CEO John Stumpf

The FDIC is proposing a higher leverage ratio -- a more strict standard than what's currently under consideration in Basel III -- for larger bank holding companies (BHCs).
(Covered in this previous post.)

Well, this Bloomberg article from last month had suggested that a 6 percent leverage ratio was being considered and pointed out that:

Among the biggest U.S. banks, only San Francisco-based Wells Fargo & Co. (WFC) would exceed the 6 percent threshold being considered...

They're currently proposing a 5 percent* leverage ratio for the BHCs.*

In the long run, a more strict leverage requirement -- whether it ends up being 5 percent, 6 percent, or even higher -- would seem to be a very good thing.
(Even if a challenge for certain banks in the shorter run.)

The 3 percent level proposed under Basel III does seem rather meager. Well, at least they appear inadequate in the context of the kind of losses that can occur during a serious financial crisis. After watching the kind of financial destabilization that occurred not long ago, and the resulting hugely negative economic impact, this warrants serious consideration.

Not all of what happened was the result of excessive leverage -- both visible and hidden -- but much of it certainly was.

The Basel III proposal belatedly introduces the concept of a leverage ratio but calls for it to be only 3 percent, an amount already shown to be insufficient to absorb sizable financial losses in a crisis. It is wrong to suggest to the public that, with so little capital, these largest firms could survive without public support should they encounter any significant economic reversals. - Thomas Hoenig, vice chairman, FDIC in this April 2013 speech

In any case, though very important, it's not just capital levels that matters. It's also the quality of a bank's core economics. That's driven by not only cheap stable funding, but also whether they put funds generally to intelligent use and in combination with other services that customers value.
(Services that help a customer manage their capital and liquidity needs, the management of risks, etc.)

That requires, among other things, the right kind of culture be in place.

Difficult to quantify but extremely important.

"And I tell you, sure as I am sitting here, that if banking institutions are protected by the taxpayer and they are given free rein to speculate, I may not live long enough to see the crisis, but my soul is going to come back and haunt you." - Paul Volcker speaking to the Senate Banking Committee

It also means that speculation with guaranteed money needs to be severely limited.


Long position in WFC established at much lower than recent prices

Basically, it appears they'd like to see a 5 percent leverage ratio for the larger BHCs, and a 6 percent ratio for any insured depository institution that's a subsidiary of these larger BHCs. The Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve Board (FRB) have proposed doubling the leverage ratio on an insured depository institution owned by a BHC. So these "agencies are proposing to establish a 'well capitalized' threshold of 6 percent for the supplementary leverage ratio for any insured depository institution that is a subsidiary of a covered BHC..."

In addition, they are also proposing that "a covered bank holding company would be subject to a supplementary leverage ratio buffer of 2 percent, above the 3 percent minimum requirement for banking organizations using the advanced approaches under the new capital rule."
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, July 10, 2013

The 5% Leverage Ratio

Well, I'm not sure a 5 percent leverage ratio shouldn't really qualify as tightening the screws, but apparently some think it's too strict.

FDIC to Tighten Screws on Banks, Require 5% Leverage

It's a tougher standard, yes, but requiring a 5 percent leverage ratio for the bigger banks seems hardly unreasonable considering the implications of a larger one getting into trouble. The 5% leverage rule does seem far more adequate than the 3 percent leverage ratio proposed under Basel III.

In fact, it seems easy to argue it should be even higher.

From this CNBC article:

The asset number includes off-balance-sheet items and will not be adjusted for riskiness. The proposed rule for so-called "simple leverage" is 2 percent higher than the minimum simple leverage rule under Basel III.

This simply means that larger bank holding companies (BHCs) will need to have capital that's at least 5 percent of its assets -- including the adequate capture of what's off-balance sheet -- compared to the 3 percent under Basel III.*

Again, seems more than fair. Also, the sheer simplicity of this rule likely makes it more difficult to game than some of the other capital rules that are based upon risk-weighting. To an extent a banker has the latitude to set the appropriate risk-weights. Well, there's just too much room for subjectivity in that kind of system.
(The simple leverage ratio relies much less on these kind of subjective judgments though, of course, no one measure is ever going to be perfect or, for that matter, even adequate by itself.)

More from the article:

By piling off-balance-sheet items into the ratio, the regulators have made banks' capital burdens much heavier.

Even if this were to cause some near-term challenges for certain banks, the long run overall benefits would appear to be more than worth the headache it causes. Fed Governor Daniel Tarullo said the following about the Basel III leverage ratio:

"Despite its innovativeness in taking account of off-balance-sheet assets, the Basel III leverage ratio seems to have been set too low to be an effective counterpart to the combination of risk-weighted capital measures that have been agreed internationally."

The 3 percent level does seem rather insufficient to absorb losses that could occur during a serious financial crisis. That doesn't mean the Basel III leverage framework isn't useful; it just means that 3 percent is too low. If set at an appropriately higher level -- necessarily a judgment call though I'll take a slight bias in favor of a stricter rule -- something like the Basel III leverage framework (or something similar) appears to have advantages over some of the other capital requirements.

Not only does it attempt to capture what's off-balance sheet, the Basel Committee on Banking Supervision thinks that this kind of leverage ratio will be more transparent than the other capital requirements.

Basel Proposes 3 Percent Bank Debt Ratio

From this CFO Magazine article: would be more transparent than other capital requirements, because banks would have to disclose the information in a common format.

Banking, at its best, is a vital utility. No standard is going to work perfectly but a high enough leverage ratio just might just help to protect against the inevitable excesses that occur from time to time. More from the article:

A simple leverage ratio would force financial institutions to hold the same amount of quality capital against any loan they make, regardless of the riskiness of the loan. That contrasts with other capital ratios that assign a "risk weighting" to loans to require a larger capital cushion for riskier instruments.

The quality bank can still make a nice return for investors at this kind of leverage ratio (and likely even a much higher standard for leverage).

Charlie Munger weighed in on bankers during this CNBC interview in early May:

"A banker who is allowed to borrow money at X and loan it out at X plus Y will just go crazy and do too much of it if the civilization doesn't have rules that prevent it."

And later...

"I do not think you can trust bankers to control themselves. They are like heroin addicts."

The system should be built to encourage more safe and sound traditional banking activities and less of the exotic stuff. Much financial innovation ultimately boils down to some clever way to increase leverage (both on and off-balance sheet) in ways that's not always transparent until it's too late.

"All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets." - John Kenneth Galbraith in the book: A Short History of Financial Euphoria (Page 19)

It's not just less leverage and more transparency that's needed.

It's stable funding sources so financial institutions are more resilient and less likely to become liquidity challenged during the tough times.**

It's less speculation and what is, effectively, even pure gambling.

It's reduced emphasis on facilitating short-term bets of various kinds and a greater emphasis on long-term outcomes.

It's less complexity; fewer derivatives.

More real accountability and financial pain for those in charge if things happen to go very wrong. This necessarily requires wise changes to the prevailing compensation systems for key individuals.

Even small step in the right direction are welcome but, realistically, a good chunk of what's really needed is unlikely to be implemented quickly if at all.

No matter what, the system will always depend on bankers who know how to effectively manage risk with enough skin in the game and integrity to care about doing the job well. Money that's government guaranteed -- the FDIC insured deposits of clients, for example -- or, more generally, other people's money, shouldn't be funding the riskiest activities without some wise limits in place.

The world needs a banking system that's less involved in speculative zero-sum "casino" bets (including things like proprietary trading), and puts more into competently getting funds to good ideas and productive activities.

An emphasis on stability, intelligent risk management, effective capital formation and allocation, while getting as many of the other frictional costs out of the system as possible. For lots of reasons much of what would improve the system isn't happening anytime soon. That reality doesn't make it any less worthwhile to understand what changes make sense.

We'll see if real progress -- even if inevitably less than perfect -- continues to be made.

Reign in the excesses and get back to an emphasis on traditional banking: Reliably taking in deposits, lending those funds intelligently, and providing related services. Within investment banking, dial way back the casino-like activities. Instead, they ought to be primarily about capably raising capital -- at an appropriate cost considering the specific risks -- and so it efficiently gets in the hands of those who can put it to good use.

These things can be a great advantage to any economy if consistently done well over the long haul.

Banking might justifiably be viewed cynically by many considering recent behavior and the consequences of  that behavior.

Yet, with better system design and some wise limitations in place, banking can better play its vital role and become much more trusted.


Basically, it appears they'd like to see a 5 percent leverage ratio for the larger BHCs, and a 6 percent ratio for any insured depository institution that's a subsidiary of these larger BHCs. The Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve Board (FRB) yesterday proposed doubling the leverage ratio on an insured depository institution owned by a BHC. So these "agencies are proposing to establish a 'well capitalized' threshold of 6 percent for the supplementary leverage ratio for any insured depository institution that is a subsidiary of a covered BHC..."

In addition, they are also proposing that "a covered bank holding company would be subject to a supplementary leverage ratio buffer of 2 percent, above the 3 percent minimum requirement for banking organizations using the advanced approaches under the new capital rule."

Raising the leverage ratio isn't enough. What ends up in the numerator and the denominator matters. The updated Basel III guidelines make significant changes to the denominator -- a bank's exposure. Leverage requirements that only take into account on-balance sheet assets make a bank appear better capitalized than it is. Some banks have derivatives that are significant compared to what's on their balance sheet.

The new leverage has to capture two important types of exposure related to derivatives. With derivatives, it's not only the exposure arising from the underlying reference asset that matters, it's also the credit risks of the counterparty.

The proposed guidelines require that the entire contingency liability related to a derivative be in the leverage ratio's denominator. With this requirement in place a bank seems more likely to be better capitalized and able to absorb an unexpected loss.

The new guidelines also require banks to disclose publicly the different components included in the leverage ratio. For any leverage ratio, a bank is going try and increase what's allowed in the numerator and try to get as little as possible included in the denominator. Disclosure makes all the difference if it is to be trusted.

The recommendation that U.S. bank holding companies have a ratio of 5% and that insured depository subsidiaries have a 6% ratio sounds good versus the 3%, but it comes down to what's required in the new measure. If it is based on the 2010 framework instead of something closer to the updated framework then it's a vastly weaker measure. In any case, the lobbying will no doubt continue.
** I'm speaking of the liquidity within leveraged financial institutions themselves so the system is more resilient and remains stable when under stress. In other words, more liquidity in capital markets to facilitate the hyperactive trading of marketable securities isn't needed, but what are fundamentally and necessarily rather leveraged financial institutions must be set up so the system overall can remain stable when certain short-term funding sources become less viable. If anything the world would surely be better a place with much less rapid fire trading in markets justified under the guise of liquidity benefits.

"It's a myth that once you've got some capital market, economic considerations demand that it has to be as fast and efficient as a casino. It doesn't." - Charlie Munger at UC Santa Barbara in 2003

Capital markets would be more useful and effective if a greater proportion of participants were encouraged to be long-term owners instead of being short-term renters of different kinds. Currently, the system appears built mostly for participants to make bets on price action and less for participants to invest with long-term effects -- increases to per share intrinsic value -- primarily in mind. That's too much of an internal focus. It should be designed, instead, with a focus on effective capital formation, wise allocation, and long-term outcomes in the real economy beyond the capital markets. It shouldn't be designed to mostly serve highly active participants who are there to profit from price action -- and maybe even profit from fee generation in different forms -- but are often otherwise least interested in the real external economic impact. With better system design, the various frictional costs in the current system would become much reduced and it would better serve its external purpose. There will always be a place for speculation, as well as the various forms of fee generation, in capital markets but the proportion does matter.
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, July 5, 2013

Buffett: "A Formula For Business Success"

" 'Buy commodities, sell brands' has long been a formula for business success. It has produced enormous and sustained profits for Coca-Cola (KO) since 1886 and Wrigley since 1891. On a smaller scale, we have enjoyed good fortune with this approach at See's Candy since we purchased it 40 years ago.

Last year See's had record pre-tax earnings of $83 million, bringing its total since we bought it to $1.65 billion. Contrast that figure with our purchase price of $25 million and our yearend carrying-value (net of cash) of less than zero." - Warren Buffett in the 2011 Berkshire Hathaway (BRKaShareholder Letter

A strong brand (or, better yet, maybe several strong brands) combined with other factors can lead to pricing power. In some instances this positions the enterprise to be a price setter on a sustained basis.

It's not the only path to business success but it's certainly among the better ones.

This is especially true when -- as is the case for a company like Wrigley and others with similar characteristics -- there's enough scale and distribution to reinforce and strengthen the key brand(s).

It starts with having a favorable product and/or experience -- possibly developed, over time, via some combination of skill and good fortune -- that becomes associated with a trusted brand. Yet, with greater scale relative to competitors that enterprise can, for example, then afford to use various forms of media the best possible way to support the brand. A distribution advantage makes it possible for the product to be placed where it needs to be (even in somewhat less accessible places where returns initially aren't necessarily great).

When so-called fast moving consumer goods (FMCG) -- relatively low cost non-durable consumer packaged goods like beverages and snacks among others -- are easily found in convenient places and become associated with a trusted brand substantial pricing power can get created.

Being well known in a particular category -- even if on a regional basis as is the case for See's -- is often no small advantage.

"If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30 cents, am I going to take something I don't know and put it in my mouth which is a pretty personal place, after all for a lousy dime?

So, in effect, Wrigley, simply by being so well known, has advantages of scale what you might call an informational advantage." - Charlie Munger at USC Business School in 1994

Psychological factors also come in to play. Consumers are influenced, consciously or otherwise, by what others do:

"The psychologists use the term 'social proof'. We are all influenced subconsciously and to some extent consciously by what we see others do and approve. Therefore, if everybody's buying something, we think it's better." - Charlie Munger at USC Business School in 1994

This is just one psychological factor at work among many but serves as a good example.* If everybody's buying a particular item, whether some of us want to admit it or not, a product is perceived to be better when others are seen to be willing to use it.

"The social proof phenomenon which comes right out of psychology gives huge advantages to scale ‑ for example, with very wide distribution, which of course is hard to get. One advantage of Coca-Cola is that it's available almost everywhere in the world.

Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup which is slowly won by a big enterprise gets to be a huge advantage.... And if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you." - Charlie Munger at USC Business School in 1994

These forces aren't necessarily difficult to understand but shouldn't be underestimated in how they work together to create attractive economics.

The above is far from an exhaustive list of advantages but competitors that lack such combined capabilities usually end up swimming against the tide. Businesses that sell into markets where it's not possible to create pricing power, that also lack a sustainable cost advantage, aren't likely to have attractive core economics over the long haul.

In any case, powerful brands and distribution is one great way to create a business with durable advantages. Otherwise, I think Jeff Bezos put it very well:

"There are two types of companies: those that work hard to charge customers more, and those that work hard to charge customers less. Both approaches can work. We are firmly in the second camp." - Jeff Bezos in this letter

A business deliberately setting its prices low, that also has developed and is able to maintain a durable cost advantage, can do very well in the long run.

In fact, some businesses succeed doing just that.

A low price agenda is established. Equally important is that, simultaneously, the scale needed for a durable cost advantage (to support that low pricing strategy) is built while also creating -- at least relative to competitors -- a high quality product/service experience.
(It's tough to maintain low prices if the low cost structure isn't there to support it. Ongoing losses can only be sustained for so long. Also, low prices may not be enough for customers if they have to put up with a lousy product/service experience.)

So they deliberately set their prices low, develop the necessary scale that leads -- among other things -- to lower costs and high quality products/services, and remain committed to this long-term. When well-executed, it's possible to consistently set prices low enough that it makes life very difficult for competitors to come in and take share (and maybe even to survive). This can work for those who are well-financed, with real sustainable cost advantages, that are willing to take the long view.**

I'm not speaking in favor or against Amazon (AMZN) specifically in this case but, with any business, it's important to understand how pricing fits within an overall strategy. Clearly, what Amazon is doing as far as pricing goes is very different than the likes of Wrigley, Coca-Cola, or See's. They are setting prices but it is deliberately on the low side. Time will tell whether Amazon can convert this into attractive long-term economics but, if nothing else, the company appears very committed to implementing its approach.

Now, beyond deliberately setting prices low, when in markets that force competitors to be price takers -- think commodities, commodity-like products, and/or lots of well-financed capable competition -- where pricing power is difficult to come by or non-existent, it's crucial to have a durable cost advantage.***

Given the choice, all things being roughly equal, I'll take being a price setter any day. To me, a business with strong brands and distribution capabilities that produces sustainable pricing power is preferable to alternatives.

Still, there are some fine businesses that set the agenda by relentlessly establishing low prices to continuously pressure weaker competition.

Finally, those that are pure price takers can also do just fine if they possess a truly durable cost advantage relative to competitors.

"How many insights do you need? Well, I'd argue: that you don't need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that's with a very brilliant man—Warren's a lot more able than I am and very disciplined—devoting his lifetime to it. I don't mean to say that he's only had ten insights. I'm just saying, that most of the money came from ten insights." - Charlie Munger at USC Business School in 1994

So it's worth remembering that one doesn't need all that many really good ideas. Some seem willing to take a more complicated approach that's likely to succeed less or even fail when a plain insight with a higher likelihood of success is right there. They avoid the simpler approach because the simplicity makes them think: "there must be more to it".

That's an unfortunate and preventable mistake. Some, though likely not many, useful insights can be rather simple yet powerful.

At times, of course, simple is just, well, simple and of little usefulness.

Occasionally, it's just knowing when to make use of a good insight -- whether simple or more complex -- one can understand when it comes along. What's understandable is necessarily unique to each investor.

No matter what there's still usually lots of required hard work getting to "simple".


Long position in BRKb and KO established at much lower than recent prices

* Charlie Munger has previously talked about some of the other psychological forces.
** Amazon has made rather brilliant use of working capital to finance itself and continues to do so. Their negative working capital cycle is a very useful source of cheap funding (actually, no cost funding while it lasts) but, to me, should not be viewed as higher quality operating free cash flow.
*** Some businesses have no discernable long-term advantages --neither pricing power nor a cost advantage -- and, sooner or later, that will be revealed in their core economics and, ultimately, also in long-term investor returns.
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.