Monday, February 24, 2014

Buffett on Cash

Warren Buffett on CNBC back in 2009:

"The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing...Cash is going to become worth less over time. But good businesses are going to become worth more over time. And you don't want to pay too much for them so you have to have some discipline about what you pay. But the thing to do is find a good business and stick with it."

That's certainly no invitation to speculate on stocks but does help make the point that risk comes in many forms. 

Having some extra cash on hand certainly creates options in the near term, but the clock is always ticking. This ends up being in direct conflict with the need to be patient then decisive as Charlie Munger explained during the 2004 Wesco shareholder meeting:*

It wasn't hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along, you pounced on them with vigor.

So having a comfortable amount of cash around makes lots of sense. This means knowing when to resist the inherent pressure to put money to work until the right opportunity presents itself. With the benefit of hindsight that might seem easy to do.

It surely is not.

In the CNBC interview Buffett continued by saying...

"We always keep enough cash around so I feel very comfortable and don't worry about sleeping at night. But it's not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially."

The problem is that the environment has changed substantially since Buffett said that back in 2009. Many stocks were quite cheap back then, in part, because we were so close in time to the financial crisis. The world seemed much more risky and uncertain at that time. (Even if, in reality, the world always is uncertain no matter how it might seem at any point in time.) The scary recent events were fresh in the minds of market participants and prices reflected it. At that time it would have felt more uncomfortable to buy stocks, but that's often when it's time to be buying.

Easier said than done.

Today, cash remains a lousy investment over the long haul, but attractive investment alternatives are harder to come by. Well, at least those can be purchased with a sufficient margin of safety. In the current environment, that sort of thing has become a whole lot more challenging to find. As always, what's not very risky at one price can become quite risky at some higher price. In other words, risk necessarily does not just come down to the intrinsic characteristics of the investment itself. What is paid upfront can regulate some of the risks involved but, unfortunately, only up to a point.
(i.e. Sometimes no price is low enough because the risks are just too hard to understand.)

Most risks just do not lend themselves to being easily quantified. This can tempt some to focus on what's more easily quantified and, as a result, is easier to analyze but just happens to matter a whole lot less than what can't be reliably quantified.

That's a mistake worth avoiding.

Unfortunately, in the near-term and even longer, none of this gives an indication what stock prices might do (as always, I never have an opinion on market price action). Market prices, at times, can go to extremes on the both high side and low side while the intrinsic values of good businesses mostly do not change so quickly. If nothing else, the past 15 years has provided us with many examples of this. What's already expensive becomes more so; what's clearly cheap goes on to get much cheaper. Some inevitably try to profit from the price action thinking they'll get in or out at the right time. Good luck to those who try to do this but, chances are, it won't end well for most who do.**

Instead, how price compares to well understood underlying value should dictate behavior.

The discipline to see market price action as being entirely there to serve you as a long-term investor isn't a bad one at all.

A successful investment outcome should never depend upon selling at an expensive price. Naturally, the more elevated current price environment doesn't mean certain individual investments aren't attractive. What it likely does mean is that, on average, more risk is being taken for less reward, and the risk of permanent capital loss has increased. Eventually, market participants in increasing numbers end up letting their guard down. They'll justify, sometimes rather creatively, paying way too much for future prospects. Well, at least that's what an extended period of rising prices inevitably tends to do.

Those that ignore this will likely end up only appreciating the full extent of their mistake after the fact.


Figuring out how price compares to likely value may not be easy, but is doable with some work.

Timing things well mostly is not.

Short run risks are very different than long run risks. Holding cash is risky over the long haul but less so in the short-term (and maybe even medium-term).

Having enough cash on hand provides the necessary flexibility to act, for example, as decisively as Buffett and Munger did during the financial crisis.

Holding onto plenty of cash while knowing it's not a great investment is not at all inconsistent. A natural tension between the need to find more lucrative, attractively priced, investment opportunities and holding enough cash in order to remain flexible necessarily exists.

Many forms of risk are out there, but they're rarely easy to quantify in any kind of precise manner (if at all). This is where the importance of quality -- those businesses that tend to have persistently attractive core economics in lots of different environments -- and buying at the right price comes in. The merits of this, in what is a vastly unpredictable world, seems not often fully appreciated when it comes to managing risk and reward.
(Those who primarily bet on what are essentially "lottery ticket" stocks will no doubt find this to be of little interest. Many of the high-flyers will turn out to be fine businesses; that doesn't mean the investor will be compensated sufficiently for the risk even if some of those who speculated on the price action happen to do just fine.)

Buying high quality all but eliminates the need to consistently make correct predictions and forecasts -- a fool's game -- in an uncertain world.

It's the inherent uncertainty -- the futility of making investment decision based upon on forecasting -- that increases the importance of a flexible approach.

So the idea that cash is safe and stocks are risky depends heavily on time horizon. The investor with a sufficiently long time horizon, who buys shares of a business that has durable and attractive economics (judged well, of course), may be taking on less risk than someone who decides to hold mostly cash (that nearly inevitably will have diminished purchasing power over time).

Cash feels safe but, again, the clock is ticking.

Paying near full value (or, worse yet, paying a premium in the hope that the investment will grow into its value someday) exposes the investor to the unforeseen and unforeseeable. Bad things inevitably happen. Sometimes, it's specific to the business itself, other times, it's something more external. Eventually, these things are pretty much a given. Even the best businesses get into trouble. Unexpected macro events occur. It's a fallacy to think one can consistently maneuver around these kind of unpredictable changing tides.

The price paid should provide a meaningful buffer against misjudgments and surprises.

Many will still unwisely feel compelled to make, or listen too much to, prognostications about the future. Well, just consider the findings of professor Philip Tetlock.***

The following excerpt from Susan Cain's book Quiet summarizes it well:

"A well-known study out of UC Berkeley by organizational behavior professor Philip Tetlock found that television pundits—that is, people who earn their livings by holding forth confidently on the basis of limited information—make worse predictions about political and economic trends than they would by random chance. And the very worst prognosticators tend to be the most famous and the most confident..."

Morgan Housel explained it the following way:

" reason people take too much risk is because they believe in their delusional forecasts, and aren't prepared to react to events." 

Housel then adds "most people can improve their financial lives by distancing themselves from as many forecasts as possible.

Sure, we'd do better if we could anticipate the paths our lives go down. But we can't. You would not wish upon your worst enemy the track record of professional economists predicting the financial events that really mattered throughout history."

Here's how Henry Singleton once explained it:

"...we're subject to a tremendous number of outside influences and the vast majority of them cannot be predicted. So my idea is to stay flexible."

The risks will always be there. Instead of trying to predict the future, better to try and be, however imperfectly, in a position to handle all but the worst things that might occur. Singleton's track record didn't come about because of some sixth sense about the future; ditto for Buffett and Munger.

Those who realistically assess their own limits and avoid trying to figure out when to jump in or out based on how the world looks on any given day can do just fine; those who do the opposite are just inviting mistakes. It requires some discipline, sound judgment, respect for some of the psychological factors that hurt results, and the right habits. The importance of eliminating error, where possible, is underestimated.

"To kill an error is as good a service as, and sometimes even better than, the establishing of a new truth or fact." - Charles Darwin

Ultimately, instead of attempting to manage risks via prescient predictions (bold or otherwise), manage risks, at least in part, using an appropriate margin of safety considering the specifics of each individual investment; manage risks additionally by sticking to what one really knows.

Unlike trying to consistently figure out what is often an unknowable set of future outcomes, paying a reasonable (or better than reasonable) price is something well within the investors control.

The same goes for buying only what one truly understands.

When you've made a judgment that a particular business is likely to do well long term, it isn't about making a definitive prediction; it is about a combination of patience, decisiveness, while also understanding the business characteristics that make it more likely for good things to happen -- even as the world, or the business itself, inevitably throws out a curve or two -- over the long haul.

Buy quality at an attractive price then have the discipline to, as Buffett says, "stick with it."

One final thing that's at least worth mentioning: the biggest potential gains -- those things that truly capture the imagination and, often, the biggest headlines as well -- usually exist not far from where big potential permanent losses of capital can happen.

Telling the big winners and losers apart without making errors that wreck returns sounds easier than it is.

In other words, the big wins must more than compensate for the losses. More excitement, maybe, but as far as risk and reward goes, seems likely to be far less than optimal. The difficulty of getting good overall results (i.e. not just the wins that look good in a vacuum) in the long run shouldn't be underestimated.

Besides, some of the very best investors have done just fine while generally avoiding such things.

"...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 Stanford Lawyer

The plainly more aggressive approach (and, yes, almost certainly a wilder ride) contrasts greatly with the elimination -- or, at least, nearly so -- of losses, wherever possible, by always buying with a meaningful margin of safety, and sticking to those well understood things that have a narrower range of outcomes.

With the bigger misjudgments mostly eliminated, the returns of the more reliable if less exciting winners tend to take care of the rest.


* Munger also said: "Success means being very patient, but aggressive when it's time." He certainly has, to say the very least, put this way of thinking to good use in recent years.
** Those interested in trading near-term price action -- even if based upon certain fundamental characteristics of a stock -- will likely find not much of use here. To me, investment involves a 5-10 year holding period and longer. Those attempting to profit from price action over shorter time horizons, even if the holding period involves a few years, is more or less involved in speculation and, in some cases, even pure gambling. There's certainly nothing wrong with making bets on such short-term moves. No doubt some are actually good at that sort of thing. Still, it has little in common with investment -- the primary focus of this site. Investment has as it's emphasis the "weighing machine" -- the value of what a productive asset itself can produce (farms, businesses, real estate etc.) for owners over longer time frames. Speculation and gambling, in contrast, more or less have as their emphasis the "voting machine" -- how the psychology of markets will impact the price of something (marketable securities, commodities, currencies, etc.) near-term and even somewhat longer.
*** Professor Tetlock puts it this way: "Hedgehogs are big-idea thinkers in love with grand theories" while "foxes are better at curbing their ideological enthusiasms."

He goes on to say foxes tend to not over-simplify and are more aware of the limits to their arguments. As a result, they become less prone to mistakes.

Philip Tetlock books:

Expert Political Judgment: How Good Is It? How Can We Know?
Why Foxes Are Better Forecasters Than Hedgehogs
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, February 17, 2014

Berkshire Hathaway 4th Quarter 2013 13F-HR

The Berkshire Hathaway (BRKa4th 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 3rd Quarter 13F-HR.)

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

New Positions
Goldman Sachs (GS): Bought 12.6 million shares worth $ 2.1 billion**
Liberty Global (LBTYA): 2.9 million shares worth $ 246.5 million

Berkshire's latest 13F-HR filing did not indicate any activity was kept confidential. 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.

Added to Existing Positions
Wells Fargo (WFC): Bought 326,500 shares worth $ 15 million, total stake $ 21.4 billion
Exxon Mobil (XOM): 1.04 million shares worth $ 97.9 million, total stake $ 3.9 billion
Wal-Mart (WMT): 236,498 shares worth $ 17.9 million, total stake $ 3.75 billion
U.S. Bancorp (USB): 203,400 shares worth $ 32.2 million, total stake $ 3.2 billion
DaVita (DVA): 5 million shares worth $ 332.8 million, total stake $ 2.4 billion**
USG Corporation (USG): 17.8 million shares worth $ 610.4 million, total stake $ 1.2 billion**
General Electric (GE): 9.99 million shares worth $ 257.3 million, total stake $ 272.5 million**

Reduced Positions
Moody's (MCO): Sold 252,400 shares worth $ 20.1 million, total stake $ 1.96 billion
ConocoPhillips (COP): 2.45 million shares worth $ 160.5 million, total stake $ 726.1 million
Liberty Media Corporation (LMCA): 322,340 shares worth $ 43.6 million, total stake $ 716.8 million
Suncor (SU): 5 million shares worth $ 167.3 million, total stake $ 434.2 million
Starz (STRZA): 1.1 million shares worth $ 32.3 million, total stake $ 135.6 million

Sold Positions
Dish Network (DISH): Sold 547,312 shares worth $ 31.1 million
GlaxoSmithKline (GSK): 345,819 shares worth $ 19.3 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 a small percentage of the overall portfolio.

These days, any changes involving smaller positions will generally be the work of the two portfolio managers.
(Though some of the holdings they're responsible for have become more substantial over time.)

Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial, consumer and, to a lesser extent, technology stocks (primarily IBM).

1. Wells Fargo (WFC) = $ 21.4 billion
2. Coca-Cola (KO) = $ 15.6 billion
3. American Express (AXP) = $ 13.5 billion
4. IBM (IBM) = $ 12.5 billion
5. Procter and Gamble (PG) = $ 4.2 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.***

We'll get firm numbers when the annual report is released, but the combined portfolio value (equities, cash, bonds, and other investments) will likely exceed $ 210 billion.

The portfolio, of course, excludes all the operating businesses that Berkshire owns outright with ~ 290,000 employees (we'll soon get an updated number that's almost certainly much higher).

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 also the deal Berkshire closed last year for 50% ownership of H.J. Heinz.

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, WFC, KO, AXP, PG, USB, WMT, COP, GSK, and GE 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 Friday's closing price.
** Goldman Sachs and General Electric common shares came from warrants converted via net share settlement. USG notes held by Berkshire were also converted resulting in additional shares of USG common stock. These all came out of moves made by Buffett during the financial crisis. Berkshire received shares in Goldman Sachs and General Electric from exercised warrants with both deals being amended from cash settlement to net share settlement. The DaVita moves were first disclosed in early December.
*** 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 the preferred shares (and, where applicable, related warrants) are also 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.

Thursday, February 13, 2014

Munger's Daily Journal Reveals Holdings

Charlie Munger has, on prior occasions, talked about the importance of patience combined with acting decisively when opportunity presents itself:

If you took the top 15 decisions out, we'd have a pretty average record. It wasn't hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along, you pounced on them with vigor. - Charlie Munger at the 2004 Wesco Shareholder Meeting


Success means being very patient, but aggressive when it's time. - Charlie Munger at the 2004 Wesco Shareholder Meeting

In addition to his role as vice chairman at Berkshire Hathaway (BRKa), Munger also serves as chairman of Daily Journal (DJCO) and naturally has plenty of influence over their investments.*

Well, earlier this week, the company provided details for the first time of their common stock positions.

More on that in a bit but first some background.

Marketable securities first showed up on their balance sheet in this 10-Q from May of 2009 with no other details provided.

Then, in this 10-Q from May 2010, finally some additional information was provided about their moves (without naming specifics) into marketable securities:

In February 2009, the Company took advantage of near-panic selling in the stock market and redeployed some of its cash, which had been invested in Treasury securities and was generating only nominal interest, to purchase the common stock of two Fortune 200 companies and certain bonds of a third.

In May 2011,they expanded this somewhat:

In February 2009, the Company purchased shares of common stock of two Fortune 200 companies and certain bonds of a third. During the second quarter of fiscal 2011, the Company bought shares of common stock of two foreign manufacturing companies.

Then, in February 2012, they revealed a fifth common stock:

In February 2009, the Company purchased shares of common stock of two Fortune 200 companies and certain bonds of a third, and during the second and the third quarters of fiscal 2011, the Company bought shares of common stock of two foreign manufacturing companies. During the first quarter of fiscal 2012, the Company bought shares of common stock of another Fortune 200 company.

Now, according to this 8-K that was filed earlier this week:

At December 31, 2013, the Company held marketable securities valued at $150,747,000, including unrealized gains of $102,770,000.

It goes on to say:

The marketable securities consist of common stocks of three Fortune 200 companies, two foreign companies and certain bonds of a sixth, and most of the unrealized gains were in the common stocks.

So it at least appears they still basically have the same positions that were established between February 2009 and early in fiscal 2012 (though, since the cost basis has risen slightly, at least some additional moves -- even if minor in percentage terms -- have been made since then), and we now have a relatively up-to-date view of how well these moves have worked out (so far).

For some context, keep in mind that Daily Journal had a bit less than $ 22 million in cash, U.S. Treasury Notes and Bills at the end of their 2008 fiscal year. They wisely held this rather conservative allocation until prices became extremely attractive in early 2009 then deployed it, along with retained earnings, aggressively into shares of businesses they apparently consider attractive.**

So I'd say they've allocated their capital rather well and that this exemplifies being very patient then acting decisively when the opportunity arises.

As I mentioned above, thanks to this 13F-HR, we also now know what four of the marketable securities they invested in happen to be:

Wells Fargo (WFC): $ 72.3 million
Bank of America (BAC): $ 35.8 million
U.S. Bancorp (USB): 5.7 million
POSCO (PKX): 5.0 million

That leaves, after subtracting the value of these four stocks from the total of $ 150.7 million noted in the 8-K filing, roughly $ 31 million for the remaining marketable securities. So nearly 80% of the portfolio is in just four stocks and, to say the very least, is heavily weighted toward financials. 

Not exactly textbook portfolio management and, well, not exactly surprising.

Munger has talked in the past about his views on the need (or lack thereof) for diversification.***

"The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn't make you with a whip and a gun?" - Charlie Munger in Kiplinger's

"I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken." - Charlie Munger in a 1998 speech to the Foundation Financial Officers Group

I'd say that the concentration of this portfolio more than reinforces his point.

Unlike the position in POSCO, which is an ADR, it might turn out that the fifth stock (as indicated in the 8-K filing), is listed on an exchange outside the United States. 
(Shares not listed on an exchange inside the United States need not be included in a 13F-HR.)

It seems fair to say that, other than possibly the common stock of Bank of America, none of these positions should really come as a surprise.

Berkshire owns the common shares of Wells Fargo, U.S. Bancorp, and POSCO along with preferred shares of Bank of America.


(Correction: Charlie Munger's thoughts above on the need for lots of patience followed by aggressive action when the opportunity presents itself are from Whitney Tilson's notes taken at the 2004 Wesco meeting. The initial version of this post had it as the 2004 Berkshire meeting.)

No position in DJCO. Long positions in BRKb, WFC, USB, and BAC established at less than recent market prices. Also, small long position in PKX established near current prices.

* From this 10-Q: The Company's Chairman of the Board, Charles Munger, is also the vice chairman of Berkshire Hathaway Inc., which maintains a substantial investment portfolio. The Company's Board of Directors has utilized his judgment and suggestions, as well as those of J.P. Guerin, the Company's vice chairman, when selecting investments, and both of them will continue to play an important role in monitoring existing investments and selecting any future investments.
** Earnings for Daily Journal came in at ~ $ 8 million per year or slightly less in 2009-11 but was down substantially from those levels in 2012-13. Now, comprehensive full year 2013 financials and the most recent fiscal 1st quarter financials have not yet been made available. The company has said they won't submit a filing (for either reporting period) until internal controls are properly assessed. Here's how they explained it in December of 2013:
Due to a significant increase in the Company's stock price in 2013, the Company no longer qualifies as a smaller reporting company and is now an accelerated filer for the first time. Accordingly, this is the first fiscal year for which an audit of the Company's internal control over financial reporting is required...
So, instead, we only have preliminary full year results. It's worth noting that, during the fiscal year 2013, the company also took on $ 14 million of margin debt, bought New Dawn Technologies, Inc. for $ 14 million -- $ 11.8 million net of cash acquired -- and bought ISD Corporation for approximately $ 16 million.
*** Munger clearly doesn't think much of diversification but does say most individual investors should probably be buying index funds: "Our standard prescription for the know-nothing investor with a long-term time horizon is a no-load index fund." As far as picking stocks he says: "You're back to basic Ben Graham, with a few modifications. You really have to know a lot about business. You have to know a lot about competitive advantage. You have to know a lot about the maintainability of competitive advantage. You have to have a mind that quantifies things in terms of value. And you have to be able to compare those values with other values available in the stock market. So you're talking about a pretty complex body of knowledge." 

Some will underestimate the difficulty of getting satisfactory results picking individual stocks over the long haul and, mistakenly, will also underestimate the wisdom of owning (i.e. not trading) low cost index funds instead. Those who concentrate their holdings and are overconfident in (or overestimate) their own investment capabilities seem destined for poor or even disastrous results. Portfolio concentration may make lots of sense for the likes of Munger and similarly capable investors, but it's probably going to make a whole lot less sense for many others. So it's knowing limits and staying well within them.
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, February 6, 2014

Asset Growth and Stock Returns

From this 2008 paper:

"ONE OF THE PRIMARY FUNCTIONS OF CAPITAL MARKETS is the efficient pricing of real investment. As companies acquire and dispose of assets, economic efficiency demands that the market appropriately capitalizes such transactions. Yet, growing evidence identifies an important bias in the market's capitalization of corporate asset investment and disinvestment. The findings suggest that corporate events associated with asset expansion (i.e., acquisitions, public equity offerings, public debt offerings, and bank loan initiations) tend to be followed by periods of abnormally low returns, whereas events associated with asset contraction (i.e., spinoffs, share repurchases, debt prepayments, and dividend initiations) tend to be followed by periods of abnormally high returns."

Paper: Asset Growth and the Cross-Section of Stock Returns

A recent Barron's article explained it this way:*

Barron's: Buy the Asset Sellers

"A 2008 study published in the Journal of Finance found that over the long term, U.S. stocks in the market's bottom decile ranked by recent asset growth outperformed those in the top decile by 13 percentage points a year."

The article also points out that...

"A 2012 paper that focused on international markets reported similar findings."

The paper's findings (on page 1610) reveal specifically the following gap in performance from 1968 through 2003:

Value weighted (VW) returns for firms with lowest asset growth: 18%

Value weighted (VW) returns for firms with highest asset growth: 5%

"...we find that raw value-weighted (VW) portfolio annualized returns for firms in the lowest growth decile are on average 18%, while VW returns for firms in the highest growth decile are on average much lower at 5%."

So there is the 13% gap but the paper also notes that "with standard risk adjustments the spread between low and high asset growth firms remains highly significant at 8% per year for VW portfolios and 20% per year for equal weighted (EW) portfolios."

I am highly skeptical of the "standard risk adjustments" but that's a subject for another day. Still, even using the most conservative numbers from this paper, the gap is not at all insignificant.

The paper concludes by calling this "a substantial asset growth effect on firm returns."**

I've mentioned the following quote before but, due to its relevance, I'll include it here for those who may not be familiar with it:

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

The bottom line is to avoid the misjudgment that exciting growth must necessarily lead to high returns. That growth might be a negative factor may or may not be counterintuitive, but understanding it is very useful and important. On occasion, the impressive growth prospects require so much capital that returns end up being poor for owners. Other times, fast growth attracts competitors, fresh capital, and possibly a disruption that changes what, for a time at least, looked like attractive economics. The list goes on. There are many variations of this that tend to be very industry specific.
(Consider how often growth is mentioned on a major business media outlet with at least the implied assumption that growth must be a good thing. Another way to think about it is this: In that context how often -- though, admittedly, a subtlety even if a crucial one -- is the potential negative implications of growth written about or discussed? I think we're talking, at best, about exceptions to the rule.)

In contrast, sometimes -- though it is far from assured -- the boring, stable, firms with only modest or low growth prospects establish themselves in a competitive framework that allows the strongest to maintain attractive return on capital for a very long time. Now, there's without a doubt many examples of growth being a very good thing for investors. The problems arise when growth is assumed to always be somewhere between a good and a great thing for investors; they arise when no consideration is given to the alternative implications of growth; they also arise when an extreme premium price is paid -- relative to approximate intrinsic value -- upfront for that potential growth.***

High growth rates and attractive long-term investment outcomes need not have much to do with each other.

The main point is that growth is too often treated as being always a good thing. Well, sometimes growth is of the low (or worse) return variety. Think airlines for many decades. That industry grew impressively for quite some time. In addition, sometimes too much is paid for the privilege of ownership due to the exciting growth prospects. The asset may end up performing well, but the owner doesn't get compensated sufficiently considering risks and alternatives.

The study above happens to focus on asset growth and returns.

Well, this is not necessarily limited to asset growth; it can apply to growth more generally (though certainly not a rule of some kind...there are plenty of examples of good growth). Below, I've included some related posts that may be of interest to explore further along these lines.

I happen to think it's not a bad habit to consider carefully things that conflict, contradict, or that might be inconsistent with what one is predisposed to think (or with prevailing wisdom). It's all too easy to quickly dismiss what's counterintuitive and just move onto the next thing. Some will run into an odd paradox, for example, and treat it as nothing more than an interesting anomaly. Too often -- or, at least, often enough -- that is a mistake. The biggest insights -- though, of course, not all -- are sometimes adjacent to what at first seems nonsensical.

Occasionally, the most useful discoveries are found inside or very near what initially seems unfamiliar, contradictory, and even uncomfortable.

"The thing that doesn't fit is the thing that's the most interesting, the part that doesn't go according to what you expected." - From The Pleasure of Finding Things Out by Nobel Prize winning physicist Richard Feynman

Another mistake is to "write off" or choose to ignore an investment idea due to some real, even significant, existing flaw. Well, sometimes the part that is right can be very useful (i.e. lucrative) while the downside (or cost) of what's wrong is very small. In the real world, at least often enough to matter, important insights will exist alongside things that are somewhat messy, incomplete, and inconsistent.

"When I was young everybody was excited by Gödel who came up with proof that you couldn't have a mathematical system without a lot of irritating incompleteness in it. Well, since then my betters tell me that they've come up with more irremovable defects in mathematics and have decided that you're never going to get mathematics without some paradox in it. No matter how hard you work, you're going to have to live with some paradox if you're a mathematician. 

Well, if the mathematicians can't get the paradox out of their system when they're creating it themselves, the poor economists are never going to get rid of paradoxes, nor are any of the rest of us. It doesn't matter. Life is interesting with some paradox. When I run into a paradox I think either I'm a total horse's ass to have gotten to this point, or I'm fruitfully near the edge of my discipline. It adds excitement to life to wonder which it is." - Charlie Munger speaking at UC Santa Barbara

Investment always involves the weighing of various pros and cons; it's making smart trade-offs between alternatives; it's about opportunity costs.

When something doesn't sit well with what is preconceived, it's just generally not a good idea to ignore it. In fact, to me it's better to develop a tendency to do the exact opposite. Admittedly, this frequently leads nowhere but, at least, new things are learned. In fact, I'd argue it's best to study and try to learn from those kinds of things at least 2 or 3 times as hard as one might otherwise be inclined to do.

So expect to run into to some paradox and messiness during the investment process. Sometimes useful insights reside near a neighborhood where there's incompleteness and/or inconsistency; they reside where something just doesn't quite fit.

This all nicely complements the reality that perfect investments -- if they exist at all -- are few and far between while, at the same time, plenty of good but flawed ones exist.

Attractive return on capital that's sustainable long-term and purchased at the right price (i.e. plain discount to value) is a priority.

Growth, in a vacuum, isn't.

Sometimes growth leads to the creation of enduring value for business owners, but too often it leads to the exact opposite outcome: Reduced rewards for the investor at greater risk of permanent capital loss.

Now, whether the business happens to be publicly traded or not is irrelevant.

"Investment is most intelligent when it is most businesslike." - From Chapter 20 of Benjamin Graham's book The Intelligent Investor

Stocks are merely a convenient way to own part of a business and should be analyzed no differently than if the business is to be owned 100%.

Those who attempt to trade excessively are turning what should be a huge advantage -- the convenience partial ownership of a business -- into a disadvantage.

Excessive trading simply all too often leads to unnecessary frictional costs and mistakes.

Many, at great cost in terms of long-term results, will continue to ignore this reality.

Some final thoughts:

- Good businesses, over the long haul, tend to increase in terms of intrinsic value and that dynamic should be an ally. Of course, in the short run share prices do not necessarily follow, but the long run is a very different story.

- Increases to underlying intrinsic business value should be the primary driver of forward returns, not clever trading.

- Buy with a plain-to-see margin of safety -- only what is well understood -- to protect against what can't be foreseen and the inevitable mistakes. What's well understood is necessarily unique to the investor. If intrinsic value can't be estimated within a narrow enough range, the investment should be avoided. It's just not possible to buy with an appropriate margin of safety if what something is roughly worth can't be figured out in the first place.

- Developing sound judgment of long-term business prospects, and the discipline to never overpay should be the focus. Neither is necessarily easy to consistently do well. It also need not be terribly complicated.

- Know limits and stay well within them. A big part of the battle is learning to avoid most of what shows up on the radar.

A sound investment process and principles guarantees nothing but at least increases the chance of attractive long-term outcomes.


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

Related posts:
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

* An excerpt from an article with a title that pretty much says it all:

 "It may surprise most investors that firms experiencing rapid growth subsequently have low stock returns, whereas contracting firms enjoy high future returns. For example, a 2008 study found that a value-weighted portfolio of U.S. stocks in the top asset-growth decile underperformed the portfolio of stocks in the bottom decile by 13 percent per year for the period 1968-2003. A recent paper shows that the same is true internationally as well." 

Article: Fast firm growth doesn't mean great stock returns

** From the conclusion: "Over our sample period firms with the low asset growth rates earn subsequent annualized risk-adjusted returns of 9.1% on average while firms with highest asset growth rates earn - 10.4%. The large 19.5% spread is highly significant. Weighting the firms by capitalization reduces the spread to a still large and significant 8.4% per year." The 13% gap noted above is value weighted (VW) but not adjusted for risk. Take your pick. These all represent rather significant gaps in performance.

*** On the surface, estimating intrinsic business value on a per share basis isn't necessarily difficult. As Buffett has said: "Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life." So just figure out what cash can be taken out of a business over the long haul then discount that cash appropriately, right? Not so fast. The definition is simple. The calculation itself is not. It's, in part, the assumptions (interest rates, future cash flows, how well future cash will be put to work, etc.), some of it hard to quantify but important stuff, that make the actual calculation more difficult and, inevitably, at best a range of possible values (even if the mechanics aren't that tough to learn). Buffett has also said there are good reasons "we never give you our estimates of intrinsic value." (The one explicit reason Buffett mentions being that not even Charlie Munger and himself will come up with the same intrinsic value estimate using the same facts.) Instead, he prefers to provide "the facts that we ourselves use to calculate this value." In the 2011 letter, Buffett explained that while they "have no way to pinpoint intrinsic value", a useful -- even if "considerably understated" -- proxy happens to be book value. This older post on how Buffett likes to specifically discount cash in order to calculate value might be of interest to some.
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