Friday, November 29, 2013

Buffett: How to Minimize Investment Returns

At the beginning of the "How to Minimize Investment Returns" section found in the 2005 Berkshire Hathaway (BRKa) shareholder letter, Warren Buffett mentions that the Dow increased from 65.73 to 11,497.12 during the 20th century.*

He then says:

"This huge rise came about for a simple reason: Over the century American businesses did extraordinarily well and investors rode the wave of their prosperity. Businesses continue to do well. But now shareholders, through a series of self-inflicted wounds, are in a major way cutting the returns they will realize from their investments."

The reason is straightforward enough as Buffett goes on to point out. He says the "fundamental truth" is that owners, in aggregate, can only earn what the businesses, in aggregate, earn over time. 

Naturally, individual participants attempt to gain advantage over other participants. 

Yet, it's not difficult to show how unwise this behavior generally ends up being.
(More on this below.)

I'd emphasize Buffett's point above that "businesses continue to do well."


Well, as long as a fair price is paid in the first place, how the businesses perform will be the long-term driver of future returns.

Buffett adds this later in the letter:

"For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.

Indeed, owners must earn less than their businesses earn because of 'frictional' costs. And that's my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.

To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We'll call them the Gotrocks."

In 2005, American corporations were earning roughly $ 700 billion each year and, as outright owners, this fictional family will spend obviously some of it. Yet that remaining large unspent portion is saved and compounds for these continuing long-term owners. More from Buffett:

"In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.

But let's now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family's annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.

After a while, most of the family members realize that they are not doing so well at this new 'beat-my-brother' game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he'll never outsmart the rest of the family. The suggested cure: 'Hire a manager – yes, us – and get the job done professionally.' These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.

The family's disappointment grows. Each of its members is now employing professionals. Yet overall, the group's finances have taken a turn for the worse. The solution? More help, of course.

It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we'll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. 'What,' the new Helpers ask, 'can you expect from such a bunch of zombies?'

The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.

The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.

And that's where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked).

A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks. Today, in fact, the family's frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one."

This 80% number might seem extreme. It's not. The reality that roughly 80% of returns is now going to "helpers" has been highlighted by John Bogle as well:

"Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return, and you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That is a financial system that is failing investors because of those costs of financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed."

Buffett closes the "How to Minimize Investment Returns" section of the letter with the quote about Sir Isaac Newton that's located in the upper right hand corner of this blog.

For lots of reasons, I've liked the story of Isaac Newton's speculative folly for quite a long time. It not only highlights that being very smart and investment success need not have much to do with each other; it also highlights, despite massive progress in other ways, the persistence of human nature and how unlikely it is to change. Similar mistakes are made under what seems to be not sufficiently different circumstances. The lessons are there for the taking but not applied. Buffett's quote about Newton provides another dimension: The folly of allowing market hyperactivity and frictional costs to enter the equation. It emphasizes how poorly lots of trading activity is going to work out for investors as a whole. Of course, that leads many to conclude they'll be on the right side of this gross returns minus frictional costs game. What Buffett calls the "'beat-my-brother' game." Well, for most market participants, the odds aren't good that this approach will fatten their portfolio. It would seem that Buffett's parable and all the other available evidence would make this pretty obvious but, well, history suggests it won't change behavior.**

Some will rightly conclude that there's no point to buying individual stocks. For many that's the right conclusion. The good news is there are many convenient, low frictional cost ways available to approach long-term investment this way. Still, for those inclined and able to judge the prospects of a business well, the same essential lesson applies: It makes little sense to allow all the frictional costs to creep into the process.
(Not to mention the chance for additional misjudgments. When an action is taken, how the move might improve results isn't the only consideration. In fact, it's the opposite outcome that just might deserve greater consideration.)

Buffett points out that the annual growth rate required to produce an increase from 66 to 11,497 over 100 years was 5.3%.

Compounding is a powerful force.

Keep in mind that, in addition to that not exactly modest increase, long-term investors would have received a not at all small quantity of aggregate dividends (which were, earlier in that century, a much larger part of total returns) over that time frame.

Investment results via marketable stocks -- in contrast to speculative results -- come primarily from the increase to per share intrinsic business value (driven by what the business earns, in aggregate, over time). Those that achieve (or claim to achieve) above average results via cleverly timed trades make for great stories and headlines. Some individuals will actually even succeed at this kind of approach but results, in total, will otherwise inevitably be gross returns minus frictional costs. It's one of "the relentless rules of humble arithmetic."

So sure there will be exceptions, but is it wise to engage in a strategy that's based upon being the exception?

At any point in time some market participant will be able to promote the brilliant trade they made. It might even get its fair share of coverage. The incentive to boast is surely there. I'm guessing the not so brilliant trades will get promoted just a bit less.

Best to trust only carefully audited results over very long time frames.

Otherwise, skepticism is very much warranted.

Investing well means not being impressed by -- and not being susceptible to -- the compelling "story". That's not only true when attempting to judge the actual capabilities and results of other market participants. That's true when judging the risk-adjusted prospects of a particular investment alternative.

Investing is about how price compares to value.

It's about how well value is truly understood (or can be understood).

It's not about how compelling the "story" sounds.

In any case, hyperactivity among market participants, combined with the willful payment of excessive fees, is a recipe for making the "helpers" rich and paying lots of taxes.

Those putting up the capital take essentially all the risk (well, at least beyond "career risk") and end up compensated insufficiently or worse.


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

* Pages 18-19 of the letter.
** If attractive long run results at the lowest possible risk is the objective, being realistic about not only one's own capabilities, but also what approach has a high likelihood of working over time, is a good chunk of the battle. Unfortunately, overconfidence in abilities and overestimating future prospects gets in the way and, naturally, isn't likely to end up being particularly lucrative. Of course, efficient market hypothesis doesn't allow for such an outcome -- less risk, more reward -- but that's another subject altogether.
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, November 22, 2013

Grantham on Efficient Markets, Bubbles, and Ignoble Prizes

The latest GMO quarterly letter was recently released.*

Below, I've highlighted some of Jeremy Grantham's thoughts on efficient markets, bubbles, and the 2013 Nobel Prize in Economics from his section of the letter:

"Economics is a very soft science but it has delusions of hardness or what has been called physics envy. One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed introduced rigor into economics, it unfortunately also brought mortis. Later in his career he felt that economics had lost sight of its job to be useful to society, having lost its way in a maze of econometric formulas, which placed elegance over accuracy.

At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not fit the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).

We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the last 25 years at least four of the great investment bubbles in all of investment history."

To me, this latest letter is Grantham at his best.
(His section begins on page 6.)

Well worth reading in its entirety.

Grantham goes on to describe the four bubbles that, for many, will hardly be unfamiliar:

1) Japanese equity bubble - By 1989 stocks were selling at 65 times earnings (on what may be not so great accounting). Grantham points out, before that, stocks had never peaked at more than 25 times earnings. Japanese stocks would go on to fall 90%.

2) Japanese land bubble - This bubble peaked a couple of years later in 1991. Grantham describes it this way:

"This was probably the biggest bubble in history and was certainly far worse than the Tulip Bubble and the South Sea Bubble. And, yes, the land under the Emperor's Palace, valued at property prices in downtown Tokyo, really was equal to the value of the land in the state of California. Seems efficient to me..."

3) U.S. equity bubble in 2000 - This one peaked at 35 times earnings but that doesn't even begin to describe how expensive certain stocks had become. For perspective, earnings peaked at 21 times earnings in 1929.

4) U.S. housing bubble - According to Grantham this was the first bubble that was truly global.

Grantham notes that, according to EMH, these annoying real world occurrences should happen something like once every 10,000 years.

He also makes the point that "this efficient market nonsense" certainly didn't hurt value managers like himself.

" I should find time to thank all those involved for producing and passionately promoting the idea. During the 1970s and 1980s I am convinced it helped reduce the number of quantitatively-talented individuals entering the money management business."

Warren Buffett has previously made a similar point.

Max Planck understood well the resistance of the human mind, even among those who happen to be very smart, to new ideas. He understood how that tendency impacted scientific advancement.

Buffett has said the same applies to finance.

Well, one of the more disappointing -- even if unfortunately not exactly surprising -- aspects of what has happened over these past decades is this:

"...the proponents of the EMH not only promoted their theory, but via the academic establishment the high priests badgered academic researchers into leaving, resigning themselves to non-tenure, or getting religion, as it were."

Much later in the letter, Grantham talks more specifically about the 2013 Nobel Prize in Economic Sciences:

"So, economics has been more or less threadbare for 50 years. Pity then the plight of the Bank of Sweden with all that money to give away in honor of Alfred Nobel and in envy, perhaps, of the harder sciences. If you had $1.2 million to give away but few worthy recipients, what would you do? I would suggest making it a once-every-three-year event..."

His primary reason?

To make it more likely that only "the Real McCoys" win the prize and to prevent "so many ordinary soldiers" from getting it.

That's unlikely to happen anytime soon, but that doesn't make it any less unfortunate that the Bank of Sweden did the following:

" further prove how completely they have lost the plot, they gave two-thirds of the prize to two economists who attempted to prove market inefficiency and one-third to another who claimed it was efficient and seriously efficient at that. What a farce. And to read all these genteel descriptions, or rather rationalizations, as to why this made sense is to realize to what extent the establishment is respected, regardless of its competence level."

The economists he is referring to are Eugene Fama, Robert Shiller, and Lars Peter Hansen.

"Robert Shiller at least served society – Kenneth Boulding would have approved – by loudly warning us of impending doom from the Tech Bubble with his superbly timed book Irrational Exuberance in the spring of 2000. Not bad! He also warned us well in advance of the much more dangerous housing bubble..."

Grantham is, not surprisingly, not quite so complimentary of Fama:

"As for Fama, who conversely provided a rationale for all of us to walk off the cliff with confidence, the less said the better. For believers in market efficiency and all the assumptions that go along with it, the real world really is merely an annoying special case."

Grantham has mentioned this so-called "special case" before.

Now, to get an idea how Eugene Fama looks at bubbles, consider what he said when presented with the following back in 2010:

Interview With Eugene Fama

"Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst."

He responded this way:

"I don't even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don't know what a credit bubble means. I don't even know what a bubble means. These words have become popular. I don't think they have any meaning."

That comment from Fama just might help begin to explain how such ideas and assumptions have been able to maintain their widespread -- some, including myself, would argue rather more than a little bit damaging -- influence for so long.

From later in the same interview:

"But you are skeptical about the claims about how irrationality affects market prices?"

Fama's response:

"It's a leap. I'm not saying you couldn't do it, but I'm an empiricist. It's got to be shown."**

Naturally, there's nothing inherently wrong with needing it "to be shown", but somehow, at least for Fama, these recent bubbles don't offer much evidence. Also, for certain things "to be shown", we'll probably need several more centuries of data (if not more) for sufficient empirical evidence to exist. In the meantime most of us have to make judgments lacking that evidence.

Other related articles:
-In praise of empiricism: a Nobel prize for everyday economics
-It's the Data, Stupid! Empiricists grab this year's Nobel Prizes.
-Eugene Fama, King of Predictable Markets**

Fama continues to think, more or less, that efficient markets made up of even-tempered and rational participants exist in the real world. This way of thinking at least implies that it's tough to distinguish between what's been mispriced and changes to risk.

Fama seems to generally view any variation in market price as being rational and the reward one gets for taking on risk. In other words, if the market price changes then it must necessarily be a reflection of changes in risk.

Shiller's view seems to be that, at least in the shorter run, less than rational psychological forces may take hold that leads to mispriced assets but, in the longer run, those mispricings tend to be corrected.

Fama does, in fact, seem to have an almost unflappable confidence in things like efficient markets.

Shiller, of course, does not.

Not long after their Nobel Prize was announced Shiller was interviewed on CNBC. In the interview, Shiller called Fama the "father" of efficient markets as a theory and most responsible for popularizing it over the years.

Shiller also said the following about Fama's rather consistent, if nothing else, view that markets are mostly quite efficient and rational:

"When you hatch a theory, you don't easily let go, that's where he [Fama) is. I think he's a -- he's a brilliant man...but he's rather involved in this theory."

CNBC Video: Robert Shiller on Eugene Fama

Maybe, just maybe, the reason Fama doesn't see the empirical evidence relates, in part, to Shiller's explanation.

That doesn't really seem a stretch at all.

Well, in any case, Fama, Shiller, and Hansen have won a big prize.

No doubt winning it involved lots of hard work by what are well-intentioned and smart people.

Still, consider me more than a little bit skeptical of thinking that's built upon the foundation of efficient markets and rational expectations. I happen to be rather convinced that the influence of these theories over time have not been a good thing at all for civilization.

To me, the sooner they lose influence the better.

Naturally, some very capable proponents of these theories (and the many related models) will offer a more favorable view.

In any case, the outcome of this debate has important consequences.

To me, the market isn't terribly efficient. Yet outperforming the market as a whole remains extremely difficult. Some use market efficiency as the explanation for this difficulty. Well, there's no reason why capital markets can't have some inefficiencies AND be difficult to outperform.

To me, these things coexist just fine.

For example, a relatively small proportion of participants might have certain capabilities (both temperamental and intellectual) to consistently benefit from mispricings while the great majority of participants overestimate their ability to do so.

The logical way to go, with this in mind, will continue to be index funds for most market participants.


Related posts:
-Efficient Markets - Part II
-Risk and Reward Revisited
-Efficient Markets
-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

* Also published in Barron's.
** Fama is described as "a careful empiricist" in the article.
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, November 15, 2013

Berkshire Hathaway 3rd Quarter 2013 13F-HR

The Berkshire Hathaway (BRKa) 3rd Quarter 13F-HR was released yesterday. Below is a summary of the changes that were made to the Berkshire equity portfolio during that quarter.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 2nd Quarter 13F-HR.)

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

New Position
Exxon Mobil (XOM): bought 40.1 million shares worth $ 3.74 billion

Most of the Exxon Mobil shares were actually purchased in the prior quarter but not disclosed.

Berkshire's 2nd Quarter 13F-HR filing did indicate some activity had been kept confidential. That filing said: "Confidential information has been omitted from the public Form 13F report and filed separately with the U.S. Securities and Exchange Commission."

We now know it was Exxon Mobil that was omitted.

It's certainly a sizable stake.

This separate 13F-HR/A filing (also released yesterday) reveals the specific number of shares of Exxon Mobil that had already been purchased by the end of the 2nd quarter:

31.2 million shares

So that means only 8.85 million shares were actually purchased in the 3rd quarter.**

Occasionally, the SEC allows Berkshire 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.

The current 13F-HR filing does not indicate any moves were kept confidential for the 3rd quarter.

Added to Existing Positions
U.S. Bancorp (USB): bought 840,200 shares worth $ 32.2 million, total stake $ 3.03 billion
DaVita (DVA): 1.5 million shares worth $ 87.98 million, total stake $ 1.85 billion
(The stake in DVA is actually now higher compared to end of 3Q.)
BNY Mellon (BK): 8,807 shares worth $ 292,000, total stake $ 816.7 million
Suncor (SU): 240,500 shares worth $ 8.58 million, total stake $ 642.4 million
Verisign (VRSN): 64,100 shares worth $ 3.58 million, total stake $ 611.8 million

Reduced Positions
ConocoPhillips (COP): sold 10.59 million shares worth $ 780.6 million, total stake now $ 996.8 million
DirecTV (DTV): 760,700 shares worth $ 48.95 million, total stake $ 2.35 billion
Sanofi (SNY): 157,800 shares worth $ 8.37 million, total stake $ 207.2 million
GlaxoSmithKline (GSK): 1.13 million shares worth $ 58.9 million, total stake $ 18.03 million

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, consumer, and technology stocks (primarily IBM).

1. Wells Fargo (WFC) = $ 19.96 billion
2. Coca-Cola (KO) = $ 16.08 billion
3. American Express (AXP) = $ 12.42 billion
4. IBM (IBM) = $ 12.41 billion
5. Procter and Gamble (PG) = $ 4.45 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 roughly $ 200 billion at the end of the most recent quarter.

The portfolio, of course, excludes all the operating businesses that Berkshire owns outright with ~ 290,000 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, Lubrizol, and Oriental Trading Company.
(Among others.)

Then there's Berkshire's rather substantial deal for 50% ownership of H.J. Heinz that closed earlier this year.

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.


Long positions in BRKb, KO, WFC, AXP, PG, USB, COP, DTV, SNY, and GSK established at much lower than recent market prices. Also, small long position in IBM established at slightly less than recent market prices.

* All values shown are based upon yesterday's closing price.
** It's worth mentioning that Berkshire did establish a small position in Exxon Mobil back in 2009, but later sold it.
*** 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. Also, after the 3rd quarter ended, Berkshire received shares in Goldman Sachs (GS) and General Electric (GE) from exercised warrants (both deals were amended from cash settlement to net share settlement). So, unless sold, those shares will show up in the next 13F-HR filing. Investments in things like the preferred shares (and, where applicable, related warrants) are not included in the 13F-HR. The same is true for the Heinz common shares (i.e. not just the Heinz preferred shares).
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, November 8, 2013

Bogle & Buffett on Stocks

John Bogle and Warren Buffett and made some rather noteworthy comments about stocks last month.

More on their comments below. First, here's a quick look at the GMO 7-Year Annual Real Return Forecast for stocks:

U.S. Large: minus 2.0%
U.S. Small: minus 3.8%
U.S. High Quality: 3.3%
Intl Large: 1.9%
Intl Small: 1.6%
Emerging: 6.5%
(GMO also provides forecasts for other asset classes that I've not included here)

Now I don't usually find most forecasts to be all that useful but, at a minimum, this probably should give someone pause who has very high expectations of future equity market returns.

Keep in mind that GMO's forecast was made when the stock market was lower than it is now.

For some context, here's an article that summarizes how past GMO forecasts (going back to 1994) have looked against reality over the years.

"While there was clearly a pessimistic bias to the forecasts, the direction of their guesses was remarkably accurate..."

The reason I don't pay much attention to forecasts is simply because, in the long run, what the market as a whole does matters far less* than whether a specific investment's intrinsic value has be judged well, and whether a nice discount was paid to that estimated value.
(I've said before: A well-judged long-term investment that temporarily gets an even bigger discount due to market conditions shouldn't be a problem. It's just an opportunity to accumulate more while making buybacks, if they already made sense, even more effective.)

John Bogle recently offered his own slightly more optimistic and straightforward view.

He said that at "a 2% dividend yield, which is roughly where we are today, and possibly--maybe a little optimistically--5% earnings growth from here; that would be a 7% what I'll call investment return, a fundamental return--the real return, not real in the inflation sense, but the actual return earned by Corporate America. And that looks to be around 7%; it could be point or two more.

I don't look for speculative return, which is will that P/E go way up or way down. I can't imagine it going way up. I think it is unlikely it will go way down."

He continued by saying...

"7% is pretty good. You double your money in a decade. Think about this for a minute: That's not a very high real return. By the time this decade over, we'll probably be around a 2% inflation rate, if we are lucky. Maybe all hell is going to break lose, with all this purchasing by the Fed of the securities. But [assuming 2% inflation], that would be a 5% real return, and that's about a point lower than the long-term norm."

There's no getting around the fact that stocks are up quite a bit in a relatively short amount of time. Anytime prices start to move up quickly, there's an increasingly high probability that the margin of safety on many investments is beginning to disappear, has disappeared completely, or worse yet, is plainly overvalued.

To me, that's the time to start being more cautious unless a specific investment one happens to understand well has remained cheap.

This unattractive near-term environment might seem at odds with the following comment by Buffett in an interview last month on CNBC:

"The stock market compared to most assets, all of the big asset classes in my view, is the most attractive place to have your money over the next 20 years; whether it's over the next 20 days or 20 weeks I don't know but..we have our money in businesses. We own all of some businesses, we own parts of some businesses and we call those stocks -- and that's where we think value lies."

To me, it really is not at odds. Sometimes a fine business just happens to not fit in with whatever is hot at the moment; for whatever reason it just doesn't capture the speculative imagination.

Sometimes a fine business has near or intermediate term real, even serious, but fixable business challenges.

These can be opportunities for those who are more interested in long-term outcomes and less concerned with near term price action.

Even very good businesses run into difficulties from time to time. Well, market participants who chase the near-term price action are naturally not going to have patience for such things. They'll likely head for the exits at the first sign of real trouble.

In other words, they're mostly interested in profiting from price action and less focused on increases to long run per share intrinsic business value. For these participants, increases to per share intrinsic value are, at most, a secondary consideration. The idea of patiently waiting for challenges to be sorted out -- and, if they do, profiting much later -- just doesn't fit in with the ethos.

What stocks might do in the near term might be of interest to speculators, but Buffett and Bogle are talking strictly about changes to per share intrinsic business value over longer time frames.

Investment returns instead of speculative returns.

Share prices may fluctuate wildly near term but, in the long run, they're going to roughly reflect changes to per share intrinsic value.

Buffett doesn't think there currently is a bubble in stocks. When asked if stocks were at bubble levels he also added:

"...we could at some point, but no, stocks are not selling at bubble levels. What do you diversify in? Do you want to diversify into cash? I think it's a terrible investment compared to equities. Do you want to diversify into long-term bonds? I think it's a terrible investment compared to equities. So...I're going to have your assets in something, and I think that good businesses held for a long period of time are certain to deliver good results."

Certain individual securities may remain attractive, but that doesn't necessarily mean the market as a whole is particularly attractive.

It also doesn't mean it's in bubble territory even if certain stocks seem to surely be getting there.

In any case, the risks of buying whatever the hot money is chasing seem undeniable (even if the risks don't become obvious until much later). In fact, many individual stocks seem extremely overvalued. Okay, maybe not late 1990s overvalued**, but actually some individual high flyers aren't far from it.

Buying with a nice margin of safety is central to the investment process. With that in mind, the time to be buying was when huge discounts to per share intrinsic value existed. Several years ago -- during and coming out of the financial crisis -- was as good an example as any of an opportunity to do just that sort of thing.

That opportunity is mostly in the rear-view mirror. This probably seems obvious now, but investment success requires decisive action when it doesn't feel particularly good, and knowing what you want to own (with a high conviction level).

Buffett's emphasis is always on the long-term. That's not exactly news. It's just that investing is never about what the price action might be in the near term or even intermediate term. It's certainly not about market timing. Somehow, this sometimes still seems to get missed. It's a focus on how price compares to the per share intrinsic value of a business that's truly well understood (in contrast to an investor who overestimates how well something is understood). It's coming up with conservative estimates of value. It's ignoring short term market noise. It's being prepared to buy when uncertainty seems at its greatest (or very near to it).

Now, I'm certainly not always reluctant to buy stocks. Prior posts during what appeared to be more uncertain times over the past five years or so should make that pretty obvious. I say "appeared" because the world is always uncertain (it's just the perception of uncertainty that changes). Adverse and unpredictable events are inevitably always ahead. From a long-term equity investor point of view, the best times to buy are usually when the headlines are the most daunting.

That's when stocks are likely to be most attractive to invest in for the long-term.

That's when the margin of safety is generally largest even if buying doesn't feel good at the time. Temporary paper losses are almost a certainty. What's cheap becomes cheaper. Attempting to always buy something that's plainly undervalued without suffering temporary losses creates a very different risk: owning far fewer shares (or even none) compared to the quantity that was wanted of a well understood business. There's only so many investments one can know well. Missing the chance to own, for the long haul, a meaningful quantity of what one knows at an attractive price makes little sense.

Buffett's view might seem to contradict GMO's view greatly but really doesn't. That the market as a whole isn't likely to do particularly well in the coming years (as always I never have a view on the markets) doesn't mean shares of an individual business aren't selling at a nice discount to value.

The latest Berkshire Hathaway (BRKa) results revealed that Buffett did slightly more buying than selling of equities in the third quarter:***

Of course, you can't read too much into how much has been bought or sold in any given quarter.

Yet he seems inclined to be buying more so than selling if you look at the first nine months of this year (especially when the Heinz acquisition is included).

The same has been true, by and large, during and since the financial crisis began.

It's not timing the market. It's comparing price to per share intrinsic value and paying a nice discount for something that's understandable.

Even if, at times (like the late 1990s, for example), it becomes generally difficult to find attractively priced equities, the emphasis isn't on timing.

The emphasis is price versus value.


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

* Though those biased in favor of efficient markets surely won't agree.
** In contrast to now, Buffett was warning that many stocks were quite overvalued in the late 1990s.
*** Subtract purchases and sales of equity securities in the current (page 5) Consolidated Statement of Cash Flows from the prior purchases and sales of equity securities.
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, November 1, 2013

John Bogle on "The Last Gatekeeper"

In this Morningstar interview, John Bogle points out that if you add together the money managed by the 25 largest firms in the mutual fund business, it represents something like 50% of the equity in America.

He goes on to say the following:

"A small handful of corporations, particularly the top five of them, control corporate America. And corporate America needs a lot of cleanup, a sweeping out. Executive compensation is a disgrace. Political contributions made by corporations are a disgrace..."

Bogle then later added...

"So when you look at the whole picture, really we're the last gatekeeper. Think about that for a minute; I have a chapter in the book* about gatekeepers. We're the last gatekeeper. We, the mutual fund industry. The courts have failed us in terms of shareholder rights. The regulators have failed. The security analysts have failed. The money managers have failed. Right down, the press has in many respects failed with a few exceptions. The fund and corporate directors have both failed, and we're now down to the last line: the shareholders who own those companies. And if they don't speak, there's nobody left, and corporations should not be left to operate as private fiefdoms of their chief executives."

Some tough talk by John Bogle but, to me, seems rather a fair assessment. It's not a small problem even if the damage done is sometimes less than intuitive and hard to measure. Quantifying how costly this is may not be easy but, even if difficult to know with precision, the current defects likely, over time, are harmful in a not insignificant way. How well the system functions eventually impacts - both positively or negatively depending on how well it's working -- wealth creation and living standards. So it may be a challenge to quantify the costs but they are very real.

Unfortunately, too many of those who are in the best position to influence sensible change in a meaningful way -- the gatekeepers -- mostly are not attempting to do so.

It's not all that hard to figure out why.

"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" - Upton Sinclair

Bogle has referred to and paraphrased that Sinclair quote on prior occasions. Making changes happen when it's so lucrative for those who operate within the existing framework is never going to be straightforward. That's especially true if those who prefer the status quo can afford to influence policy. It's not easy to make what might otherwise be considered sensible changes when, as a direct result of the changes, there's a real risk the game will become a whole lot less lucrative for those involved.

Fortunately, the current system still has many strengths to go along with the plain defects. We might get by okay with things remaining as they are, but not fixing at least some of the most obvious flaws is, well, dumb and costly. So it's not completely broken but rather just isn't serving the world nearly as well as it could be.

The compounded costs seem likely to be significant if, longer term, something close to the status quo remains in place.

There just aren't enough John Bogle's in the world. Wise changes would certainly come about more quickly if that were the case.


Related posts:
Munger on Corporate Finance and Psychology
Upton Sinclair
Bogle: History and the Classics

* John Bogle is referring to his book: The Clash of the Cultures: Investment vs. Speculation
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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