Friday, March 29, 2013

Buy the Business, Not the Stock

Here's what Warren Buffett had to say about the group of investors he highlighted in the Superinvestors of Graham-and-Doddsville:

"I selected these men years ago based upon their framework for investment decision-making. I knew what they had been taught and additionally I had some personal knowledge of their intellect, character, and temperament. It's very important to understand that this group has assumed far less risk than average; note their record in years when the general market was weak. While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock. A few of them sometimes buy whole businesses. Far more often they simply buy small pieces of businesses. Their attitude, whether buying all or a tiny piece of a business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value.

I'm convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a "herd" on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical."

Some thoughts:

- The idea that more risk must be taken to achieve greater returns seems persistent to this day. Well, Warren Buffett more than just suggested that the opposite might be true in this article nearly 30 years ago.

It's fine to disagree with something after serious examination, but this way of thinking about risk and return seems to have been effectively ignored by many. When something successful flies in the face of conventional wisdom or, at least, a prevailing model, it deserves to at least be carefully considered before choosing to discard or ignore it.
(Also, it's not like the idea is from some random unproven source.)

- This idea of "buying the business, not buying the stock" is hardly a new insight, but it's worth emphasizing in an era where the average holding period of stocks is either at or near all-time lows. A very short average holding period may not prove fewer market participants than ever are primarily thinking about "buying the business". Yet, when the length of time many stocks are being held can be measured in months, weeks, minutes, or even less, it's not likely that thinking like a business owner is front and center for those participants.

Naturally, many market participants are well aware of and understand this way of thinking, but quite a few must not value it or think it unimportant. The successful value-oriented investors doesn't just think that buying pieces of a business is one and the same with buying the whole business, they act accordingly. The group of investors highlighted by Buffett in the article certainly thought and behaved in a way that's consistent with a buy the business ethos.

Those own a business outright generally won't sell it at the first sign of trouble with the hope of jumping back in if and when the trouble wanes. Well, those that own a small pieces of a business can choose to think and behave in the same manner.

The fact is even the best businesses gets into some difficulties from time to time and, considering the relative liquidity of stock markets, it's obviously tempting to just sell and move onto something else.

It certainly is more convenient and costs less than ever to trade hyperactively. So it's understandable that many market participants are tempted to take full advantage of this reality.

That doesn't make it wise.

Of course, inevitably, misjudgments are made and a stock must be sold; inevitably, better use for the capital arises; inevitably, a stock gets extremely expensive and warrants selling.

Still, that doesn't mean the value-oriented stock market participant can't choose to think like the buyer of a business as a core part of their investment process.

- Quite a few seem convinced that the market remains quite efficient even if, as Donald Yacktman points out, shares of a relatively large businesses tend to fluctuate roughly 50% over a 12-month period.

Well, intrinsic value just doesn't move around that much.

"Shares of a relatively big company will fluctuate probably 50% from low to high in a 12-month period. That encourages a lot of short-term trading, and yet short-term traders tend not to do very well over time." - Donald Yacktman

Whether buying an entire business or part, the long run results will still mostly come down to having some patience, the right temperament, an ability to judge business economics, then paying an appropriate price.

Well that and, of course, the integrity and competence of management.

Taking some time to read (or re-read) The Superinvestors of Graham-and-Doddsville in its entirety is at least as useful now as it was nearly 3 decades ago.

Adam

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

Tuesday, March 26, 2013

Berkshire, Goldman Amend Warrant Deal

From this Goldman Sachs (GSpress release on the amended terms of warrants held by Berkshire Hathaway (BRKa):

Warrant Amendment

The warrant had provided Berkshire Hathaway the right to purchase 43,478,260 shares of Goldman Sachs' common stock, par value $0.01 per share, at an exercise price of $115 at any time until October 1, 2013. Under the amended agreement, Goldman Sachs will deliver to Berkshire Hathaway the number of shares of common stock equal in value to the difference between the average closing price over the 10 trading days preceding October 1, 2013 and the exercise price of $115 multiplied by the number of shares of common stock covered by the warrant (43,478,260).

So the warrant agreement has been converted from cash settlement to net share settlement. Some things worth noting:

- The amended deal eliminates some risk of dilution for Goldman. Let's say Goldman's common stock trades near current levels next fall. Well, under the new terms, Berkshire ends up with a much smaller number of shares (roughly a fifth as many). The end result is a bit less than 2 percent of additional shares outstanding. This will likely place Berkshire among the top ten owners of Goldman shares this fall.

- Under the original scenario, Berkshire would have been able to purchase ~ 43.5 million shares of Goldman at $ 115. That would have, instead, resulted in roughly 9 percent of additional shares outstanding.

- The benefit for Berkshire is that it does not have to lay out a big chunk of change upfront in order to exercise the warrants. Naturally, as a result, the company also ends up with far less exposure to Goldman's common stock.
(Though Warren Buffett could just sell a portion to bring it in line with the ownership level he considers appropriate.)

- If Goldman's shares happen to trade near the recent price (~ $ 145 per share) over the 10 trading days prior to October 1, 2013, Berkshire would end up with ~ 9 million shares worth roughly $ 1.3 billion.* In the prior scenario, Berkshire would be paying $ 5.0 billion to get more like $ 6.3 billion (the same net amount). Basically, instead of writing a check to buy 43.5 million shares at $ 115 per share, Berkshire is getting compensated in stock for the difference between Goldman's market price this fall and the $ 115 exercise price.

A similar result actually could be accomplished without an amendment.**

This should work out fine but what if a big move in the stock in either direction occurs? The strike price inherently provides substantial leverage, so it wouldn't take much of a move in either direction to make a meaningful difference in value. Also, in the original deal, Berkshire had the right to act at any time. In this deal, what happens to be the average closing price over ten trading days determines the value. Seems less than ideal, but there are many trade-offs to consider here.

So, yes, if Goldman's stock is selling near the current price during the crucial 10 preceding trading days, Berkshire will get the ~ 9 million shares worth roughly $ 1.3 billion.

Yet, unless there's something in the fine print, if the stock drops to an average closing price of $ 115 -- just over 20% lower than now -- or less on those 10 trading days, Berkshire would end up with no shares and the value of this amended deal will be zero. Unfortunately for Berkshire, that'd be true (and quite annoying) if Goldman's share price recovered shortly after that.

Now, if the opposite were to happen -- a roughly 20 % increase in Goldman's stock price -- it would clearly be a nice benefit to Berkshire.
(Berkshire would end up with nearly 15 million shares of Goldman instead of 9 million.)

A relatively minor decrease in the stock price results in Berkshire getting meaningfully fewer Goldman shares (or maybe even none). A relatively small increase in the stock results in Berkshire getting quite a nice bump in additional Goldman shares.

In a calm market this dynamic probably isn't a big deal. Still, agreeing this far in advance seems to potentially create a rather unpredictable and wide range of outcomes.

Who knows what the world might look like this fall.

Both companies naturally understand this well but clearly have decided the benefits of the new terms outweigh the negatives.

Adam

* Here's the math assuming a $ 145 average 10 day closing price: (43,478,260*(Avg 10 Day Closing Price - Exercise Price))/Market Price = 43,478,260*($ 145-$ 115)/$ 145 = $ 8.996 million shares
** Alternatively, this fall (using the same average 10 day closing price) Berkshire Hathaway could just pay $5 billion to Goldman Sachs, receive the $6.3 billion in stock, then sell $5 billion (back to the market or Goldman) and end up with the same net $ 1.3 billion in stock. Goldman could also take the $5 billion paid by Berkshire in cash (for the $6.3 billion worth of stock), then just buy $5 billion back (from the market or Berkshire) using that cash. The mechanics of doing this may not be terribly difficult, but it's also not necessarily all that easy to buy back $ 5 billion of stock (at least not very quickly). There's the transaction costs. There's dealing with potentially unpredictable price action (never mind the fact that $ 5 billion of buying is enough to move the stock). This amendment's approach makes the whole process quite a bit cleaner for both parties. In the amended form, Berkshire doesn't have to write a big check upfront and doesn't end up exposed to so much Goldman stock. (It's worth noting, under the original deal, that Berkshire apparently wouldn't be able to sell the $ 6.3 billion in stock right away. So if Buffett wanted to reduce Berkshire's exposure there'd at least be a lag before it was possible to do so.) In the new deal, Goldman also doesn't have to deal with buying back the stock to reverse the dilution. With the original deal, consider the possibility that regulators (and possibly politicians) might just pressure (or require) Goldman to hold onto at least some of that $ 5 billion in cash received from Berkshire (from purchasing the warrants). I'm guessing there's more than a few who wouldn't mind if at least some of the bigger banks had additional liquidity for a rainy day. Too-big-to-fail is still rightfully front and center in the minds of many. Still, short of forcing the bank to hold onto the capital instead of using it buying back the stock, Goldman would end up with the same capital levels when it's all said and done under both scenarios (even if the mechanics are quite different). It's worth pointing out that the regulatory filing by Goldman states that the new deal becomes effective only if the "Board of Governors of the Federal Reserve System has approved or has stated that it has no objection to the net share settlement of the Warrant."
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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, March 22, 2013

Warren Buffett on "The Key to Investing"

Warren Buffett had this to say in a 1999 Fortune article that was written as the tech bubble was coming to an end:

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

In the article, Buffett also points out that many of the most "glamorous" businesses -- many that have changed the world dramatically for the better -- did not ultimately reward their investors.

One often has little to do with the other.

At the time, he was saying that stocks, due to excessive valuations and the high expectations of investors, were likely to disappoint (of course, he supposedly didn't get the "new paradigm"). Yet, Buffett was still optimistic that the businesses themselves would keep increasing in value and that, over time, investors would be "considerably wealthier, simply because the American business establishment that they own will have been chugging along, increasing its profits..."

The intrinsic worth of American business has been increasing since that article was written. Businesses just needed a good chunk of the past decade plus for the per-share value to catch up to the then prevailing premium market prices.

At the time that article was written, Buffett made it clear he wasn't predicting what stock prices might do in the near-term or even longer.

Those who have read and listened to him over the years knows Buffett has never really been interested in that sort of thing.

Instead, he was thinking in terms of how price compared to valuation, and likely longer term outcomes, not trying to predict price action. Eventually, value is what counts, but individual marketable securities, and markets more generally, are capable of moving in ways that have little to do with value for very long periods of time.

The intrinsic worth of American business might be increasing over time, but stock prices may not necessarily reflect that until much later.

So while valuations may be less nonsensical these days, it still reveals nothing about what stocks might do over the next several years. Attempting to judge where market prices stand in relation to per-share value is time well spent. Guessing what the price action might be over the next month or even several years is not.

Buffett added this in the most recent Berkshire Hathaway (BRKa) shareholder letter:

"American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor. (The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions. And don't forget that shareholders received substantial dividends throughout the century as well.)

Since the basic game is so favorable, Charlie and I believe it's a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of 'experts,' or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it."

It's understandable, even if not particularly enriching, that investors and other market participants weigh the risk of loss versus the possibility of gains asymmetrically.

Loss aversion is a very powerful thing.*

Having said that, those who think they can "dance in and out" effectively (and many certainly seem to try!) might want to carefully consider the last line in the above excerpt from the letter.

Adam

Long position in BRKb established at much lower than recent prices

* Those who underestimate the potential impact of loss aversion on long-term results are likely making an expensive mistake. This potent bias can be, to an extent, overcome, but requires first that it be taken seriously followed by some kind of trained response to counter it. For me, learning to manage the tendency only begins with an awareness of and respect for its significance.
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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, March 20, 2013

Dividend Reinvestment & Total Returns

Here's what $ 10,000 would now be worth if it had been invested since December 31, 1989 up until last Wednesday in the S&P 500.*

From this article in Barron's:

S&P 500
Price Return (excl. dividends): 6.59%
Now Worth: $ 43,988

Total Return (incl. dividends): 8.90%
Now Worth: $ 72,293

An additional $ 28,000+ from reinvested dividends in a bit over two decades. Here's what $ 10,000 looks over the same time frame for the industry groups that performed better than the S&P:

Energy
Price Return: 8.27%
Now Worth: $ 63,201

Total Return: 11.27%
Now Worth: $ 119,081

So nearly half the total return came from dividends reinvested.

Health Care
Price Return: 8.85%
Now Worth: $ 71,560

Total Return: 10.96%
Now Worth: $ 111,675

Consumer Staples
Price Return: 8.32%
Now Worth: $ 63,881

Total Return: 10.92%
Now Worth: $ 110,658

Info Tech
Price Return: 9.05%
Now Worth: $ 74,211

Total Return: 9.95%
Now Worth: $ 90,410

Consumer Disc
Price Return: 7.93%
Now Worth: $ 58,709

Total Return: 9.55%
Now Worth: $ 82,972

Industrials
Price Return: 7.02%
Now Worth: $ 48,262

Total Return: 9.30%
Now Worth: $ 78,796

The industry groups that underperformed the S&P were:

Financials
Price Return: 5.20%
Now Worth: $ 32,390

Total Return: 7.81%
Now worth: $ 57,298

Materials
Price Return: 5.14%
Now Worth: $ 32,003

Total Return: 7.68%
Now worth: $ 55,623

Utilities
Price Return: 2.69%
Now Worth: $ 18,529

Total Return: 7.55%
Now Worth: $ 54,118

Telecom Services
Price Return: 1.95%
Now Worth: $ 15,652

Total Return: 5.78%
Now Worth: $ 36,847

So certain industry groups have done well over the past 20 plus years. Good to know, I guess, but it of course guarantees absolutely nothing about the future.

That utilities, and some might even say telecom services (though not in my book), did much worse than the S&P 500 probably isn't a surprise to some; after all, they're considered to have more "defensive" characteristics. Well, it's at least worth noting (and I've certainly done so before) that consumer staples -- frequently also referred to as defensive --over this longer time horizon performed quite a bit better than the S&P 500. It's only worth pointing because of the defensive label. Otherwise, it would just be another industry group that happened to do well over that time frame. Consumer staples, of course, may not do nearly as well going forward (especially in a very bullish environment...which, in part, explains the label) but it's worth at least recognizing the fact that an industry group often viewed as defensive held its own on "offense" over that longer horizon.

It's through several booms and busts that the merits of the higher quality businesses become more plain. There just happens to be some very high quality business franchises among the consumer staples.

Durable businesses with attractive core economics.

Not all, of course, but those with the most attractive and durable business economics aren't just useful to own for defensive purposes.

A bunch of different stocks -- those with very different risks, opportunities, and economic characteristics -- get labeled as defensive. I think it is clear that not all are anywhere near being equals. More than a few of the best offer both defensive and long-term offensive characteristics; quite solid long-term risk-adjusted prospects, even if a less exciting ride, especially when bought well.**

No matter how high quality an investment is, those long-term investors (i.e. not traders of near-term price action) paying an expensive price relative to current value will likely, best case, have to wait for that value to "catch up" to the too high price. Naturally, that premium price might instead converge on value. Paying a premium to value also doesn't protect the investor from the unforeseen.

Inevitably, things go a bit wrong. Even the best businesses get into difficulties, sometimes severe, from time to time.

Adam

* All returns according S&P Dow Jones Indices.
** For those inclined and comfortable investing in individual stocks. There certainly are some lower quality consumer staples businesses out there. Also, even a good business that has durable advantages needs a management that is capable and inclined to focus on sustaining, and even increasing, the "economic moat". As is competent capital allocation more generally.
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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 are never a recommendation to buy or sell anything.

Friday, March 15, 2013

Big U.S. Banks Boost Dividends, Increase Buybacks

The Federal Reserve disclosed the results of the 2013 Comprehensive Capital Analysis and Review (CCAR) yesterday.

CCAR determines whether the dividend payment increases and/or buybacks proposed by individual banks will be allowed. Only 2 of the 18 banks had their planned capital actions rejected. 2 others were allowed to implement their proposed capital actions but were asked to submit another plan to address some weaknesses by the end of the third quarter.

The rest received no objection from the Federal Reserve on their planned capital actions.*

Wells Fargo (WFC) and U.S. Bancorp (USB) are two of the larger banks that had their capital plans approved outright who will be allowed to both increase their dividends and buyback more stock.

The largest of the U.S. banks in terms of assets, JPMorgan Chase (JPM), also has a capital plan that includes dividend increases and buybacks. The only difference being that -- according to JPMorgan's press release -- it is one of the two banks that must submit an additional capital plan by the end of the third quarter. The plan must address what the Federal Reserve views as weaknesses in their capital planning processes.

The Federal Reserve also did not object to the requested capital actions of Goldman Sachs (GS) but, like JPMorgan, it was conditional. Goldman was similarly asked to resubmit its capital plan by the end of the third quarter. One of the other very large banks -- Morgan Stanley (MS) -- did not ask to increase its dividends or buyback any stock. Morgan Stanley will, however, be allowed to buy the 35 percent of Morgan Stanley Smith Barney it doesn't already own.

Here's a quick summary of the three of the larger banks that were allowed to both increase dividends and buyback stock:**

Wells Fargo
Quarterly dividend increased from $0.25 per share to $0.30
New Annualized Dividend Yield: 3.2% (based upon yesterday's closing price)

Wells Fargo Receives No Objection to its 2013 Capital Plan

The bank said the following in their press release:

Wells Fargo & Company (NYSE: WFC) announced today that the Federal Reserve Board (FRB) has not objected to the Company's 2013 Capital Plan under the recently concluded Comprehensive Capital Analysis and Review (CCAR) of the nation's largest banks.

The Company confirmed that its 2013 Capital Plan includes a proposed dividend rate of $0.30 per share for the second quarter of 2013, subject to consideration and approval by its Board of Directors at its regularly scheduled meeting in April. The plan also includes a proposed increase in common stock repurchase activity for 2013 compared with 2012.

U.S. Bancorp
Quarterly dividend increased from $0.195 per share to $0.23
New Annualized Dividend Yield: 2.7%

U.S. Bancorp Receives Results of Comprehensive Capital Analysis and Review

The bank had the following to say in their press release:

The Company expects to recommend a second quarter dividend of $0.23 per common share, an 18 percent increase over the current dividend rate. At this quarterly dividend rate, the annual dividend will be equivalent to $0.92 per common share. Consistent with the Company's change in the timing of the annual dividend increase, today the board of directors of U.S. Bancorp (NYSE: USB) declared the Company’s first quarter dividend of $0.195 per common share, equal to the prior quarter’s dividend, payable April 15, 2013, to shareholders of record at the close of business on March 28, 2013.

Additionally, the board of directors of U.S. Bancorp has approved a one-year authorization to repurchase up to $2.25 billion of its outstanding stock...

JPMorgan Chase
Quarterly dividend increased from $0.30 per share to $0.38
New Annualized Dividend Yield: 3.0%

JP Morgan Chase Announces Capital Plan

From their press release:

Following the Federal Reserve Board’s release of 2013 CCAR results, JPMorgan Chase & Co. (NYSE: JPM) today announced that:

- The Firm is authorized to repurchase an additional $6 billion of common equity between April 1, 2013 and March 31, 2014.
- The Board of Directors intends to declare the first quarter common stock dividend of $0.30 per share.
- The Board of Directors intends to increase the Firm's quarterly common stock dividend to $0.38 per share, effective second quarter of 2013.

The Federal Reserve Board informed the Firm today that it does not object to the Firm's proposed 2013 capital distribution plan. The Federal Reserve Board also asked that the Firm submit an additional capital plan by the end of the third quarter addressing the weaknesses identified in the Firm's capital planning processes. Following their review, the Federal Reserve Board may require the Firm to modify its capital distributions.

Wells, U.S. Bancorp, and JPMorgan are each selling near multi-year highs. So the dividend yield against the prevailing and much lower market prices that were often available in recent years would be far more attractive.

The tough part, of course, was knowing which of the banks would ultimately weather the chaos of the financial crisis and come out in good shape.

As far as the other big banks go, both Bank of America (BAC) and Citigroup (C) said they will be buying back their stock but neither bank is boosting their dividends.

Bank of America Plans to Repurchase up to $5 Billion in Common Shares

BofA will also redeem roughly $ 5.5 billion in preferred stock.

Citi Statement on 2013 CCAR Planned Capital Actions

Citigroup's planned action is to buyback $1.2 billion of common stock through the first quarter of 2014.

A number of banks, generally somewhat smaller, also have capital actions that either increase dividends, allow for the buying back of their stock, or some combination of both.

Here's a useful summary of what all the 18 banks will (or will not) be allowed to do.

Adam

Established long positions in WFC, USB, and JPM at much lower than recent prices. Also, a very small long position in BAC.

* American Express (AXP) received approval to for its plan but had originally asked to buy back more stock until deciding to rein it in.
** Goldman Sachs received no objection on their proposed capital actions but the bank was not specific about whether the actions included dividends and/or stock buybacks.
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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 are never a recommendation to buy or sell anything.

Wednesday, March 13, 2013

Charlie Munger: Focus Investing and Fuzzy Concepts

Charlie Munger on why more companies don't copy Berkshire Hathaway's (BRKa) approach:

Charlie Munger Speaks

"It's a good question. Our approach has worked for us. Look at the fun we, our managers, and our shareholders are having. More people should copy us. It's not difficult, but it looks difficult because it's unconventional -- it isn't the way things are normally done. We have low overhead, don't have quarterly goals and budgets or a standard personnel system, and our investing is much more concentrated than average. It's simple and common sense.

Our investment style has been given a name -- focus investing -- which implies 10 holdings, not 100 or 400. Focus investing is growing somewhat, but what's really growing is the unlimited use of consultants to advise on asset allocation, to analyze other consultants, etc.

I was recently speaking with Jack McDonald, who teaches a course on investing rooted in our principles at Stanford Business School. He said it's lonely -- like he's the Maytag repairman."

Munger said the above at Wesco's annual meeting back in 2000.

It's worth at least noting that, while Warren Buffett and Charlie Munger both prefer to concentrate their holdings, it's not really practical to do so these days considering Berkshire's scale.

That inevitably -- among other things -- makes generating the kind of results they did in the early days extremely tough.

"I'm not discouraged, but I don't think your money here is going to do anything like what you're used to."

Munger also added this thought at that meeting:

Charlie Munger Speaks - Part II

"It's obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn't sell books, so there's a lot of twaddle and fuzzy concepts that have been introduced that don't add much -- like cost of capital. It's accepted because some of it is right, but like psychoanalysis, I don't think it's an admirable system in its totality."

Investing may not necessarily be the easiest thing to master, but adding unnecessary complexity to make it seem more mysterious and involved is surely no recipe for success. Shrouding what can otherwise be explained in a simple and plain manner with, instead, difficult to understand concepts is distraction from what it takes to get good results over time.

Complexity is fine as long as the benefits of it exceed the costs of that added complexity.

It's difficult enough to do consistently well as an investor over time without the distraction of unneeded and, best case, often useless complexity.

Berkshire's per-share book value* has tripled since Munger said these things back in 2000. A good result, no doubt, but nothing like their historic returns. What he said about future performance back then is certainly no less true today.

The company is even bigger now.

Yet, that Berkshire can't produce quite as exceptional returns** these days doesn't invalidate the usefulness and merits of their core investing ideas and principles. In fact, the good news for most investors is that few have to wrestle with Berkshire's challenges that come from being very large.
(There are naturally some advantages to their size as well but, as far as total returns go, the disadvantages are greater.)

Those who give Berkshire's way of thinking some deserved respect seem unlikely to regret doing so.

There are many variations of ways to apply the ideas and principles in practice so they fit unique circumstances and capabilities. So it's plainly not one size fits all but, no matter how applied, there's generally no shortage of hard work involved.

Warren Buffett: What He Does Is "Simple But Not Easy"

Investing can be simple.

Easy?

Not at all.

Adam

Long position in BRKb established at much lower than recent prices

* Book value, as explained in the Berkshire owner's manual, is an imperfect, significantly understated, but still useful tracking measure for the company's intrinsic value.
** From 1965 up to when that Wesco annual meeting occurred, Berkshire's average annual gain in per-share book value had been ~ 24%.
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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, March 8, 2013

Buffett on Berkshire's Float

A follow up to this post.

As I mentioned in the prior post, a part of Berkshire Hathaway's (BRKa) advantage is the $ 73.1 billion of "float" -- essentially free money if they break even on underwriting -- that comes from their various insurance businesses.

Well, the fact is that Berkshire has actually had underwriting profits for ten straight years. So they've done a whole lot better than breakeven.

Having cost-less and enduring float (and, at times, even better-than-cost-less) is not a minor strength.

From Warren Buffett's 2012 Berkshire Hathaway shareholder letter:

"If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it. That's like your taking out a loan and having the bank pay you interest."

It's not just the quantity of the float, it's the quality. Buffett then added:

"...we have now operated at an underwriting profit for ten consecutive years, our pre-tax gain for the period having totaled $18.6 billion. Looking ahead, I believe we will continue to underwrite profitably in most years. If we do, our float will be better than free money."

The quality of Berkshire's float is a big source of the gap between Berkshire's book value and intrinsic value.

"So how does our attractive float affect the calculations of intrinsic value? When Berkshire's book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and were unable to replenish it. But that's an incorrect way to look at float..."

and...

"The value of our float is one reason – a huge reason – why we believe Berkshire's intrinsic business value substantially exceeds its book value."

Berkshire's float being free -- never mind getting paid to hold it -- is far from an industry norm. Property-casualty ("P/C") insurers, of course, receive their premiums upfront then pay the claims at a later time. Well, in the letter, Buffett makes the point that P/C industry premiums have not covered claims plus expenses in 37 of the 45 years.*

So, for the industry as a whole, underwriting losses are the norm. As a result, industry returns for decades have been subpar. In fact, the industry's returns are worse than the average return of American industry more generally. It gets worse:

"A further unpleasant reality adds to the industry's dim prospects: Insurance earnings are now benefitting from 'legacy' bond portfolios that deliver much higher yields than will be available when funds are reinvested during the next few years – and perhaps for many years beyond that. Today's bond portfolios are, in effect, wasting assets. Earnings of insurers will be hurt in a significant way as bonds mature and are rolled over."

Consider what they've accomplished in a bit more than four decades in terms of float. In 1970, Berkshire's float was just $ 39 million.

Adam

Long position in BRKb established at much lower than recent prices

* Ending in 2011.
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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 are never a recommendation to buy or sell anything.

Tuesday, March 5, 2013

Buffett on Berkshire's 'Powerhouse Five' & 'Big Four'

From Warren Buffett's 2012 Berkshire Hathaway (BRKashareholder letter:

Berkshire's 'Powerhouse Five' Businesses
Berkshire's five most profitable non-insurance businesses are BNSF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy.

Of these five, Berkshire only owned MidAmerican Energy as of eight years ago. At that time, MidAmerican earned just under $ 400 million pre-tax.

In acquiring the other four businesses since, Berkshire has used mostly cash to do so.

In fact, the company added just 6.1% to shares outstanding as a result of the BNSF deal. Otherwise, the deals were done with cash.

Well, those five businesses earned $ 10.1 billion pre-tax in 2012. Last year, Buffett had said he expected this to happen and, well, it did.

So a rather substantial $ 9.7 billion increase in pre-tax earnings while adding few shares outstanding. More from the letter:

"...the $9.7 billion gain in annual earnings delivered Berkshire by the five companies has been accompanied by only minor dilution.That satisfies our goal of not simply growing, but rather increasing per-share results."

Not all dilution is equal.

Dilution can make sense if it increases per-share value.

Dilution can make sense if investors get at least sufficient value per-share relative to what's being given up in value per-share.

Buffett covers this in the 1982 letter:

"...we will not issue shares unless we receive as much intrinsic business value as we give. Such a policy might seem axiomatic. Why, you might ask, would anyone issue dollar bills in exchange for fifty-cent pieces? Unfortunately, many corporate managers have been willing to do just that."

The above acquisitions, at least in combination, clearly worked out just fine on a per-share basis for investors.

Still, as Buffett explained in the 1997 letter, it's not often going to make sense to use Berkshire's stock as a currency in acquisitions:

"For a baseball team, acquiring a player who can be expected to bat .350 is almost always a wonderful event -- except when the team must trade a .380 hitter to make the deal.

Because our roster is filled with .380 hitters, we have tried to pay cash for acquisitions..."

In all too many deals, getting sufficient value in return is hardly the norm. A particular acquisition may result in a larger entity overall, but ends up not necessarily making sense on a per-share intrinsic value basis. In fact, per-share value too often gets destroyed in pursuit of an expanded domain.

Naturally, what a transaction does to intrinsic value on a per-share basis is ultimately what matters to investors.

Page 104-105 of the 2012 annual report provides an explanation of the elements that Buffett thinks should go into an - even if necessarily imprecise -- estimate of Berkshire's intrinsic value.*

Two of the elements are quantitative:

- Investments in stocks, bonds, and cash. These investments are funded by retained earnings and insurance float. If Berkshire ends up breakeven on insurance underwriting that float is free. Of course, over their history they've generated underwriting profits so those funds have actually been better than free. (That means they've, in fact, been paid to hold the funds.) Well, if Berkshire is just breakeven going forward on their insurance underwriting results, then the investments can be considered an element of value. Key measure: per-share value of investments.

- Earnings that come from sources other than investments and insurance underwriting. Key measure: per-share earnings from non-insurance businesses.

One element is not:

- How well will Berkshire's retained earnings will be deployed over time. That's, of course, necessarily more subjective, difficult to measure, yet hardly unimportant.

Berkshire's 'Big Four' Investments
American Express (AXP), Coca-Cola (KO), IBM (IBM) and Wells Fargo (WFC).

Berkshire's ownership interest in each increased during the year. That happened even though they purchased additional shares of only two of them:

"We purchased additional shares of Wells Fargo (our ownership now is 8.7% versus 7.6% at yearend 2011) and IBM (6.0% versus 5.5%). Meanwhile, stock repurchases at Coca-Cola and American Express raised our percentage ownership. Our equity in Coca-Cola grew from 8.8% to 8.9% and our interest at American Express from 13.0% to 13.7%."

Buffett then makes the following point:

"At Berkshire we much prefer owning a non-controlling but substantial portion of a wonderful business to owning 100% of a so-so business. Our flexibility in capital allocation gives us a significant advantage over companies that limit themselves only to acquisitions they can operate."

Berkshire's portion of these four businesses 2012 earnings combined was $ 3.9 billion but a whole lot less than that $ 3.9 billion shows up on Berkshire's income statement. The fact they don't show up on the income statement doesn't make them any less real from a business economics point of view:

"In the earnings we report to you, however, we include only the dividends we receive – about $1.1 billion. But make no mistake: The $2.8 billion of earnings we do not report is every bit as valuable to us as what we record.

The earnings that the four companies retain are often used for repurchases – which enhance our share of future earnings – and also for funding business opportunities that are usually advantageous. Over time we expect substantially greater earnings from these four investees. If we are correct, dividends to Berkshire will increase and, even more important, so will our unrealized capital gains (which, for the four, totaled $26.7 billion at yearend)."

Buffett later points out that, since 1970, Berkshire has increased per-share investments 19.4% annually while increasing per-share earnings 20.8% annually. In the letter Buffett points out:

"It is no coincidence that the price of Berkshire stock over the 42-year period has increased at a rate very similar to that of our two measures of value. Charlie and I like to see gains in both areas, but our strong emphasis will always be on building operating earnings."

An important part of Berkshire's advantage, of course, is the generally costless (in fact, often better-than-costless) and enduring float they get from the insurance businesses. As mentioned above, what ends up essentially being free money if they can just breakeven on underwriting.

Well, for the tenth consecutive year they had an underwriting gain.

More on that in a follow-up.

Adam

Long position in BRKb established at much lower than recent prices

* Initially this was covered in the 2010 annual report (pages 6 and 7 of the letter).
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, March 1, 2013

Benjamin Graham: Timing vs Pricing Stocks

From Chapter 8 of The Intelligent Investor:

"By timing we mean the endeavor to anticipate the action of the stock market—to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value. A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks. This may suffice for the defensive investor, whose emphasis is on long-pull holding; but as such it represents an essential minimum of attention to market levels.

We are convinced that the intelligent investor can derive satisfactory results from pricing of either type. We are equally sure that if he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator's* financial results." - Benjamin Graham

Back in 2009, Warren Buffett said the following:

"We don't try to pick bottoms. To sit around and not do something sensible because you think there might be something better…. doesn't make sense. Picking bottoms is not our game. Pricing is our game. And that's not so difficult. Picking bottoms is, I think, impossible." - Warren Buffett

Buffett: Picking bottoms is impossible

Market participants attempting to get the timing right (something that seems more close to futile than not) end up distracted from what's important: Making price versus valuation judgments that, over the long haul, will get the best possible result at the least risk.

Attempts at timing is inherently speculative and a distraction away from the all-important price versus value discipline.

Mispriced assets often seem to get sorted out in nearly, if not completely, unpredictable ways in terms of timing. It's important to be realistic -- when the timing does happen to work out -- about the real reasons why. Successful moves don't always get the scrutiny they deserve.

Sometimes the favorable outcome was more about luck than great foresight.

Sometimes it has little to do with having some unusual talent for predicting the amount and timing of price movements.

Not knowing when a favorable outcome was mostly accidental is a recipe for future mistakes.

An approach dependent on lucky or accidental outcomes is destined to result in even bigger losses down the road if it leads to unwarranted overconfidence. A few successful outcomes resulting more from good fortune, less on real foresight, might encourage that market participant to put even larger amounts of capital at risk (with maybe less favorable outcomes). I'm not saying no one can effectively time these things (even though my interest in such an approach is effectively zero). I'm saying those that try had better have a realistic view of their own abilities.

Overestimation of one's own talent in this regard will likely end up being very expensive.

The good news is a long-term investor doesn't have to get the timing right if sound price versus value judgments are mostly being made. Mistakes are inevitable, of course. The key is keeping them small and infrequent. One way to keep them small and infrequent is to always pay an appropriate discount to a well-judged valuation. An appropriate margin of safety is protection against small misjudgments (since valuation even done well is inherently imprecise) and the unforeseen adverse developments that inevitably arise in an unpredictable world.

Developing competence when it comes to understanding how price relates to the value of an asset is a good use of energy.

Attempts at timing the market generally isn't.

Expect wild fluctuations in price and allow that inevitable dynamic -- Mr. Market's inherent moodiness and -- to serve.

Adam

* Earlier in Chapter 8 Graham writes: "If you want to speculate do so with your eyes open, knowing that you will probably lose money in the end..."
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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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