Friday, May 31, 2013

Stock Buybacks: A Good Thing...If The Price Is Right

From this Barron's article:

PUBLICLY TRADED COMPANIES generally face two choices when their cash exceeds reinvestment needs: Pay shareholders via dividends, which are double-taxed, or buy their own shares in the market, increasing the company's value to remaining shareholders.

What's a sensible use of capital at one price naturally becomes not so sensible at some higher price.

Well, buybacks are only a good thing if: consistently executed when the stock price is below -- and, ideally comfortably below -- per share intrinsic business value, company finances are in good shape with routine operational/liquidity needs of the business well-covered (enough to at least maintain competitiveness but possibly also including those things that widen the all-important moat), and no other action offers, considering the specific risks, a plainly better return.

When a corporate buyback is announced it is frequently greeted with cheers. A buyback, when done the right way and for the right reasons, can certainly end up being a very good thing for shareholders. At times, however, buybacks are executed for the wrong reasons -- i.e. to offset the dilution resulting from exercised stock options, for example* -- or when shares are expensive.

Unfortunately, too often buyback announcements end up not being followed up by wise action.

The net result being minimally beneficial to long-term owners (or worse).

According to Barron's, a study by advisory service MG Holdings/SIP of companies (primarily technology) and their share repurchase behavior reveals, at best, mixed results.

It shows that, while some buyback programs have delivered favorable results, a large percentage have not been effectively implemented and delivered subpar results for shareholders. The article points out that managements have a tendency to execute more buybacks during the good times and less when times are tough. Well, that behavior almost certainly leads to paying, at best, more than necessary, or worse, maybe even a premium to per share intrinsic value.

The study was of $ 457.6 billion in buybacks from 2000 through 2012 of 232 companies. According to the study:

- 75% of the 232 companies bought back stock.
- At the end of 2012, 51% of the programs are now profitable while the rest, of course, were still not.
- The shares are worth just 13% more than what they cost to repurchase for the group. Not a disaster, maybe, but hardly a great result considering it has been over a 13 year period.
(It's worth noting that this is based on market prices. Again, what really matters is what was paid compared to per share intrinsic business value.)

The article also points out that this doesn't include the foregone interest on the cash if the shares had not been bought back. For that and other reasons the 13% is actually an overstatement.
So buybacks can be a very good thing but one cannot assume they will be done in a way that is highly beneficial to shareholders.

That's why -- all else equal -- a firm led by someone with wise capital allocation skills has higher intrinsic value even if that additional worth is difficult to quantify.

A good explanation of when it is advisable to buyback stock and when it is less so can be found in the Share Repurchases section of Warren Buffett's 1999 letter.

Adam

* Stock-based compensation is not a small expense for a number of tech firms. Dilution that comes from this form of compensation can prove a meaningful (and costly) offset to what would otherwise be a further reduction in share count. In some cases, this is literally a case of buying high and selling low

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, May 29, 2013

Efficient Markets

"...if you are in the shipping business, it's helpful to have all of your potential competitors be taught that the earth is flat." - Warren Buffett in the 2006 Berkshire Hathaway (BRKaShareholder Letter

Professor Gregory Mankiw recently wrote this New York Times article and opened with this:

OVER the last few weeks, as the stock market has reached new highs, my thoughts have turned to my 85-year-old mother. 

"O.K. Mr. Smarty-Pants," she often asks me, "what stock should I buy now?"

A very fair question and, according to the article, one she has asked him many times over the past three decades.

He goes on to explain why economists tend to be not good stock pickers and, generally, why it's foolish for most to even try to pick stocks.

Here's part of his explanation:

"One prominent theory of the stock market — the efficient markets hypothesis — explains how answering my mother's question would be a fool's errand. If I knew anything good about a company, that news would be incorporated into the stock's price before I had the chance to act on it. Unless you have extraordinary insight or inside information, you should presume that no stock is a better buy than any other."

Well, he's certainly right that picking stocks over the long-term in a way that does better than the market isn't an easy thing to do.

Many who attempt to beat the market over the long haul by picking individual stocks do not succeed. The evidence is overwhelming in this regard.

So, for lots of reasons, too many participants tend to underperform and that's likely to continue. There would seem to be little doubt about that considering the evidence. As I see it, here's the problem and where the disagreement begins:

When someone -- I think it is fair to say -- rightly points out how difficult it is to outperform the market over the long haul, it seems the default primary reason offered is often the inherent efficiency of markets.

At first glance seems reasonable enough yet that, I think, is not just somewhat incorrect but, more or less, a grossly wrong conclusion.

The fact that so many participants underperform doesn't logically lead to the conclusion markets must be efficient.

Underperformance by a large proportion of market participants and inefficient markets can and do comfortably coexist.

Warren Buffett had this take nearly 30 years ago:

"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." - Warren Buffett

Charlie Munger added this back in 2003 when speaking at UC Santa Barbara back in 2003:*

"...Berkshire's whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to." - Charlie Munger

This is about criticizing what I happen to think has been and remains a very flawed way of thinking that just won't go away (or, at the very least, gain somewhat less influence).

This isn't about criticizing anyone in particular, and certainly not Professor Mankiw, who from much can be learned. I mean, it's inevitable to end up at odds on a particular idea. One disagreement -- though in this case a major one -- need not take away from the merits of all else someone has written or said.**
(Besides, though I do happen to have rather strong views on this subject, who says I've got it completely or even mostly right? Still, I do think that the idea that markets are efficient -- or that they are even mostly efficient -- will prove to deserve little respect. Best case, efficient markets and related ideas are just a flawed distraction but, to me, they seem to belong on a short list for the most damaging things to come out of economics and finance.)

This also certainly isn't an argument to buy individual stocks.

Quite the opposite.

John Bogle has it just about right when he says most investors would be better off buying index funds (and, in the article, Greg Mankiw notes that economists tend to follow that advice) consistently over time and to trade them infrequently, if at all. Minimize frictional costs then capture increases to the per share intrinsic value of the businesses within the index. Getting good results picking individual marketable stocks requires not just a great amount of effort but, in some ways more importantly, the right temperament, an objective assessment of one's own abilities/limits, and the minimization of frictional costs. That sounds much easier than it actually is. Of course, it's important to know how to value a business and have the discipline to always buy with a comfortable margin of safety. Yet it's emotions, overconfidence, and excessive frictional costs that often destroys long-term investor returns.
(Buying in the good times when price relative to value is often less attractive, selling in the more challenging times when fear overwhelms the fact that price relative to value is often most attractive. All the while, incurring frictional costs and making unnecessary mistakes resulting from too much trading activity.)

The periodic purchase of an index fund may eliminate the very best possible investment outcomes. Still, since so many participants do underperform, it puts the average investor with a keen awareness of limits (and a controlled temperament such that they don't go crazy at market extremes) at an immediate advantage against many other investors. From the 1993 Berkshire Hathaway shareholder letter:

"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb." - Warren Buffett

The bottom line is that many participants are kidding themselves that they will outperform buying individual stocks in the long run.
(And a little success early on -- especially if accomplished during a bull market -- will convince some they are good at it before time and experience proves otherwise.)

So many do and likely will continue to have a difficult time beating the market. Again, no argument. It's the attempt to explain that reality with the efficient market hypothesis where the trouble begins. To me, investor underperformance seem mostly unrelated to market efficiency.

The reasons so many underperform?

Some examples but hardly an exhaustive list:

It's cognitive biases of various kinds. It's the wrong kind of temperament. It's overconfidence in abilities; a lack of awareness of limits. It's too much trading and frictional costs. It's ultra short investment time horizons. It's too much emphasis on macroeconomic analysis, not enough on microeconomics and accounting. It's too much energy spent attempting to outsmart/outguess near-term market price action.*** It's too much predicting, too little admission what can't be known about an always uncertain future. It's too little focus on and/or not being skilled at judging how market price compares to real per share business value. It's buying something without sufficient margin of safety. It's too little emphasis on long-term effects. It's buying what one doesn't truly understand. It's the view of stocks primarily as something to be flipped for gain -- whether driven by near-term fundamentals or, even worse, something more technical in nature -- instead of as incredibly convenient partial ownership of a business (after all, that's ultimately what a marketable stock is) with the emphasis on what it can produce over time.

It is not necessarily because markets are efficient.

Market participants are certainly free to trade all they want but, for most, that seems rather likely to be not very enriching. Even if many of these things are not easy to entirely fix, the most damaging behaviors, biases, and tendencies can, at least in part, become a bit less damaging. It just requires a serious attempt -- a thoughtful trained response -- by individual market participants as well as those in a position to educate and influence.
(Buffett and Munger certainly try to educate and influence in this way. They have for years even if it seems too many -- though not all, of course -- market participants have decided to mostly ignore their best ideas and, instead, mostly attempt to profit from near-term price action.)

The inevitable reality is that, in aggregate, market participants can only produce the market returns minus frictional costs. That doesn't mean it's not worthwhile to reduce the adverse effects, where possible, of the many behaviors that get market participants into trouble or otherwise hurt results; that doesn't mean it's not worthwhile to seek improved capabilities among market participants.

I happen to think, for lots of reasons, that even if a generalized improvement in participant behavior and skills were to somehow occur, it would still likely result in most underperforming the market as a whole.
(Keep in mind that I consider the above list to be, best case, a mere starting point. In other words, it's hardly a prescription for improvement. Via this list I'm simply suggesting that many of the things in combination could move us, at least directionally, toward capital markets that might serve us better.)

Now, I realize there's an embedded paradox here. Improved participant capability will not necessarily lead to improved returns. If one or a relatively small proportion of participants were to improve their investment skill, they surely may get improved results. Yet if capabilities were to improve somehow, en masse, for a large proportion of participants, results might not improve at all. In fact, it may even, somewhat oddly, lead to fewer participants outperforming.

The reason is simple enough.

Mispriced marketable stocks would become more difficult to find.

Some might then logically wonder: "Then why should we be terribly concerned about widely improving the investment capabilities of participants if overall results won't necessarily improve?" That's a question I'll take a shot at partially answering later on in this post.

Of course, this all begins with thinking it's even worth trying. In other words, if something is difficult to do well and deserves treatment as a serious undertaking, it doesn't seem wise to broadly propagate the very flawed idea that essentially concludes there's no point in even trying to think about business value because the price is always right or, at least, very nearly right. From the 1985 Berkshire Hathaway shareholder letter:

"Most institutional investors in the early 1970s...regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell. This now seems hard to believe. However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore calculations of business value - and even thought, itself - were of no importance in investment activities." - Warren Buffett

Buffett: Indebted to Academics

Take this a step further. If more participants decide to take this way of thinking seriously -- that market prices are generally always correct due to market efficiency so there's no point in trying to outperform -- it should logically lead to prices being even less likely to be "efficient". Think about that. I mean, doesn't an efficient market require very capable, highly engaged, market participants who attempt to make difficult judgments on price versus value in an always uncertain world?

This seems worth at least some careful consideration.

Now, generating attractive results -- all risks considered -- may not be the easiest thing to do.

Yet it's hardly an impossible thing to learn how to do well.

Proponents of efficient markets seem to more than imply it is very nearly a pointless exercise.

There will surely always be mispriced assets -- including the extreme variety -- but some desirable changes to market participant behavior just might lead to fewer of them. That, in itself, would be a victory. There are, of course, many reasons why assets might become mispriced, but aspects of human nature alone pretty much assures they will. In fact, no matter what wise systemic changes are made in the future, they'll almost certainly still decouple from a reasonable estimate of underlying value from time to time.

In any case, fewer mispricings just might mean that capital gets misallocated a bit less frequently and maybe on a smaller scale.

So what's the point of improving investment skills if it's not necessarily going to lead to better results? Well, the market primarily exists to move capital efficiently to where it is needed. It doesn't exist to enrich the participants. In a world of hyperactive casino-like markets, it's worth reminding oneself of this. If desirable changes to market participant behavior actually ended up making it more difficult for individuals to outperform that seems like a perfectly good outcome to me.
(All of this, of course, is unlikely to occur -- at least not with actual human beings on planet earth -- but it's at least one theoretical implication.)

Returns would then mostly have to come from increases to per share intrinsic value of the underlying businesses.
(Instead of via an attempt to profit from price action which is what dominates the current landscape.)

Maybe, just maybe, then all the unnecessary frictional costs -- some that are visible, some that are less so -- in the current system would become front and center.

Okay, so back in the real world that is also not likely to happen anytime soon. It's simply too lucrative for those involved. That doesn't mean it wouldn't be a very good thing if it did happen.

Much of what the beneficiaries of the current system are paid functions, quite literally, like a "tax" on capital.

The compounded long-term real world effect of this "tax" is not at all small.

It all happens rather quietly.

So it seem harmless.

It's not.

Adam

Related posts:
-Efficient Markets - Part II (follow-up)
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* Later in the same UC Santa Barbara speech Munger added this: "...when you logically derived consequences from this wrong theory, you would get conclusions such as: it can never be correct for any corporation to buy its own stock. Because the price by definition is totally efficient, there could never be any advantage. QED. And they taught this theory to some partner at McKinsey when he was at some school of business that had adopted this crazy line of reasoning from economics, and the partner became a paid consultant for the Washington Post. And Washington Post stock was selling at a fifth of what an orangutan could figure was the plain value per share by just counting up the values and dividing. But he so believed what he'd been taught in graduate school that he told the Washington Post they shouldn't buy their own stock. Well, fortunately, they put Warren Buffett on the Board, and he convinced them to buy back more than half of the outstanding stock, which enriched the remaining shareholders by much more than a billion dollars. So, there was at least one instance of a place that quickly killed a wrong academic theory."
** I say that as someone who thinks much can be learned from economists whether they lean politically one way or another. It's too easy to write off or ignore someone's whole body of work because you happen to disagree with an aspect of their thinking -- even if the disagreement happens to be a major one. Beware of confirmation bias. I realize some may not like such an ethos but it's really not such a bad way to go. On this blog, I generally avoid politics and will continue to do so. Having said that, I will say that no one person or political party has the definitive answers when it comes to economics. It's inherently incredibly complex and confusing no matter what one's politics happens to be. Charlie Munger said it very well at the most recent Berkshire shareholder meeting

"Our current problems are very confusing. If you aren't confused, you don't understand them very well." 

Of course, some ideas warrant more respect and attention than others. I still think it's a good habit to draw from and understand the broadest possible base of ideas as possible even conflicting ones (in fact, especially the conflicting ones).
*** Now this seems a true fool's errand whether the speculation on price action is one done via what seem to be sophisticated methods or not. To me, it's best to be wary of impressive looking but otherwise unnecessary complexity that is, in reality, rather ineffectual (though I'm not suggesting there aren't very successful speculators...of course there is). In my book, speculation includes even those who use some form of fundamental business analysis but are otherwise mostly focused on price action. Investment versus speculation does not come down to whether fundamental analysis is used or not. Both may do so. Investment has as its emphasis what a productive asset will produce over varying but generally very long time horizons; an emphasis on how price compares to what something is intrinsically worth and how that might change -- within a range -- over time. Speculation does not. A speculator's emphasis is mostly if not completely on market price action. There's naturally nothing wrong with speculation in itself, of course, but it just has less in common with investment than some think (even if there's no clear cut line that separates the two activities and there's occasional overlap). There will always be room for speculation. The question is in what proportion. There also will always be businesses with inherently speculative prospects -- more unpredictable future outcomes -- and the shares will trade accordingly. Even with the very best system design, the nature of equity markets is such that they'll always produce, at least in the shorter term, unpredictable and volatile price action.
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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, May 24, 2013

Munger and Buffett: High-Frequency Trading and the Flash Crash

Charlie Munger recently weighed in on high-frequency trading (HFT) and the flash crash during an interview with CNBC's Becky Quick:

"I think the long term investor is not too much affected by things like the flash crash. That said, I think it is very stupid to allow a system to evolve where half of the trading is a bunch of short term people trying to get information one millionth of a nanosecond ahead of somebody else."

He then added...

"I think it is basically evil and I don't think it should have ever been allowed to reach the size that it did. Why should all of us pay a little group of people to engage in legalized front-running of our orders?"

I understand why the comment on "legalized front-running" might make for a better headline but, at least to me, his comment about the impact of the flash crash on the long term investor is of more interest.

If you've bought shares of a sound business with solid prospects at a discount to value, and intend to own it many years, what does it matter if the market price trades down -- even if substantially -- on any given day or even much longer?

A huge drop matters if the funds are needed in the near-term, but shorter term funds don't belong in equities anyway. Otherwise, it only matters if you react to the near-term move emotionally, try to trade it, or something similar that involves the focus on stock price action.

So the speculator may need to worry about price action but a long-term investor does not.

Warren Buffett recently made a similar point. Things like the flash crash is just noise for a true long-term investor. In this recent interview on CNBC also with Becky Quick, he said this about HFT:

"...it is not contributing anything to capitalism."

Then later added this about the flash crash:

"The flash crash didn't hurt any investor. I mean, you know— you're sitting there with— with a stock. And, you know, and the next day...it's gone past. The frictional cost in...investing for somebody that does it in a real investing manner are really peanuts. I mean, they're far less than the cost in real estate or farms or all kinds of things. So it's— unless you turn it to your disadvantage by trying to do a lot of trading or something of the sort, it's a very, very inexpensive market to operate in...and all that noise should not bother you at all. Forget it."

So the true long-term investor in shares of a good business isn't adversely impacted even if the temporary paper losses are annoying. In fact, the lower prices in the near or even intermediate term will benefit the long-term investor.
(Since a drop allows more shares to be bought cheap by the long-term oriented owner and the company itself can do the same via buybacks also to the benefit of continuing owners. Somehow, this fact sometimes seems to get lost. )

Now, it certainly matters if how the market is structured and system weaknesses causes instability in such a way that it reduces confidence or leads to reduced investment and economic activity more generally.

Highly volatile or unnecessarily unpredictable markets (whether due to self-inflicted instability/uncertainty -- things like market structure and poor system design among others -- or external shocks) can impact the real economy if severe enough to damage business and consumer confidence.

Lowered investment. Reduced consumption.

That's quite a different but potentially very real problem.

Yet, the long-term investor who buys a quality asset at reasonable valuation in the first place isn't hurt (even if the quoted price might be unpleasant to look at for a while). For productive assets, especially those with durable advantages, intrinsic business value just doesn't change nearly as much as quoted prices might otherwise suggest from time to time.

"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett

For a good business (or any productive asset), temporarily reduced prices (i.e. shares bought at a discount to value that temporarily sell for an even bigger discount to value) can be a big advantage depending on the particular circumstances, but at a minimum they should be ignored by the long-term investor.

It's when too high price is paid (plainly expensive or an insufficient margin of safety), the business ends up having less attractive future prospects than initially thought, or intrinsic value is poorly judged that a drop in price becomes a problem.

Permanent capital loss.

There's entirely too much emphasis on near-term price action. It's not a small advantage to, instead, place the emphasis on judging well per share intrinsic value and how -- within a range -- it is likely to change over time.

Overconfidence destroys returns. Yet, when justifiably confident in real business value per share, the investor focused on long-term effects is not going to mind if something bought at a discount temporarily gets an even bigger discount.

Adam

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

Wednesday, May 22, 2013

Coca-Cola Leads Global Consumer Brand Rankings

According to Kantar Worldpanel, Coca-Cola (KOleads their recent ranking of global fast-moving consumer goods (FMCG) brands:

"Kantar Worldpanel's Brand Footprint Ranking reveals the strength of brands in 32 countries around the world, across the food, beverage, health and beauty and homecare sectors."

Kantar Worldpanel Brand Footprint Report

As I've covered in some (okay, so actually many) prior posts, businesses that sell well-known, trusted, small-ticket consumer goods with great brands and broad-based distribution capabilities tend to also have attractive economic characteristics over the longer run.

Small-ticket consumer goods -- in particular those with excellent brand recognition and substantial distribution strength -- frequently have sustainable competitive advantage, pricing power, and, ultimately, desirable core business economics.

Unfortunately, the stocks of many of the great consumer goods franchises have become, unlike several years ago, at least a bit expensive.

Here are the top five brands according to the report:

Brand                | Company
Coca-Cola        | The Coca-Cola Company
Colgate             | Colgate-Palmolive Company (CL)
Nescafé            | Nestlé (NSRGY)
Pepsi                 | PepsiCo (PEP)
Lifebuoy          | Unilever (UL)

Even though Coca-Cola has the top spot, it is Unilever that has what seems an astonishing 15 of top 50 global brands:

Company                          |Number of Brands in the Top 50
Unilever                            |                  15
Procter & Gamble (PG)|                   8
Coca-Cola                         |                    4
PepsiCo                             |                    5
Nestlé                                 |                    3

So these 5 companies own 70% of the top 50 brands.

Of these companies, all but Coca-Cola's stock comfortably outperformed the S&P 500 over the past 15 years. Check other longer time frames and it becomes obvious that more than solid stock performance among these great franchises is hardly unusual (especially if the initial valuation was not excessive). In fact, though there will always be exceptions, the best among these high quality franchises -- those with the great brands and strong distribution -- have generally done quite well over longer periods of time.

Coca-Cola's underwhelming stock performance is not a reflection of poor business performance. In fact, the business did just fine. It's more a reflection of an extraordinarily high valuation back in 1998. It's as good an example as any that, even for a very high quality business, paying a discount to the current intrinsic value (i.e. not what it might be worth some day), conservatively estimated, matters if an investor wants better than satisfactory investment results at reduced risk.

Occasionally, I'll hear someone argue that the current share price of a particular stock is justified because the future business prospects are unusually good; that it eventually will be intrinsically worth that much some day.

Maybe, but investing is not about whether valuation might be justified (or even more than justified) some day.

It's instead about which well understood investment, among the alternatives, will provide the most attractive returns considering the specific risks.
(What is well understood is necessarily unique to each investor. That's why buying something based upon what someone else thinks is just generally not a good idea. The conviction just won't be there when it counts; when it needs to be.)

It may be, in certain cases, that paying a somewhat higher valuation for a business with clear and sustainable competitive advantages is wise. The reason is simple enough. Those with sustainable advantages will often generate durably high return on capital for long-term owners. In the very long run, it's return on capital that primarily drives value creation and results.*

Return on capital provides a tailwind to the long-term investor (and, if current valuation is misjudged somewhat, it can help dig the investor out of a hole from time to time).

That's no justification for unnecessarily paying premium prices. Even the best business operates in a world of uncertain outcomes, so paying a discount to conservative value in order to protect against what can't be fully known remains a smart practice. The fact that many of these higher quality franchises with the great FMCG brands have done very well in the past guarantee nothing when it comes to the future. The best businesses can still be hurt by unforeseen difficulties -- sometimes serious even if fixable -- from time to time.

As with any business, financial strength as well as competent and honest management with wise capital allocation skills matters. Yet, if looking for businesses that generally have sustainable competitive advantages, companies like the above aren't a bad place to start
(Even if, at this point, it requires the patience to wait for an attractive price to become available in the markets. An investor only has to buy a truly great business at the right price once. After shares of a good business are bought at a fair or better price, it's the intrinsic value created by the business itself that does the heavy lifting when it comes to generating returns. In other words, no unusual trading skills required. In fact, trading likely just adds mistakes and lots of frictional costs.)

So are the best days behind these kinds of businesses? Is it too late? Well, maybe, but consider this:

Some think if an investment idea is well-known and seems obvious it can't be really good. In 1938, Fortune Magazine concluded "Several times every year, a weighty and serious investor looks long and with profound respect at Coca-Cola's record, but comes regretfully to the conclusion that he is looking too late." Since that time, Coca-Cola has grown significantly both domestically and around the world. It was not too late in 1938, and we believe it is far from that today. - From the 1Q 2010 Yacktman Quarterly Letter

To me, the probability that a business like Coca-Cola will perform just fine, even if not quite as well, over a longer future time horizon is not low. Of course, in the short and even medium term, just about anything can happen to share prices.**

Yet, as the short-term "voting machines" gives way to the long-term "weighing machine", share prices will at least roughly track increases to per share intrinsic business value. Well, that value is ultimately driven by business performance. Much as it was not too late for investors to benefit from Coca-Cola's future prospects in 1938, it seems unlikely that it is too late now. Many, if not all the forces, that created these long-term results remain in place.

These are mostly durable high quality businesses -- some, of course, more so than others --that produce high return on capital, at relatively lower risk, especially if bought at the right price.

As I've previously said, what's sensible to buy at a plain discount doesn't make sense at some materially higher valuation no matter how good the business may be.

They have a good probability of continuing to possess competitive advantages but, as always, an investor has to keep an eye on how the economic moat may be changing over time along with capital allocation decision-making by management.

When evaluating the quality of a business, one question worth asking is this: If a business stopped innovating for five years what would happen to its financial performance? Most consumer staples businesses would miss some opportunities, maybe lose some market share, yet would still likely continue to make a nice living and produce at least decent returns.***

Nothing catastrophic.

Not so for most tech stocks. Imagine Apple (AAPL), as good as the company is, not innovating for five years.

Not all so-called "defensive" stocks are created equal. Some of the better ones have more than solid "offensive" characteristics over a true investment time horizon. As I've said before that the reputation for these being defensive stocks isn't incorrect, it's just incomplete. The best of these businesses are not really just defensive, they're higher quality.

Yes, these higher quality stocks usually have less than exciting near-term price action and volatility and are likely to do better in bear markets.
(Though they certainly can drop in price substantially from time to time even if per share intrinsic value does not...I mean, they're still common stocks impacted by the psychology of market participants.)

Yes, they're also likely to not do particularly well in bull markets. Anyone who expects the higher quality stocks to outperform during a bull market is likely to be disappointed. 

That is, in part, how they have earned the reputation of being defensive. Yet, it's when they're looked at over longer time frames (more than a full business cycle or two) that the picture becomes more clear. This may be less exciting, I suppose, but for the long-term investor it should be the overall (full cycle) result and the exposure to relatively less risk that counts.
(Some no doubt attempt to jump in and out of these stocks depending on the market environment. Sounds good in theory but more likely just leads to added frictional costs and expensive errors of omission and commission.)

So these high quality businesses can provide both long-term offense and defense especially if purchased with an appropriate margin of safety in the first place.

Now I suspect one of the reasons why more professional investors do not make full use of, what Jeremy Grantham calls "the one free lunch", is this:


"Smart people aren't exempt from professional disasters from overconfidence. Often, they just run aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger in a speech to the Foundation Financial Officers Group

Some seem to think that when a prudent but more straightforward approach comes along there must be more to it. Occasionally, there isn't. When something like that comes along, seems reasonable to considering making some use of it. For many reasons, investing is already inherently difficult enough to do well. No need to make it more so. The difficulties come not just from the need to acquire the necessary investing skills and knowledge, but also from temperamental and psychological factors; from a keen awareness of one's own limits. 

"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." - Charlie Munger in the Stanford Lawyer (Page 19)

Finally, it's worth considering that, too often, those stocks that seemingly provide the prospect of excitement price action and quick gains (i.e. the next big thing or "lottery ticket" stocks that sometimes capture the imagination of market participants) can just as easily produce some big and quick losses. Potential big winners often reside in the same neighborhood as potential big losers and sometimes, at least beforehand, they're difficult to tell apart.

It only takes one big loss to undo a whole bunch of smart investments. Avoiding the material losses while minimizing trading and the related frictional costs is a good place to start.

So is buying everything with a sufficient margin of safety.

When losses and frictional costs get minimized, and shares are consistently bought cheap, it allows the magic of compounding real per share business value over time to be primary driver of long-term returns.

Adam

Established long positions in KO, PEP, PG, and AAPL at much lower than recent market prices

* With any investment, no matter how seemingly attractive, margin of safety is all-important. It protects against the unforeseen real, even if fixable, business problems. Still, it's worth keeping in mind what Charlie Munger said at USC Business School in 1994"If the business earns 6% o­n capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% o­n capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."
So the businesses that can maintain durable and attractive returns on capital have the wind at the back of an investor.
** As always, no views on the price action of marketable stocks are ever offered here. Those who choose speculation on stock price action -- even if informed by fundamentals -- over investment are participating in a very different game. There's nothing wrong with speculation, of course, but it has less in common with investment than some might think. The investment process isn't about price action, it's about what a productive asset can produce with long-term effects mostly in mind. Consider what, in this interview, Warren Buffett had to say"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return. So if I buy a farm and I expect it to produce $80 an acre for me in terms of its revenue from corn, soybeans etc. and it cost me $600. I'm looking at the return from the farm itself. I'm not looking at the price of the farm every day or every week or every year. On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation."
*** In fact, remember what happened when Coca-Cola tried to "innovate" with New Coke?
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, May 16, 2013

Berkshire Hathaway 1st Quarter 2013 13F-HR

The Berkshire Hathaway (BRKa1st Quarter 13F-HR was released yesterday. Below is a summary of the changes that were made to the Berkshire equity portfolio.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 4th Quarter 13F-HR.)

There was plenty of buying and selling during the quarter. Here's a quick summary of the changes:*

New Positions
Chicago Bridge & Iron (CBI): Bought 6.51 million shares worth $ 376 million
Liberty Media (LMCA): 5.62 million shares worth $ 714 million**

Added to Existing Positions
Wells Fargo (WFC): Bought 18.3 million shares worth $ 720 million, total stake now $ 18.0 billion
IBM (IBM): 6.50 thousand shares worth $ 1.3 million, total stake $ 13.9 billion
Wal-Mart (WMT): 1.75 million shares worth $ 139 million, total stake $ 3.93 billion
DirecTV (DTV): 3.24 million shares worth $ 211 million, total stake $ 2.43 billion
U.S. Bancorp (USB): 193.5 thousand shares worth $ 6.64 million, total stake $ 2.1 billion
DaVita (DVA): 1.37 million shares worth $ 178 million, total stake $ 1.95 billion (Previously disclosed in SEC filings. Also, a "Standstill Agreement" between Berkshire-DaVita is now in place.)
National Oilwell Varco (NOV): 2.19 million shares worth $ 149 million, total stake $ 510 million
Verisign (VRSN): 4.49 million shares worth $ 403 million
Wabco Holdings (WBC): 4.40 thousand shares worth $ 341 thousand, total stake $ 316 million

In the 1st quarter of 2013, there apparently was nothing purchased that was kept confidential. Berkshire's 13F-HR filings will sometimes say: "Confidential information has been omitted from the Form 13F and filed separately with the Commission."

Not this time.

Occasionally, the SEC allows Berkshire Hathaway to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

Reduced Positions
BNY Mellon (BK): Sold 695 thousand shares worth $ 21 million, total stake $ 572 million
Mondelez International (MDLZ): 5.79 million shares worth $ 182 million, total stake $ 222 million
Kraft Foods Group (KRFT): 66.7 thousand shares worth $ 3.7 million, total stake $ 88.4 million

Sold Positions
Archer Daniels Midland (ADM)
General Dynamics (GD)

Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity portfolio, even if they still manage only a small percentage of the overall portfolio.

These days, any changes involving smaller positions will generally be the work of the two portfolio managers.

Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial (approaching ~ 40%) and consumer stocks (~ 30%).

The remainder is spread across technology (primarily IBM), energy, communication services, healthcare, and industrials.

1. Wells Fargo (WFC) = $ 18.0 billion
2. Coca-Cola (KO) = $ 17.2 billion
3. IBM (IBM) = $ 13.9 billion
4. American Express (AXP) = $ 11.0 billion
5. Procter and Gamble (PG) = $ 4.26 billion

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

The top five often represent 60-70 percent and, at times, even more of the equity portfolio. In addition, Berkshire owns equity securities listed on exchanges outside the U.S., plus cash and cash equivalents, fixed income, and other investments.***

The combined portfolio value (equities, cash, bonds, and other investments) was just under $ 200 billion at the end of the most recent quarter.

The portfolio, of course, excludes all the operating businesses that Berkshire owns outright with ~ 288,000 employees.

Here are some examples of the non-insurance businesses:

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

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

See page 106 of the annual report for a full list of Berkshire's businesses.

Adam

Long positions in BRKb, KO, WFC, AXP, and PG established at much lower than recent market prices.

* All values based upon yesterday's closing price.
** The Starz/Liberty Media spin-off was completed earlier this year (spin-off of Liberty from Starz). Liberty Media changed its name to Starz and trades as STRZA. The spin-off is called Liberty Media Corporation and trades as LMCA. These new shares are a reflection of the spin-off. So Berkshire now owns shares of both STRZA and LMCA.
*** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside the United States. The status of those shares are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F-HR is if Berkshire happens to buy the ADR. Investments in things like preferred shares (and related warrants) are also not included in the 13F-HR.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, May 15, 2013

Charlie Munger: What Buying a Housing and Rabbit Hunting Have in Common

Charlie Munger recently weighed in on this past decade's boom and bust in the housing market during an interview with CNBC's Becky Quick.

In the interview, Charlie Munger took some time to use rabbit hunting as a way to help explain what happened during the housing crisis:

"Partly there was a time you felt foolish you didn't buy a house because you weren't making all the money everybody else was making, so it was a typical crazy boom. Now people have learned house prices can go down as well as up."

Munger then added this:

"It's like a fella who goes rabbit hunting and thoroughly enjoys himself. And then the rabbits haul out guns and start firing back. It would dim your enthusiasm for rabbit hunting, and that's what happened in the housing market."

For another good example of a "typical crazy boom",and the "rabbits" eventually "firing back", consider long ago what happened to Sir Isaac Newton during the South Sea Bubble.

Chart: Isaac Newton's Nightmare

Anyone who thinks that a high IQ is protection against foolish investing behavior should consider what happened to the otherwise often brilliant Sir Isaac.

The exchange about housing and rabbits starts at around the 24:12 point in the video. Check it out. Munger's delivery often adds a bit of an edge to the words.

Here's my summary of some of the other points that Charlie Munger made about what contributed to the real estate boom and subsequent crisis:

- We were building more houses than we needed leading inevitably to a glut driven by unwise home lending and bond financing. It was a combination of extreme stupidity and extreme immorality. This all led to what should not be considered an unexpected result (Munger also described it as "craziness and crookedness").

- Both the government and private sector had a role in it. Stupidity, incompetence, and venality behind it.

"We were exceptional in stupidity and immorality and we paid the price."

- We've learned our lesson either not at all or only somewhat. The new rules meant to reign in the worst behavior aren't strong enough. Take the easy money out of the system.

"The people who used to make the money they can hardly wait to start doing it again. The rest of us are going to have to curtail them."

- There's nothing wrong with pro-housing policies. We just don't need housing loans that aren't sound. We don't need a policy that leads to building lots of unneeded houses. We don't need the "fraud and folly" in the business of issuing securities who'll unload them on whoever will buy them.

These sorts of things combined with excess leverage (much of it via cheap and what probably seemed at the time like reliably available short-term funding) and insufficient liquidity among other things was just asking for trouble.

There needs to be stronger limits in place to prevent the same set of behaviors that got us into trouble from re-emerging. Maybe this has been accomplished to some degree, but Charlie Munger seems far from convinced of this. Some of the excesses -- probably in some creative new form -- seem certain to come back if we aren't careful to prevent it.

The interview is well worth listening to in its entirety. As is often the case, Charlie Munger had many other useful and insightful things to say.

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.

Friday, May 10, 2013

Buffett on Bonds and Productive Assets

From this past Monday's interview of Warren Buffett by CNBC's Becky Quick:

"I bought a piece of real estate in New York in 1992, I have not had a quote on it since. I look to the performance of the assets. Maybe...my piece of real estate have had pull backs, but I don't even know about 'em. People pay way too— way too much attention to the short term. If you're getting your money's worth in a stock, buy it and forget it."

He then added this on interest rates and how they affect all other assets:

"...interest rates act like gravity to other asset prices. Everything is based off them."

Buffett then also said:

"...interest rates have a powerful effect on...all assets. Real estate, farms, oil, everything else...they're the cost of carrying other assets. They're the alternative. They're the yardstick."

Interest rates may be the yardstick, but the time to buy certainly isn't when the world is free of trouble.

"...the fact that there are troubles in Europe, and there are plenty of troubles, and they're not going go away fast, does not mean you don't buy stocks. We bought stocks when the United States was in trouble, in 2008 and— and it was in huge trouble and we spent 15 1/2 billion in three weeks in— between September 15th and October 10th. It wasn't because the news was good, it was because the prices were good."

He also said that, while he doesn't have any idea when, some day bond yields will be a lot higher.

"Oh...it's going to happen. And question is...the question is always when. I'm no good on that. The question is to what degree it happens. But you could have interest rates very significantly different than what they are now— in some reasonable period in the future. It's not a game that I can play. I mean, I— I don't have any special insight into that sort of thing..."

As far as Buffett's concerned stocks might have been cheap not long ago, but they're now merely decent values.

"In terms of stocks, you know, stocks are reasonably priced. They were very cheap a few years ago. They're reasonably priced now. But stocks grow in value over time because they retain earnings..."

Bonds, on the other hand...

"There could be conditions under which we...would own bonds. But— they're conditions far different than what exist now."

Becky Quick then pointed out that her co-host on CNBC's Squawk Box, Joe Kernen, went into a retirement specialist recently. The specialist said he should be 40% in bonds. Buffett's response was "you shouldn't be 40% in bonds." He said investors with the "proper attitude" should have "enough cash on hand so they feel comfortable, and then the rest in equities..."

He then added:

"I would have productive assets. I would favor those enormously over fixed dollars investments now, and I think it's silly — to have some ratio like 30 or 40 or 50% in bonds. They're terrible investments now."

Of course, productive assets include not just equities (pieces of businesses) but naturally also entire businesses, as well as things like farms and real estate. As always, they must be attractive assets bought at attractive valuations. Even the best asset can be a dumb and risky investment at the wrong price.

Buffett did explain what he meant specifically by "proper attitude".

He said it's those investors who won't be bothered whether stocks were to drop, for example, 20% in the next month.

Now, 20% over the next month was used to help make his point, but it's not really about a specific percentage.*

It's just that those who tend to react the wrong way to negative price action aren't likely to do very well in equities. In fact, those who react emotionally to price action in either direction will likely end up with poor results in the long run. That more than a few investors tend to buy and sell at the wrong times is, unfortunately, an all too reliable pattern. Buying when the news appears good and selling when the outlook appears less rosy or seems more uncertain isn't a brilliant way to invest. The fact that a favorable outlook makes it feel safer doesn't mean that it is. All else equal, the higher prices that will generally prevail during the good times increases the risk of permanent capital loss (and, of course, the lower prices often available during the not so good times reduce that risk.) Investors often try to time their moves but the evidence is that this is mostly a good idea in theory only. It is likely to increase mistakes and just generally reduce returns.
(Though I'm sure there's some who are able to do this sort of thing...it's just that far more seem to think they can do this effectively than the available evidence suggests.)

The intrinsic value of most quality productive assets simply doesn't move around nearly as much as stock market prices. With so much inherent price movement, eventually sound long-term investments should become available at a discount.

Investment is attempting to capture the long-term compounding of real value, instead of the near-term price movements. That the macro environment will go sour from time to time over a true investment horizon is inevitable. Expect it while realizing that attempts at correctly timing it is folly. The evidence that attempts at properly timing moves consistently well is not smart thing to do isn't insignificant yet, no doubt, many will still ignore this reality.

The good news is that timing things well isn't important over the long haul, paying the right price is.

In any case, buying when the skies are clear then selling during the storm is a great way to pay more than necessary for assets and, ultimately, sell them for too little.

More risk, less reward.

It's clearly not impossible to counteract this adverse tendency, but that starts with being aware of it.

Buffett's not always against the ownership of bonds by the way. In the interview, he points out that he made a lot of money in zero coupon bonds in the early 1980s and added that "...the price of everything determines its attractiveness."

Buffett said that a few years ago "The news was terrible, but the stocks were cheap, you know. News is better now. Stocks are higher. They're still not— they're not ridiculously high at all, and bonds are priced artificially. You've got some guy buying $85 billion a month. (LAUGH) And— that will change at some point. And when it changes, people could lose a lot of money if they're in long-term bonds."

Much later in the interview, Buffett once again talked about the folly of trying to buy and sell stocks based on current news. He said those that do this are "giving away an enormous advantage" then added:

"...I bought a farm in 1985, I haven't had— had a quote on it since. But I know what it's produced every year. And I know it's worth more money now. You know, it— if I'd gotten a quote on it every day and somebody's said, "You know, maybe you oughta sell because there's, you know, there's clouds in the West," or something. (LAUGH) It's — it's crazy."

Investment, in contrast to speculation, has as its focus what a productive asset can produce over a long time frame. Of course, what you pay for that asset -- whether it be an entire business, part of a business, or a farm. or other real estate -- matters. Many think of the stock market primarily in terms of where prices will be over the near or even intermediate term. Learning to think primarily about what something will produce over time instead of price action can make all the difference.

In this recent post, I mentioned that Buffett last year said "bonds should come with a warning label." Then, as now, he wasn't saying when yields would rise. Getting the timing right is always difficult at best. In fact, it is mostly a waste of energy or worse. The good news is that timing things consistently well is not a requirement when it comes to getting attractive investment results. Look no further than Warren Buffett himself for evidence of this.

As Donald Yacktman and his team like to say"It's almost all about the price."

That just about sums it up. It's buying productive assets, particularly those that the individual investor understands well, at a price that represents a nice discount to per share intrinsic value.

Adam

* To make his point about the "proper attitude", Buffett used stocks going down 20% in the next month as an example. In this interview back in 2009, Charlie Munger talked about stocks dropping more like 50%:

"I think it's in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by say 50%."

The point isn't really the percentage. It's to focus on what an asset is intrinsically worth and buy it cheap enough instead of focusing on what the quoted price happens to be on any given day. If cheap, and you want more of a particular asset, buy more. If expensive, and you want less of the asset, then maybe sell. Otherwise, ignore the quoted prices and use that energy making sure value has been judged well. Better yet, if justifiably confident about an assets prospects, expend that energy elsewhere once enough shares are owned at an attractive valuation. The bottom line is to keep fear and greed in check and just mostly ignore the quoted prices. Emotional reactions cloud investment judgments and destroy returns.
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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, May 8, 2013

2013 Berkshire Shareholder Meeting - Part II: Buffett on Timing Purchases

***Update: Separated today's earlier post into Part I & Part II. A shorter version of the following was initially in the bottom half of Part I.***

According to The Motley Fool, here's what Warren Buffett said at the 2013 Berkshire Hathaway (BRKa) shareholder meeting about attempting to time the purchase of marketable securities:

"If they try to time their purchases they will do very well for their broker and not very well for themselves."

I realize some will continue to try and time their purchases (and maybe some are even good at it), but the right time to buy or sell any asset is rarely if ever obvious. The good news is it's not all that important to get the timing right if you can judge value well, and always buy that value at a discount (i.e. dollar bills for fifty cents, especially if those "dollar bills" increase intrinsically in value over time as most good businesses do).

The right price to pay for an asset may not be an easy thing to figure out but is, by comparison, at least doable with some work (and a good understanding of business economics, of course).

Those that try to get the timing and price right are making the job more difficult than it needs to be. When something becomes plainly expensive, avoid it. When something becomes plainly cheap, buy it. Always buy with a nice margin of safety. Do these things consistently well and timing things right becomes far less relevant in the long run.

It is as Seth Klarman said in his 2010 annual letter:

"Risk is not inherent in an investment; it is always relative to the price paid."

What's sensible and low risk at one price is risky at some higher price. Getting that right consistently is difficult enough.

Add timing to the equation and errors of omission along with other misjudgments are almost certain to increase.

In the short run (and even longer), poorly timed investments can certainly lead to temporary paper losses -- sometimes rather substantial. Market prices in the short run can do just about anything.* That's a problem for those who speculate on price action. Yet, for those that take more of a long-term investment approach, a declining price shouldn't matter as long as the price paid represents a discount to per share intrinsic value and the business has attractive and durable core economics. If anything, it is a net benefit when prices go lower over the near-term or even intermediate term since more shares can be bought below value (both by the company via buybacks and by the investor over time). It is only when it comes time to sell that an investor should hope that price fully reflects the -- if a good business -- increased per share intrinsic value many years down the road.

So getting the timing wrong matters little in the long run if an investor generally judges value of a good business correctly in the first place and buys at a price that represents a discount. In the short run, the "voting machine" can create nonsensical prices but, in the long run, the "weighing machine" will adjust to something that more closely reflects per share intrinsic business value.

It's only when price versus value is judged poorly that the long-term investor becomes exposed to the risk of permanent capital loss.

It's getting the valuation roughly right, within a range, then make purchases with an appropriate margin of safety to account for most of the worst outcomes.

The appropriate margin of safety is necessarily different for each investment.

For the long-term investor, getting price versus value right is all-important. Attempts to also get the timing right is often just a foolish distraction and, worst case, very costly.

Tempting, yes, but generally unwise.

Adam

Long position in Berkshire (BRKb) established at much lower than recent prices

Related post:
2013 Berkshire Shareholder Meeting - Part I

* Paper losses may not be pleasant but consider this: When a business that isn't public is bought (with the intent to own it longer term), the new owner(s) generally will not focus on what someone else tells them it is worth day after day (or, in the case of the stock market, every second). They focus on the income stream the business produces. They focus on whether that stream of income relative to the price they paid remains attractive. They don't sit their considering what other "voters" are saying the business is worth in the short-term or even longer. To a business owner, the price of only matters when buying or selling. It's the same for a partial owner of a business but unfortunately the minute-by-minute quoted value becomes a distraction for many market participants. It is only those speculating on market price action who should expend their energy thinking about near-term quoted prices.
** Missing the chance to build a meaningful position in (or missing entirely) a well understood business you like that was at one point was sensibly priced.
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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.

2013 Berkshire Shareholder Meeting - Part I: Not Picking Stocks By The Numbers

***Update: Separated this post into Part I & Part II. The bottom half of the original version of this post is now in Part II.***

In an interesting exchange at the 2013 Berkshire Hathaway (BRKa) shareholder meeting, Warren Buffett and Charlie Munger made it clear that, for them, the numbers play a lesser role than some might otherwise think when it comes to picking stocks.

Their focus is on how a business (whether buying an entire business or shares of the business) will be doing in ten years or so. For Buffett and Munger, it's about what the competitive advantages will look like many years from now.

Here's part of the exchange as summarized by the Wall Street Journal's live blog of this year's meeting:

"We are looking at businesses exactly like we are looking at them if somebody came in and asked us to buy the whole business," Buffett said. He said they then want to know how it will do in ten years. 

Munger was even more forceful: "We don't know how to buy stocks by metrics ... We know that Burlington Northern will have a competitive advantage in years ... we don't know what the heck Apple [AAPL] will have. ... You really have to understand the company and its competitive positions. ... That's not disclosed by the math.

Buffett: "I don't know how I would manage money if I had to do it just on the numbers."

Munger, interupting, "You'd do it badly."

It's mostly not about the numbers but I'm guessing at least some who hear or read this don't completely believe it. There's got to be more of a heavy numerical emphasis in their analysis, right?

Nope.

Maybe those who don't quite buy this are picturing instead something like these huge proprietary Berkshire spreadsheets, other complex analytical tools and methods, that they just aren't willing to reveal. 

That's simply not the case. Most of what matters whether buying pieces of businesses (in the case of marketable stocks) or buying entire businesses can't be seen in the numbers. Consider this Wall Street Journal article from a while back on how Buffett likes to operate:

He keeps no calculator on his desk, preferring to do most calculations in his head. "I deplore false precision in math," he says, explaining that he does not need exact numbers for most investment decisions.

There's also the following comment from Charlie Munger during his 2003 UC Santa Barbara speech that I've referenced before:

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

Understanding competitive advantages and whether they will remain in place for a very long time matters a whole lot. Yet much of what's important in this regard just isn't quantifiable or, at least, can't be measured very well.

Naturally the numbers matter to an extent. It's just that some assume that valuations need to be estimated with precision via complex methods. That's just not the case. In fact, with investing it is the simple methods that are often more useful. Approximate value does have to be estimated in a meaningful way but doesn't require a bunch of complex calculations and higher forms of math. Additional unneeded complexity often just leads to precisely the wrong answers.

A good understanding of accounting is, of course, rather very important. Unfortunately, the accounting numbers are only a starting point and have to be translated into something economically meaningful. That's not necessarily an easy thing to do consistently well.

There are many ways to misjudge a business if an investor doesn't know how to read and interpret what's in a 10-K, 10-Q, and other SEC filings.

So understanding financial statements is important yet much of what matters in investment analysis is not going to be found in the numbers.

I'll get to more from the meeting in a follow up.

Adam

Long positions in Berkshire (BRKb) and Apple (AAPL) established at much lower than recent prices

Related post:
2013 Berkshire Shareholder Meeting - Part II (follow up)

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