Friday, June 27, 2014

Charlie Munger on Complexity, Hedge Funds, and Pension Funds

Some comments by Charlie Munger from the 2006 Wesco meeting:*

On Complexity
We don't do a lot of involved math... Certainly we expect a decent return or we don't do it. We use a lot of experience and do it in our heads. We distrust others' systems [and complex models] and think it leads to false confidence. The harder you work, the more confidence you get. But you may be working hard on something you're no good at. We're so afraid of that process that we don't do it.

The emphasis is on keeping it as simple as possible (but not too's a balance) and sticking to what they know well.

It's the avoidance of unnecessary complexity and playing to strengths.

On Hedge Funds
Somehow we've created a perverse system of incentives. At Samsung, their meeting of engineers is at 11pm. Our meetings of engineers [meaning our smartest citizens] are also at 11pm, but they're working to price derivatives. I think it's crazy to have incentives that drive your most intelligent people into a very sophisticated gaming system.

A rich system can endure a lot. If 10% of our people over age 60 want to spend X hours per week playing Texas Hold Em, we can afford it. But it's not good. But do we want our auto industry to just crumble away and somebody else's to take over because they do it better? I don't think it's a good outcome. I don't think we can stand a diversion of our best minds to hedge funds.

This may be less than ideal but, considering how lucrative the hedge fund business usually is, it's not terribly surprising. Strong incentives remain in place that likely will continue to divert talent away from more useful things.

For some perspective, hedge fund industry assets under management now stands at $ 2.5 trillion. This is a substantial increase compared to the $ 38 billion that was being managed back in 1990.

On Unrealistic Return Assumptions by Pension Funds
Both Warren and I have said that to predict 9% returns from those pension funds is likely to be wrong and it is irresponsible to allow it. They do it to delay bad news. Look at Berkshire and our paper record, which is obviously much better [than the investment track records of the pension fund managers]: we use 6.5%. For example, the Washington Post has the best record [of virtually any pension fund, yet it assumes a 6.5% annual return].

Munger then goes on to suggest it just might be wise to consider what those who have the best track record have to say over those who do not. These days, too many pensions continue to make unrealistic assumptions about future returns.

The following trend just might end up exacerbating the problem:

How Harvard and Yale's 'Smart' Money Missed the Bull Market

"How did this happen? Well, the average college endowment has just 16% of its investment portfolio in U.S. stocks—half the exposure they had a decade ago. In the years following the Internet bust and then the financial crisis, managers steadily shifted assets to alternative investments like hedge funds, venture capital investments, and private equity."

Recent results haven't been all that impressive but, for the schools highlighted, the longer term results look a whole lot better compared to the S&P 500.**

A similar strategy shift into alternative investments has occurred at corporate and public pension funds.

Big Investors Missed Stock Rally

"Corporate pension funds and university endowments in the U.S. have missed out on much of the rally for stocks since 2009, following a push to diversify into other investments that have had disappointing performances."

Of course, what matters for pension funds and university endowments is the long run results.

What matters is how well their investment policies will work going forward.

It's worth noting that the Washington Post (now Graham Holdings: GHC) -- mostly due to long making reasonable pension promises then producing returns nicely in excess of conservative return assumptions -- continues to have quite a track record.

In fact, the company's pension fund these days sits rather solidly overfunded compared to just about anyone else.

Reasonable promises comfortably aligned with sound investment policy.***

In stark contrast, some seem to have decided to add lots of complexity and frictional costs to their approach.

Complexity that may not at all be needed for achieving desired outcomes.

Costs that, at least in aggregate, create their own headwind.


Very small long position in GHC

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

* These comments are based upon notes taken by Whitney Tilson.
** Here's how the returns look for hedge funds, stock-focused funds, and the S&P 500 over the past 10 years: The S&P 500 gained 114% (including dividends), the average hedge fund gained 75%, while the average stock fund gained 68%. Private-equity and venture-capital funds performed much better.
*** Warren Buffett wrote a memo to Katharine Graham in 1975 to guide her on pension obligations and the right investment policy. His input and position on the board for 37 years no doubt has had at least something to do with the company's healthy pension plan. That memo can be found here on pages 118-136. Buffett, in his latest letter, said the following about pension funds and that memo: "During the next decade, you will read a lot of news – bad news – about public pension plans. I hope my memo is helpful to you in understanding the necessity for prompt remedial action where problems exist."
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, June 20, 2014

Buffett & Munger on Compensation - Part I

From Warren Buffett's 1985 Berkshire Hathaway (BRKa) letter:

"...retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign - with no one examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest."

He then adds...

"Many corporate compensation plans reward managers handsomely for earnings increases produced solely, or in large part, by retained earnings - i.e., earnings withheld from owners."

When it comes to stock options, according to Buffett, two important factors are too often ignored:

"It would be particularly unthinkable for managers to grant a long-term option on a business that was regularly adding to its capital. Any outsider wanting to secure such an option would be required to pay fully for capital added during the option period.

The unwillingness of managers to do-unto-outsiders, however, is not matched by an unwillingness to do-unto-themselves. (Negotiating with one's self seldom produces a barroom brawl.) Managers regularly engineer ten-year, fixed-price options for themselves and associates that, first, totally ignore the fact that retained earnings automatically build value and, second, ignore the carrying cost of capital."

Unfortunately, when the economic rewards of stock options do end up being reasonable and fair, it usually is by accident:

"Of course, stock options often go to talented, value-adding managers and sometimes deliver them rewards that are perfectly appropriate. (Indeed, managers who are really exceptional almost always get far less than they should.) But when the result is equitable, it is accidental."

He adds that the "managerial Rip Van Winkle, ready to doze for ten years, could not wish for a better 'incentive' system."

Stock options are often described as aligning managers and owners but, in reality, that's just not the case:

"Ironically, the rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I'll be happy to accept a lottery ticket as a gift - but I'll never buy one.)"

The holder of a stock option actually benefits from a no-dividend policy. Funds paid out as dividends reduce retained earnings and should, all else equal, lower option value (whatever the difference is, if anything, between market price and exercise price). So maybe no dividend is paid -- or less of a dividend -- because incentives aren't better aligned. Creative justifications for the policy no doubt likely will follow.

"...most people either seem to have difficulty recognizing what lies in plain sight, right before their eyes, or, perhaps even more pervasively, refuse to recognize the reality because it flies in the face of their deep-seated beliefs, their biases, and their own self-interest. Paraphrasing Upton Sinclair: 'it's amazing how difficult it is for a man to understand something if he's paid a small fortune not to understand it.'" - From John Bogle's remarks at NYU in 2007

The misalignment can lead to behavior often far from ideal for the owners.

Options can work out okay in some circumstances but Buffett's criticism is of "their indiscriminate use". Some managers Buffett admires ("whose operating records are far better than mine") disagree with him on the use of stock options and he mentions this in the letter. Buffett says that certain business leaders have developed the right kind of (but rare) corporate culture where employees mostly think and act like owners. So, in those cases, options end up being an effective incentive despite their flaws and shortcomings.

"'If it ain't broke, don't fix it' is preferable to 'purity at any price'."

The tough part for the investor is judging which company has the right kind of corporate culture.

In contrast, Berkshire's compensation system "rewards key managers for meeting targets in their own bailiwicks. If See's does well, that does not produce incentive compensation at the News - nor vice versa. Neither do we look at the price of Berkshire stock when we write bonus checks. We believe good unit performance should be rewarded whether Berkshire stock rises, falls, or stays even. Similarly, we think average performance should earn no special rewards even if our stock should soar. 'Performance', furthermore, is defined in different ways depending upon the underlying economics of the business: in some our managers enjoy tailwinds not of their own making, in others they fight unavoidable headwinds.

The rewards that go with this system can be large."

The preference is for Berkshire's stock to be purchased by the managers with their own funds:

"Obviously, all Berkshire managers can use their bonus money (or other funds, including borrowed money) to buy our stock in the market. Many have done just that - and some now have large holdings. By accepting both the risks and the carrying costs that go with outright purchases, these managers truly walk in the shoes of owners."

I think it's fair to say that the pay controversy at Coca-Cola (KO) might have gone somewhat differently if they had taken more of this thinking into account.

In this CNBC interview, Warren Buffett commented on Coca-Cola's equity compensation plan (among other things).

Comments that, at least initially, were also somewhat controversial.

Some related articles:
Buffett Punts on Pay
Warren Buffett: We took a stand on Coke's pay package
Buffett Bites Back
Warren Buffett Defends Coca-Cola Abstention
Coke's Pay Hurts the Media's Brain

In any case, it's a plan that Buffett didn't like very much and ended up letting it be known in his own way.

Well, it turns out Coca-Cola's equity compensation plan is now likely to be altered due, at least in part, to some of the pressure.

Here was Munger's take on the way Buffett handled the Coca-Cola compensation controversy during this separate CNBC interview:

"I thought he did it just right. He complained a little, but not too vociferously. I think that was just the right tone, and with compliments which were deserved to the management of Coca-Cola. I thought he handled it perfectly."

More in a follow up.


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

Related post:
The Illusion of Consensus
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, June 13, 2014

The Growth Trap: IBM vs Standard Oil

Imagine it's 1950 and a decision needs to be made between two common stock investment alternatives:


- Standard Oil (now ExxonMobil: XOM)

IBM at that time had superior growth prospects compared to Standard Oil.

Below is a quick summary of the growth measures from 1950-2003 for both companies.*

Revenue Growth
IBM: 12.19% per year
Standard Oil: 8.04%

Earning Per Share Growth
IBM: 10.94%
Standard Oil: 7.47%

Dividend Growth
IBM: 9.19%
Standard Oil: 7.11%

Sector Growth
IBM: 14.65%
Standard Oil: negative 14.22%

So the advantage goes to IBM in every category except the one that really counts.

Standard Oil actually produced the better total return.

Total Return
IBM: 13.83%
Standard Oil: 14.42%

Why did Standard Oil's stock perform better? Simply put, it was the difference in valuation and the effect of dividends reinvested.

Average Price to Earnings
IBM: 26.76
Standard Oil: 12.97

Average Dividend Yield
IBM: 2.18%
Standard Oil: 5.19%

Those higher dividends reinvested, over time, in a stock with a more reasonable valuation made all the difference.** The end result being an investor in Standard oil increased their holdings by 15x while an investor in IBM only accumulated 3x more shares. IBM had vastly superior fundamentals over those 50 plus years. In fact, the market value of IBM actually went up more than Standard Oil. Yet, all those additional shares, bought with reinvested dividends, meant that the individual investor in Standard Oil ended up with the better overall result.

"...despite the better fundamentals, investors paid too high a price for IBM, while old Standard Oil was cheaply priced. I call this the 'growth trap.' Investors make the mistake of buying the new thing, irrespective of price." - Jeremy Siegel in an interview back in 2006

This is at least worth consideration the next time there's the temptation to pay a premium for exciting growth prospects. The return comparison is not all that matters, of course. IBM's results depended on much higher sustained growth. More risk was taken in the process simply due to the higher multiple of earnings paid. One of the best tools available to an investor to manage risk is price. That's under an investor's control; what happens as far as future growth goes is not.

Still, both IBM and Standard Oil generated very nice long run investment results. Things worked out well for long-term investors in both companies but, when you pay a high multiple, the margin of safety just isn't there to protect against what might go wrong.***

This naturally reveals nothing about the unique risks, challenges, and opportunities for these two businesses going forward. Future long-term investment results, at least to me, seem likely to be far more modest. No complaints if things turn out a bit better than expected, of course.

As always, it's not just about the absolute return; it's about judging risk versus reward and comparing to alternatives.

Unlike those 50 plus years, these days IBM has a much lower earnings multiple and, apparently, far less exciting growth prospects. Well, at least for now. It's never easy to tell, favorable or not, how those prospects might change over the very long haul. Price paid should assume and reflect the least optimistic scenario. (Especially for technology stocks.)

In other words, the expected outcome should be an attractive one even if nothing great happens.

If the likely worst case can't be judged with high confidence, buying makes no sense.


Small long position in IBM; no position in XOM.

Other related posts:
Asset Growth and Stock Returns, Part II - Mar 2014
Asset Growth and Stock Returns - Feb 2014
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
Technology Stocks - May 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

* Source: The Future for Investors by Jeremy Siegel
** Dividend reinvestments function like buybacks but, compared to buybacks, are generally less tax efficient. This depends on the type of account. Other than the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned.
***  Both companies, inevitably, ran into plenty of their own specific difficulties over those 50 plus years. Even very good businesses will have their fair share of challenges. Anyone expecting a smooth ride investing in common stocks is, well, guaranteed disappointment.
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, June 6, 2014

Wells Fargo vs S&P 500

From the most recent Berkshire Hathaway (BRKashareholder meeting:

The intrinsic value of any business is the present value of all cash distributed between now and Judgment Day. - Warren Buffett

Stock prices can fluctuate -- and, well, almost certainly will fluctuate -- much more so than a fair estimate of per share business value over time.
(Jeremy Grantham, in this letter, provides a useful long-term chart along these lines. See Exhibit 1 on page 8.)

Investing well means mostly learning to ignore what end up being costly distractions. There's just too much coverage of, and energy spent on, what ends up mostly being noise.

Sometimes, it's worthwhile to step back a bit.

With this in mind, let's take a look at the S&P 500's earnings before the financial crisis:

2006 S&P 500 earnings = 87.72 (peak pre-crisis earnings)

S&P 500 at year-end 2006 = 1,418.30

P/E = 16.2

2013 S&P 500 earnings = 107.45

S&P 500 = 1,940.46 (yesterday's close)

P/E = 18.1

% increase in earnings from 2006 to 2013 = 22.5%

A snapshot of earnings -- whether a company or, in this case, an index of many companies -- is only useful if it serves as a reasonable representation of a normalized earning trajectory going forward (over many years); it's only useful if it's a reasonable proxy for all the cash that will be distributed going forward. I'm sure there are all kinds of opinions about how S&P 500 earnings might change over the next few years. Well, I certainly never try to figure out such a thing (that window of time is way too small to be meaningful) even if I think odds are rather good that, let's say 10 or 20 years from now, S&P 500 earnings will likely be quite a bit higher than now.

To me, it's better to ignore short-term predictions. Ditto for fluctuations unless they happen to serve the investor in some way.

Other than choosing to own quality businesses in the first place, it is price, at least up to a point, that can be used to manage risks.*

Sometimes -- in fact, I'd say often -- extreme amounts of patience followed by decisive action will be required to buy enough at the right price.

Consider the wide range of prices that have been paid for what is not terribly difficult to estimate normalized S&P 500 earnings.

Even if the earnings power of the S&P 500 happens to drop dramatically in any given year, its intrinsic value is based upon the estimated earnings trajectory on a normalized and conservative basis over the long haul.
(A 50% drop in earnings in the short run might lead to a similar drop in market prices. That doesn't mean intrinsic value changed by that much.)

Since estimates like this are necessarily within a range, when in doubt choose the lower end of the range to estimate value.

The market prices fluctuate far more than the combined intrinsic value of those many S&P 500 businesses. Again, instead of being a detriment, those sometimes crazy fluctuations should serve the investor. Wild price action simply offers more chances to make purchases at a nice discount to approximate present value or, alternatively, to do some selling when prices become rather high relative to value.

Now, lets take a look at the same sort of numbers for Wells Fargo (WFC).

2006 WFC earnings per share = 2.47 (peak pre-crisis earnings)**

WFC at year-end 2006 = 35.56

P/E = 14.4

2013 WFC earnings per share = 3.89

WFC price = 51.63 (yesterday's close)

P/E = 13.3

% increase in earnings per share = 57.5%

Back in 2006, Wells Fargo seemed more expensive -- based upon on price to earnings -- than some other big banks. That Wells Fargo multiple of earnings may not look particularly high compared to the S&P 500, but it certainly was relatively high compared to some other big banks at that time.

Now, imagine buying Wells Fargo at that relatively expensive looking price back in 2006. Despite the slight P/E multiple contraction -- from 14.4 to 13.3 -- Wells Fargo's share price still went up more than the S&P 500 (and paid out more in dividends despite the dividend temporarily being cut).

The returns, while hardly spectacular -- in part, due to the at least somewhat expensive price back in 2006 -- contrast greatly with some other large financial institutions.
(Beyond those that got wiped out completely, of course.)

Unlike Wells Fargo's 57.5% increase in earning per share since 2006, a bunch of the big banks that are still around earn less than what they earned pre-crisis; in some cases, a small fraction. Much of this is due to dilution, of course. So, even if things go rather well for them from here, it's unlikely that their common shares will get to pre-crisis levels anytime soon.

Wells Fargo, with superior core economics, proved much more resilient than most others despite its own challenges and mistakes.

My point is that the importance of durable and superior economics is not only the upside; it's also the protection it provides on the down side. The financial system will, unfortunately, at some point down the road likely experience some real difficulties again. It seems, at least, wise to assume that's the case.

Some will try to protect against the downside by attempting to cleverly time the market. Good luck to those that do. That'd be one of those good ideas mostly in theory. A more practical approach is owning quality businesses and staying focused on price versus intrinsic worth. For those who decide owning shares of banks is worth the trouble (and I often wonder whether it really is considering alternatives), it's better to stick with quality. What looks cheap might have all kinds of downside. A reasonable valuation certainly matters, but it's just that, when it comes to investing in what are inherently very leveraged businesses, sometimes it's best to be skeptical of what appears on the surface to be a bargain.

In fact, I'm especially wary of financial institutions that look cheap during the good times. What seems like a seaworthy ship when the ocean is calm and the skies are blue can prove to be anything but once the storm clouds arrive.

Now, imagine having bought -- whether it was good fortune or otherwise -- shares of the larger financial institutions when they were selling at or near their lows. I mean, the very best banks as well as the weaker banks saw their stock prices collapse during the financial crisis. Most of the bigger banks -- at least those that survived the crisis a bit bruised but not broken -- would have generated very nice results for those who happened to buy near their lowest market prices.

In the real world, of course, most of us aren't going to consistently be able to buy shares when they are at or near their lows.

Most of the big banks were just generally NOT built such that the investor who, at least somewhat unfortunately, bought at pre-crisis prices came out okay. The fact that a bank like Wells Fargo stock would have produced good or better results, whether purchased pre-crisis or during the crisis, is an indication -- albeit a simplistic one -- of the very different risk versus reward profiles among the bigger banks.

A stock price that declines while per share intrinsic value remains roughly in tact is not, at least in the long run, a real problem. It may not be pleasant to look at the quoted prices for some time, but a stock that drops further below intrinsic value is an opportunity not a problem for the long-term investor. Besides, temporary paper losses are an inevitable part of the investing process. Those that can't stomach such things really shouldn't be exposed to the stock market.

On the other hand, a stock price that declines along with per share intrinsic value is a very real problem.

The quality banks -- usually those with higher return on assets and equity that also possess other important but less easy to measure characteristics -- should generally sell for a relative premium.

Margin of safety still matters but, with banks, it's usually better to avoid the bargain basement.

I'll stick with the quality stuff and, maybe, pay just a bit more if necessary.
(Though, as always, at what is still a nice discount to intrinsic value.)

It's worth mentioning that even the best bank's common shareholders won't necessarily be protected against another very serious financial collapse.

There's no rule that says the most recent financial crisis is as bad as it can get.

These businesses have unique risks even when they are run brilliantly.

Something to consider.


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

* The investor has control over what they are willing to pay for an asset they like if not much else. Yet t
he price paid provides only limited protection against permanent capital loss for some investments. In certain instances, the worst case valuation is either unclear or such that no price is low enough to protect against the worst possible outcomes. Naturally, the price paid should be comfortably below the estimated present per share intrinsic value. My preference is to calculate per share intrinsic value based upon lower end of an estimated range of future free cash flow, discounted appropriately. Confidence in those estimates should be very high and, well, warranted.  If not better to move onto something else. Never get caught up in a compelling story. That's a great way to pay too much for promise that may or may not be realized.
** The 2006 annual report showed diluted earnings per common share to be $ 2.49 per share but subsequent reports have it as $ 2.47.
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.