Friday, October 24, 2014

Buffett on Investing Mistakes

There have been plenty of headlines lately about things not going Warren Buffett's way -- at least in the short-term -- with some of his investments.

As long time owners and followers of Berkshire Hathaway (BRKa) know well, Buffett over the years has gone out of his way -- usually in the annual letters -- to point out when he makes a misjudgment that ends up costing Berkshire investors. Some of these -- though not necessarily all -- will prove to be just the latest examples. That investing mistakes will be made is close to inevitable even for those who are very good at it. From the 2013 Berkshire Hathaway shareholder letter:

"It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses."

IBM's (IBM) stock -- one of Berkshire's bigger equity holdings -- recently took a particularly significant hit. The company's stock fell as a result of disappointing near-term results and the outlook. It's, in fact, now selling a bit below the price that Buffett paid a few years back. Time will tell whether the investment wasn't a good one for Berkshire. I'm sure some will conclude that, based upon the price action, the market has spoken and therefore it has not been a good investment. What will really matter, as Buffett explained in the 2011 letter, is this:

"In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity."

Maybe IBM will prove to be a case of Buffett stepping outside of his 'circle'. I'm not convinced of that just yet but it's certainly possible.

IBM's recent challenges in meeting near-term expectations does cast at least some doubt on IBM's future earning power. So far it's hardly catastrophic but we'll see how it develops over time. The company, though it faces real challenges, still has far better core economics today compared to a decade or so ago. What they've done in that regard has been no small achievement. Revenue growth has been and likely will continue to be nonexistent. Yet IBM's return on capital has been improved substantially over the years. In the end, it's returns on capital and the price paid compared to intrinsic business value that mostly dictates future risk and reward. Revenue growth -- as long as it's high return variety -- can certainly be a good thing. It's just not necessarily a good thing. The problem is that some act as if, unless there is revenue growth, the results must be some form of financial engineering. Well, revenue growth for it's own sake may serve the speculator but doesn't serve the long-term owner. Some companies undoubtedly do engage in what appear to be questionable financial practices but, as far as I can tell, IBM does not seem like one of them. Now, I've written on prior occasions that -- and it continues to be the case -- I'm not a big fan of owning shares of technology businesses unless they are very inexpensive. Even then I'll, in general, only own certain tech stocks in small amounts.

Of course, some could fairly argue that IBM has already been a mistake.

It might just prove to be.

To me, it's a mistake if per share intrinsic value drops in a meaningful and permanent way*; it's a mistake if an unsatisfactory return is generated compared to understood alternatives; it's also a mistake if risks were taken that were poorly understood even if the investment happens to work out. For the long-term investor, the fact that the stock is currently higher or lower than the purchase price has nothing to do with this assessment. In fact, a stock falling stock even further below intrinsic value can be an unqualified advantage for the long-term owner if the business itself remains sound. Stock price action often fluctuates far more wildly than per share intrinsic business value. Lets say, for example, when quarterly results -- or even several quarterly results -- turn out to be disappointing.

Check out some of the recent headlines:

Warren Buffett just lost about $ 1 billion on this

Warren Buffett just lost ANOTHER $1B on this

Warren Buffett loses $2.5 billion in three days on Coca-Cola and IBM

Those headlines might just be more a reflection of an ethos that focuses on near-term price action and the speculative renting of stocks -- even if based upon fundamentals -- instead of ownership with an eye towards intrinsic values.

In each case the billions of dollars "lost" simply hasn't been lost unless Buffett needs to sell or the fundamentals have changed such that real intrinsic value has been or will be destroyed.
(It would end up being a loss, for example, if he required the funds near-term to buy an alternative investment that's more attractive -- opportunity costs.)

I'm definitely NOT a huge fan of IBM. It's a business that's constantly dealing with change. Far from the ideal investment. The stock may in fact turn out to be a subpar investment or worse. It's just not yet clear, at least to me, that the longer term investment outcomes will be unfavorable despite the real current difficulties. Even good businesses experience challenges from time to time and one usually doesn't get a chance to buy something sensible (for the long-term) at a nice discount when the near-term outlook seems rosy. IBM's stock may in fact underperform for some time, but the long-term oriented owner should be hoping for this so the buybacks can more effective.

Otherwise, the price paid along with how the business performs will ultimately have the most influence over long-term results. For investors that pay a fair (or better than fair) price, what's likely to happen to per share intrinsic value over long time frames, considering the risks and in comparison to well understood alternatives, is what really matters.

It's not about quarterly results.

It's absolutely not about what the stock does in the next few days, weeks, or even years.

It will be interesting to see what Buffett has to say about IBM at some point down the road. Maybe he's already concluded that buying IBM's stock wasn't a brilliant move on his part. If history is any guide he will make it clear if and when he considers it a mistake.

My own expectation is that IBM's specific challenges aren't going away anytime soon. Still, while IBM is not exactly my favorite business in the world, I do still plan to maintain a small long position.**

Errors of commission, where it's rather obvious what went wrong and how costly it ended up being, aren't necessarily the biggest problem for investors. Buffett has in the past emphasized the very costly, less explicit, but sometimes at least as important errors of omission. In recent years I've probably made too few errors of commission but too many errors of omission.***

Too few errors of commission may seem like an odd self-criticism but, in attempting to avoid possible losses, I sometimes end up not owning (or owning too little) of something sensible (when it was cheap enough to buy). So the too few errors of commission directly relates to making too many errors of omission. The power of loss aversion no doubt contributes to this. The risk that shares at a particular point in time sell at a reasonable discount to value might soon get too expensive to buy is a real one. Think about how many good businesses had shares that were selling at substantial discounts to value not all that long ago. The situation is very different these days.The avoidance of permanent loss should, of course, be the top priority. The tough part is not allowing that prime objective to get in the way of doing something sensible when the opportunity presents itself. It's easy to focus too much on the possibility of loss and not enough on well understood missed opportunities.

Investing always comes down to working within one's own limits. I don't doubt for a minute that others do a better job finding a good balance.

So the more explicit mistakes -- those of commission -- are not necessarily the most costly. There have been many times where I own a small amount of something when I should own a lot. It's a weakness that I've attempted to fix but, while some progress has been made, it's rather amazing how often I still end up owning too few shares of a business that I like and think I understand well.

It's worth pointing out that I'm not talking about missing the next transformational business. If I don't buy the next Facebook (FB) that's not a mistake even if it proves to produce a brilliant investment outcome. I'll almost always miss those kind of opportunities and I'm fine with it. That sort of thing is almost always going to be well outside my own "circle of competence". If I don't know how to value a business (within a narrow enough range), and it can't be bought at a nice discount to that estimate, the right move is to avoid.

Some might choose to focus on investments that went right and gloss over those that did not.

Successful investing requires a serious assessment of what didn't go right and why.

I'd add that few of us are able to understand how to value lots of different businesses.

"If you are really a value investor and do deep research, how many investments can you be involved in at the same time? If you are a high-frequency trader, you could trade 100 securities today. The real value investors are lucky if they can do 10 investments at a time." - Marty Whitman in this Barron's Interview

For me, it's important to stick to what I understand and, more importantly, knowing what I don't really understand. Maybe others can truly understand hundreds of different stocks but I'm more than a bit skeptical of this.

Some commentators seem willing to offer opinions on just about every investment alternative that comes up. Well, if someone has an opinion on just about every investment that's out there, it's probably going to be tough to figure which ones they truly understand.

I'm always impressed when someone responds with something along the lines of "I don't know".

Adam

Established a long position in BRKb at much lower than recent market prices; small long position in IBM established at slightly higher than recent market prices.

Related posts:
Buffett's Purchase of IBM Revisited
Why Buffett Wants IBM's Shares "To Languish"
Buffett on IBM: Berkshire Buys Big Blue
Technology Stocks

* IBM should earn ~ $ 16 per share this year. The company earned $ 11.52 per share in 2010 and $ 4.93 per share in 2004. That's certainly not a bad decade of performance for a larger company. The question is, of course, what will happen in the future. Maybe IBM's earnings are about to meaningfully decline. Does what happened this past decade say much about what's in store going forward? It may not. There's certainly no guarantee that the current earnings power will be persistent. That's only one of the many important judgments -- some easily quantifiable, many that are not -- any investor has to make.

** My position in the stock would change if the core business economics were to become materially altered, prospects have been misjudged by me (more likely to happen with IBM than some of my other investments), or maybe if opportunity costs come into play. If it does end up working out okay as an investment, it's going to be over a rather long time horizon. In fact, I won't be surprised if IBM's stock continues to disappoint for quite a while. In other words, those who like to profit from near-term price action will likely, and understandably, not find much use for it. The speculator naturally has a very different set of priorities.
*** Some focus on the risk of temporary loss but forget to consider the risk of losing the chance to own something sensible when it becomes available at an attractive price.
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