Thursday, January 30, 2014

John Bogle's "Relentless Rules of Humble Arithmetic"

From some remarks by John Bogle at NYU back in 2007:

"...it's been said (by my detractors) that all I have going for me is 'the uncanny ability to recognize the obvious.' The curious irony, however, is that 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.' But only by facing the obvious realities of investing will the intelligent investor succeed."

Later in those same remarks Bogle added the following:

"The first of the two relentless rules of humble arithmetic I'll mention is a simple one: Gross return in the financial markets, minus the costs of financial intermediation, equals the net return that we investors share."

He goes on to explain "the foolishness and counterproductivity of our vast and complex financial market system."

He does this by using his own version of a parable by Warren Buffett.*
(The original version was covered in a post last year.)

Bogle's version of the parable:

"Once upon a time...a wealthy family named the Gotrocks, grown over the generations to include thousand of brothers, sisters, aunts, uncles, and cousins, owned 100 percent of every stock in the United States. Each year, they reaped the rewards of investing: all the earnings growth that those thousands of corporations generated and all the dividends that they distributed. Each family member grew wealthier at the same pace, and all was harmonious. Their investment had compounded over the decades, creating enormous wealth, because the Gotrocks family was playing a winner's game.

But after a while, a few fast-talking Helpers arrive on the scene, and they persuade some 'smart' Gotrocks cousins that they can earn a larger share than the other relatives. These Helpers convince the cousins to sell some of their shares in the companies to other family members, and to buy some shares of others from them in return. The Helpers handle the transactions, and as brokers, they receive commissions for their services. The ownership is thus rearranged among the family members.

To their surprise, however, the family wealth begins to grow at a slower pace. Why? Because some of the return is now consumed by the Helpers, and the family's share of the generous pie that U.S. industry bakes each year—all those dividends paid, all those earnings reinvested in the business—100 percent at the outset, starts to decline, simply because some of the return is now consumed by the Helpers.

To make matters worse, while the family had always paid taxes on their dividends, some of the members are now also paying taxes on the capital gains they realize from their stock-swapping back and forth, further diminishing the family's total wealth.

The smart cousins quickly realize that their plan has actually diminished the rate of growth in the family's wealth. They recognize that their foray into stock-picking has been a failure and conclude that they need professional assistance, the better to pick the right stocks for themselves. So they hire stock-picking experts—more Helpers!—to gain an advantage. These money managers charge a fee for their services. So when the family appraises its wealth a year later, it finds that its share of the pie has diminished even further.

To make matters still worse, the new managers feel compelled to earn their keep by trading the family's stocks at frantic levels of activity, not only increasing the brokerage commissions paid to the first set of Helpers, but running up the tax bill as well. Now the family's earlier 100 percent share of the dividend and earnings pie is further diminished.

'Well, we failed to pick good stocks for ourselves, and when that didn't work, we also failed to pick managers who could do so,' the smart cousins say. 'What shall we do?' Undeterred by their two previous failures, they decide to hire still more Helpers. They retain the best investment consultants and financial planners they can find to advise them on how to select the right managers, who will then surely pick the right stocks. The consultants, of course, tell them they can do exactly that. 'Just pay us a fee for our services,' the new Helpers assure the cousins, 'and all will be well.'

Alarmed at last, the family sits down together and takes stock of the events that have transpired since some of them began to try to outsmart the others. 'How is it,' they ask, 'that our original 100 percent share of the pie—made up each year of all those dividends and earnings—has dwindled to just 60 percent?' Their wisest member, a sage old uncle, softly responds: 'All that money you've paid to those Helpers and all those unnecessary extra taxes you’re paying come directly out of our family's total earnings and dividends. Go back to square one and do so immediately. Get rid of all your brokers. Get rid of all your money managers. Get rid of all your consultants. Then our family will again reap 100 percent of however large a pie that corporate America bakes for us, year after year."

Market participants have a better alternative even if too many choose to ignore it. The emphasis should be on generating returns via increases to the intrinsic value of business instead of more cleverly trading price action than the next guy.

More from Bogle:

"That brings us to my second relentless rule of humble arithmetic. Successful investing is not about the stock market, but about owning all of America's businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation's—and, for that matter, our world's—corporations. For in the very long run, it is how businesses actually perform that determines the return on our invested capital."

This can be accomplished by owning an index fund bought well. It can also be accomplished, at least for those inclined and able to do so effectively, by owning a shares of good businesses, also understood and bought well.

In any case, it's buying only what one truly understands (an easy mistake to make is overestimating how well understood an investment truly is), knowing one's own limits, minimizing frictional costs, then allowing -- instead of clever trading -- the per share increase to intrinsic value to be the primary driver of future long run returns.

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

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you." - Warren Buffett in the 1993 Berkshire Hathaway (BRKaShareholder Letter

In both cases the emphasis is on not making the mistake that was made by the Gotrocks family.

This plainly makes a huge amount of sense but I suspect, since not many seem to have taken the advice of Buffett or Bogle before, they aren't likely to be inclined to do so now.

One of the reasons?

It's just too simple.

"...our model is too simple. Most people believe you can't be an expert if it's too simple." - Charlie Munger at the 2007 Wesco Meeting

"Stocks are simple. All you do is buy shares in a great business for less than the business is intrinsically worth, with managers of the highest integrity and ability. Then you own those shares forever." - Warren Buffett

"The business schools reward difficult complex behaviour more than simple behavior, but simple behavior is more effective." - Warren Buffett

Warren Buffett: What He Does Is "Simple But Not Easy"

And, as Bogle points out above, too obvious. Well, sometimes what's simple and obvious also happens to be wise.

"The statistical evidence proving that stock index funds outperform between 80% and 90% of actively managed equity funds is so overwhelming that it takes enormously expensive advertising campaigns to obscure the truth from investors." - From The Motley Fool

Some will continue to think they can pick the winning funds beforehand. Some actually will. Others will pay excessive fees thinking that the skill involved will more than offset it.

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value." - Jack Meyer, former President and CEO of the Harvard Management Company from 1990 to 2005, commenting on investment managers

An investment plan based upon picking the exception seems not a realistic plan at all.

The same is true for stocks. Many shouldn't be trying to pick individual stocks -- especially if their particular approach involves excessive amounts of trading -- but will continue to do it anyway despite the evidence that they're likely to underperform.

Investor overconfidence is a big part of the problem.

Bogle rightly emphasizes humble arithmetic. Yet, in what may seem but is not at all contradictory, Buffett and Munger say, when it comes to investing well, the numbers themselves matter less than some think.**

"If you need to use a computer or calculator to make the calculation, you shouldn't buy it." - Warren Buffett at the 2009 Berkshire Hathaway Shareholder Meeting

They're hardly implying that the numbers aren't relevant, it's just that there's no place for false precision in the investment process.

Too much of what matters isn't quantifiable.

Adam

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

Related posts:
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
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
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* The parable can be found in the 2005 letter
on pages 18-19. Buffett's version of this parable is also covered in the prior post. For those familiar with it, there'll be not much new here in Bogle's version. Still, I do happen to think it's the kind of thing worth revisiting from time to time. Others will likely see it, much like Bogle's detractors, as just more recognition of what is obvious. Well, considering the large proportion of participants who underperform the market as a whole, it sure seems that, too often, the obvious gets ignored by some otherwise very smart people. Too often investors do end up being their own worst enemy. Unfortunately, it's the thinking that it's possible to be in and out of positions at the right time -- with the idea of improving investment results, of course - that gets investors in trouble.
** Charlie Munger in this speech at UC Santa Barbara: "You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically (1) everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, January 23, 2014

Is Buffett Just Lucky? - Part II

A follow up to this recent post.

Is Buffett Just Lucky?

This recent paper attempts to better understand what's behind Buffett's success through empirical analysis.

Here is an excerpt from the conclusion section:

"In essence, we find that the secret to Buffett's success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails. Indeed, we find that stocks with the characteristics favored by Buffett have done well in general, that Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and that leveraging safe stocks can largely explain Buffett's performance.

Buffett has become the focal point of the intense debate about market efficiency among academics, practitioners, and in the media (see, e.g., Malkiel (2012)). The most recent Nobel prize has reignited this debate and, as a prototypical example, Forbes writes 'In the real world of investments, however, there are obvious arguments against the EMH. There are investors who have beaten the market – Warren Buffett.' The efficient-market counter argument is that Buffett may just have been lucky. Our findings suggest that Buffett's success is not luck or chance, but reward for a successful implementation of exposure to factors that have historically produced high returns.

At the same time, Buffett's success shows that the high returns of these academic factors are not just 'paper returns', but these returns could be realized in the real world after transaction costs and funding costs, at least by Warren Buffett. Hence, to the extent that value and quality factors challenge the efficient market hypothesis, the actual returns of Warren Buffett strengthen this evidence."

Let's consider further the leverage Buffett uses that is mentioned above. The kind of stable leverage -- mostly in the form of insurance float -- employed by Buffett is tough for most to replicate.

Some think all leverage is bad leverage. Yet, when leverage is in the right proportion, is cheap, and stable in nature, it can work very well.

Stable means that sources of funding won't dry up when the going gets tough. Funding can't be highly dependent on short-term creditors who'll cut credit lines when there are signs of trouble.

That just makes a difficult situation untenable. A big source of the financial stress -- along with too much leverage -- for some financial institutions during the crisis five years ago or so.

This Morningstar article by Sam Lee explains it very well:

"The poster boy for leverage done right is none other than Warren Buffett."

Lee mentions that Buffett once had the following to say about leverage:

"A long, long time ago a friend said to me about leverage, 'If you're smart you don't need it, and if you're dumb you got no business using it.'"

This naturally at first seems inconsistent. Buffett does in fact like some leverage but, well, it must be in the right form and the right proportion. So then what exactly is the right kind of leverage? That'd be, as Lee explains, "a special kind of leverage, the prepaid premiums, or 'float,'", produced by Berkshire Hathaway's (BRKa) many insurance businesses.
(The quality of the "float" will come down to whether underwriters do a sound job of assessing risks and premiums are set accordingly.)

So what is it that makes "float" potentially superior to other forms of leverage?

"Float can never be called away at the whim of a nervous counterparty. Even better, the timing of the payouts is unrelated to market conditions, so Berkshire doesn't have to stump up a mountain of cash just as the markets are going to hell in a handbasket."

Unfortunately, this is the one important aspect of what Buffett does that most investors can't realistically make happen. A point that is well made later in the same Morningstar article. Most leverage available to investors is often not only too costly to make sense but, more importantly, is also not stable enough during the tough times even if used in moderation. In other words, the requirement to post collateral at the worst possible time must be avoided.

Margin, for example, simply doesn't cut it as a stable source of funding. Very short-term financing -- in pretty much all its forms -- that's employed to fund the purchase of longer term assets just doesn't cut it. That sort of funding is likely to become scarce just when it is needed most (maybe during the next financial crisis). It only seems to work really well until it suddenly doesn't. The result being forced sales of assets at (or nearly at) just the wrong time.

Buffett's leverage, in contrast, is set up such that doesn't need to worry about a counterparty who requires the posting of collateral at the worst possible time (i.e. a margin call).*

He also knows that the eventual payouts are usually far removed from current market conditions.
(e.g. Consider the put options Buffett has previously written on indexes. These options generally expired far into the future (a decade plus). Little collateral was required. They also could only be exercised upon expiration. These may seem to be minor differences, but it means that what is happening to the market near-term matters little as far as cash needs go. The potential payouts aren't connected to the current market environment. A big advantage.)

As I mentioned in the prior post, the deals Buffett made during the financial crisis understandably get lots of attention. This leads, I think, to the incorrect conclusion that outperformance is primarily the result of his unique position.**

There's no doubt that the modest leverage Buffett uses -- mostly in the form of insurance float which provides cheap and, crucially, stable funding -- plays an important role. Yet, as I've already said, I think it's a mistake to conclude this alone or mostly is the driver of his results. From earlier in the paper:

"...Buffett's leverage can partly explain how he outperforms the market, but only partly."

Also, that leverage is only put to work in moderation is hardly unimportant factor.***

So the leverage Buffett uses is cheap, stable, and moderate. He keeps lots of cash on hand. Each of these things, in combination, matter.

Naturally, the way that Buffett invests takes not a small amount of discipline. The leverage advantage aside, many aspects of the approach can be learned. Well, at least they can if the ideas are treated with deserved respect and with enough hard work.

This doesn't suggest his incredible results over the decades can be matched by many, but it just might help someone who takes it seriously to avoid taking on more risk for less reward (and maybe avoid paying a whole lot of frictional costs for the privilege).

I'm sure that some will think it necessary to continue waiting for sufficient empirical evidence. Debate and disagreement that moves the world closer to what's reasonably true is a healthy thing. On the other hand, resistance to ideas with greater merit because it's at odds with a preferred but flawed theory, for whatever reason, is not.

When something that seems to work in the real world conflicts with an established theory, it's a useful habit to give it serious consideration.

For those who still choose to completely ignore Buffett's way of thinking, all I can do is wish best of luck with their own investments.

Doing better than the market as a while long-term is never going to be easy. Most market participants will not. That doesn't logically lead to the conclusion that the markets are efficient.

In fact, these two seemingly conflicting things can coexist just fine.

Adam

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

* At least not a large amount of collateral in proportion to total resources.
** Well, a little quick math will reveal that, while those deals are surely good for shareholders, they just aren't big enough relative to the all other assets to really drive increases to intrinsic value. From earlier in the paper: "We find that both public and private companies contribute to Buffett's performance, but the portfolio of public stocks performs the best, suggesting that Buffett's skill is mostly in stock selection."
*** During the financial crisis some large financial institutions employed extreme leverage -- easily 25-to-1 and even much worse with an appropriate consideration for what, in many cases, was off-balance-sheet -- while often relying too much on short-term funding sources.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, January 16, 2014

Wells Fargo's 2013 Results

Here's a quick summary of Wells Fargo's (WFC) latest earnings:

Full year 2013
- Net income: $ 21.9 billion, up 16 percent from 2012
- Diluted earnings per share: $ 3.89, up 16 percent
- Revenue: $ 83.8 billion, down 3 percent
- Return on Equity (ROE): 13.87%, up 92 basis points
- Annualized net charge-offs as a % of average total loans were less than half than the previous year
- Average loans increased to $ 805.0 billion from 775.2 billion
- Average core deposits increased to 942.1 billion from 893.9 billion

Net interest margin continued to decline from 3.76% at year end 2012 compared to 3.39% at the end of 2013. In a vacuum that naturally is not be a good thing but, in the context of the current interest rate environment and relative to competitors, they continue to do just fine. Net interest margin remains a real relative advantage for Wells compared to other large banks which directly contributes to the bank's more than solid ROE.

One way to look at their performance overall since the financial crisis is that, despite that narrowing net interest margin and the year over year decline in revenue, they just earned $ 3.89 per share compared to $ 2.47 in their peak earnings year leading up to the financial crisis.

In contrast, some other large financial institutions are still earning only a fraction per share of what they earned prior to the crisis or, well, had a far worse fate.

I think it is fair to say that the decline in net interest margin is hardly surprising considering the current interest rate environment.

Any improvement to this environment could favorably impact net interest margin and, ultimately, Wells Fargo's overall earnings power. The good news for shareholders is the bank is doing just fine even if that does not occur anytime soon.

Of course, inevitably, the economic environment will erode some time down the road. When (not if) that time comes, what will matter is whether the bank is capable of handling it. That comes down to things like pre-tax pre-provision profit (PTPP)*, making quality loans, along with sufficient liquidity and capital.

The diluted average share count did decline in 4Q 2013 compared to 3Q 2013 due to buybacks (from 5,381.7 billion to 5,358.6 billion). We'll see if this continues. They did say in their news release that additional shares were bought back through a forward repurchase transaction that's expected to settle in 1Q 2014.

Net interest income after provision for credit losses increased to $ 40.5 billion from $ 36.0 billion, the biggest driver of the increase to earning in 2013. Net interest income was actually slightly down year over year but the reduction in provision for credit losses was substantial. This, more than anything else, was a key driver of the 2013 earnings increase.

Noninterest expense declined to $ 50.4 billion from $ 48.8 billion.

This also partly accounts for the increase to earnings.

On the other hand, noninterest income declined from $ 42.9 billion to $ 41.0 billion. This was the biggest hit to earnings and was driven by a decline in mortgage banking. It should be noted that 2012 was an elevated year for mortgage banking activity compared to 2011 and 2010. In fact, the noninterest income not related to mortgage banking were, in total, actually higher year over year.

With these 2013 earnings in mind, consider the following comments about Wells Fargo by Warren Buffett in the 2012 Berkshire Hathaway (BRKa) shareholder letter. In the letter, Buffett explains the "'non-real' amortization charge" that burdens Wells Fargo's earnings:**

2012 Berkshire Hathaway Annual Report

"...serious investors should understand the disparate nature of intangible assets: Some truly deplete over time while others never lose value. With software, for example, amortization charges are very real expenses. Charges against other intangibles such as the amortization of customer relationships, however, arise through purchase-accounting rules and are clearly not real expenses. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenses when calculating earnings – even though from an investor's viewpoint they could not be more different."

He later adds the following:

"A 'non-real' amortization charge at Wells Fargo, however, is not highlighted by the company and never, to my knowledge, has been noted in analyst reports. The earnings that Wells Fargo reports are heavily burdened by an 'amortization of core deposits' charge, the implication being that these deposits are disappearing at a fairly rapid clip. Yet core deposits regularly increase. The charge last year [2012] was about $1.5 billion. In no sense, except GAAP accounting, is this whopping charge an expense."

So there may be actually be more earnings power --  economically speaking, even if the accounting indicates otherwise -- at Wells Fargo than meets the eye.

In any case, what Wells Fargo does in any particular quarter -- or, for that matter, any particular year -- just is not that interesting. It may be for traders, it shouldn't be for long-term owners. Similarly, when and by how much interest rates will be up or down isn't something I'm going to try and figure out. Sometimes the environment will be favorable; sometimes it will not be.

What really counts -- since the environment inevitably oscillates between being more and less favorable -- is whether a banking franchise is likely to produce attractive relative and absolute results at less risk over the long haul. The focus is on whether the moat will remain wide (better yet, can it be widened?), smart management of risk, and the long run trend of normalized earning power.***

Banking is by its very nature a very leveraged institution (even if less so these days). The real question with any investment but especially leveraged institutions is whether it has been built to be resilient during times of severe -- especially if systemically destabilizing -- economic stress.

As some learned the hard way during the financial crisis, funding sources for leveraged institutions must remain stable; liquidity plentiful. A bank can look or even be profitable but that won't matter much if suddenly the balance sheet comes under real pressure.

The only thing worse than being forced to raise capital when prices are least favorable for owners, is seeing funds leave, en masse, and being unable to raise capital in a timely manner from other sources.

Quality management will do smart things during the good times that anticipates the not-so-good times.

Adam

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

* Pre-tax pre-provision profit (PTPP) -- net interest income, noninterest income minus noninterest expense -- is the first line of defense for any bank against credit losses. Otherwise, those losses begin impacting the balance sheet (i.e. allowance for loan losses and/or shareholders' equity balance). PTPP is a useful measure of a bank's ability to generate sufficient capital to cover credit losses during the worst part of a full credit cycle. Morningstar provides an explanation here (page 3). Strong PTPP relative to assets (and equity) isn't just about the potential for greater returns. It's not just about the upside. To me, what is far more important is that strong core earnings provides greater capacity to absorb credit and other losses that will inevitably arise at some point during a credit cycle even for the highest quality bank. Knowing that pre-tax, pre-provision capacity to earn is strong reduces at least one form of risk (among many others). 

** see pages 12-13 of the letter.
*** Some might be tempted to trade around the environment based upon how more or less favorable it seems. Best of luck. I mean, no doubt there are exceptions who actually do this successfully, but an approach based upon the exception seems more than just a bit unwise to me.
---
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.

Thursday, January 9, 2014

Henry Singleton: Why Flexibility Beats Long-Range Planning

James Grant recently reviewed a new book by Walter Friedman about the first economic forecasters in America.

Book Review: 'Fortune Tellers'

It's mostly about the folly of attempting to predict future financial and economic outcomes. From the review:

"The financial and economic future has been, is now and forever will be a mystery. Yet the power and dominion of the forecasting profession only seem to grow..."

Grant points to how Henry Singleton viewed forecasting:

"Henry Singleton (1916-99), longtime chief executive officer of the technology conglomerate Teledyne Inc., is not one of Mr. Friedman's subjects, but the corporate visionary understood the limits of forecasting. Once a Business Week reporter asked him if he had a long-range plan. No, Singleton replied, '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.' His plan was to bring an open mind to work every morning."

This is, of course, just one man's view of the world, but considering his long-term track record I think his view deserves above average consideration. Investing with the long-term primarily in mind does not mean trying to figure out what's going to happen many years down the road. That's effectively impossible to do and mostly a waste of energy.
(Even if, as Grant points out, this reality hasn't exactly discouraged those in prediction business and their followers.)

Investing long-term means being positioned for just about whatever the world throws at you and accepting that the world will always be unpredictable.

Think of the position of strength that Berkshire Hathaway was in during the financial crisis. It wasn't necessarily due to brilliant foresight regarding the crisis; it was mostly due to the company's inherent flexibility that allowed for decisive action when others could not act in such a way.

This Bloomberg article quickly summarizes Singleton's approach to investing. It also mentions the incredible 23 percent annual returns he produced over two decades.

According to John Train's book The Money Masters, Warren Buffett once said the following about Singleton:

"Henry Singleton of Teledyne has the best operating and capital deployment record in American business."

Here's another good excerpt from Train's book:

"According to Buffett, if one took the top 100 business school graduates and made a composite of their triumphs, their record would not be as good as that of Singleton, who incidentally was trained as a scientist, not an MBA. The failure of business schools to study men like Singleton is a crime, he says. Instead, they insist on holding up as models executives cut from a McKinsey & Company cookie cutter."

Singleton's results are nothing short of impressive, but it's not just the returns that are admirable. It's the way that he accomplished those returns that, to me, makes him so worthwhile to study further.

Some might think investing well requires some unique ability to see the future. In fact, it's recognizing that you mostly can't. It's understanding that some who make predictions for a living are better at selling the brilliance of their unique crystal ball than providing useful prognostications.

From this interview with Charlie Munger:

"Warren and I have not made our way in life by making successful macroeconomic predictions and betting on our conclusions.

Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.

I recommend to all of you exactly the same attitude.

It's kind of a snare and a delusion to outguess macroeconomic cycles...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?"

So consistently correct and useful predictions may not be impossible, but they sure seem to be an exception to the rule.

Well, an investment strategy based upon the exception seems like no strategy at all.

The good news for the long-term investor is that an unusual talent for making predictions is not a required skill. Investing certainly isn't an easy thing to do well. If it was more market participants would outperform the market as a whole. A sound investment process is made of many things (the right skills, experience, knowledge, and temperament etc.) and, at times, requires difficult judgment calls. The nice thing about investing is that the investor can always choose to take a pass if it's too close a call.

Buffett once explained it this way:

"I call investing the greatest business in the world...because you never have to swing."

Patiently wait for a "pitch" you like and have enough justifiable confidence to act decisively. The reason to buy should be obvious and provide a large margin of safety.

That's the idea. Sound easy enough but, well, it's not. One tricky aspect of all this can be that much of what matters in investing is hard to quantify. Investing requires, instead, lots of sound qualitative judgments combined with a good understanding of the numbers.

Here's how Charlie Munger explained it at the 2002 Wesco shareholder meeting:

"Organized common (or uncommon) sense -- very basic knowledge -- is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little."

More recently, at last year's Berkshire annual meeting, here's an exchange between Warren Buffett and Charlie Munger that was captured on Wall Street Journal's live blog:

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

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

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

Munger also said the following back in 2003:

"...practically (1) everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."

Beyond that critical mistake, recognizing that the future is always uncertain -- even when it seems otherwise -- isn't a bad place to start for investors. In other words, just because the world happens to seem more certain from time to time doesn't mean that it actually is.

"The world's always uncertain. The world was uncertain on December 6th, 1941, we just didn't know it. The world was uncertain on October 18th, 1987, you know, we just didn't know it. The world was uncertain on September 10th, 2001, we just didn't know it. The worldthere's always uncertainty. Now the question is, what do you do with your money? And if you—the one thing is if you leave it in your pocket, it'll become worth less—not worthless—worth less over time. That's certain—that's almost certain. You can put it in bonds and then you can get a certain 2 percent for 10 years and that's almost certain to be less than the decline in the purchasing power." - Warren Buffett on CNBC

Much goes into the generation of attractive long-term investment outcomes. There'll never be an easy recipe for investing effectively because, well, so much of it necessarily comes down to the experience, abilities, and limits of each individual investor.

Successfully allocating capital is never going to be an easy job, but it's not quite so difficult to create a what NOT to do list of the things that tend to hurt investment performance.

So here goes my what NOT to do list:

- Buy what is not well understood.

- Always seek confirming information.

- Never carefully examine misjudgments.

- Be overconfident in (and overestimate) your own investment talents and insights.

- Focus on the easy to quantify in lieu of the more important but sometimes tough to measure stuff.

- Ignore the many psychological factors (i.e. things like emotional and cognitive biases, fallacies, and illusions) that lead to misjudgments (even when the investment process is otherwise sound).

- Invest without an appropriate margin of safety considering the specific risks and opportunities.*

- Do not sell assets -- even very good ones -- when they get plainly expensive.**

- Do not carefully weigh opportunity costs.

- Focus on near-term price action.***

Among other things.

Though hardly exhaustive, the above list seems as sound a way as any to begin absolutely minimizing potential long run investment results.

Wise investors will, more or less, basically do something close to the opposite.

That, in itself, won't necessarily lead to great investment results, but at least is likely a step in the right direction.

Adam

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

Related prior posts:
Buffett: Forecasters & Fortune Tellers
Not Picking Stocks By The Numbers
Buffett on Teledyne's Henry Singleton

* Margin of safety is necessary because the future is always uncertain and mistakes inevitably get made. Yet the overconfident investor might feel sure that the investment they've made will eventually justify what initially seems a rich valuation. Sometimes they do, of course, but I always find it amusing when I read or someone says that a particular investment will eventually grow into its valuation. Investing isn't about growing into a particular valuation; it's about -- or should be about -- whether the forward returns are attractive considering the specific risks and compared to other well understood investment alternatives. Partial ownership of even the best business can become a dumb investment if the share price paid isn't right.
** This would seem obvious but some market participants are willing to own an expensive stock for technical reasons (e.g. momentum). Others will get caught up in a compelling -- possibly even legitimately so -- story despite the fact that so much has to go right to even justify the current price (never mind produce an attractive return going forward). On the other hand, this doesn't mean shares of a very high quality business should be sold just because it has become fully valued. That's a recipe for unnecessary mistakes and frictional costs. Buying and selling isn't just a opportunity to improve results, it's a chance to make a mistake. Making fewer well thought out decisive moves generally beats lots of unwarranted activity. Invest with "forever" or, at least, decades in mind whenever possible. The best businesses increase intrinsic value at an attractive rate and over a very long time horizon. 
*** Near-term is not measured in days weeks, or even months. Here's how Peter Lynch looks at it: "Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide."
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Wednesday, January 1, 2014

Quotes of 2013 - Part II

Some additional quotes from 2013 as a follow up to this recent post.

Quotes of 2013

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

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

"...it [HFT] is not contributing anything to capitalism." - Warren Buffett

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

Efficient Markets
"Our current problems are very confusing. If you aren't confused, you don't understand them very well." - Charlie Munger

Market Freezes Up
"Plainly, physics has made a different kind of contribution to human society than economics has. Then, again, physics is an easier nut to crack than economics. Electrons don't have feelings, as they say.

Progress in science is cumulative; we stand on the shoulders of giants. But progress in finance is cyclical; in money and banking, especially, we seem to keep making the same mistakes." - From Page 17-18 in Grant's Interest Rate Observer, Volume 31 Summer Break, August 23rd, 2013

Deadly Sins of Investing
"What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding cost. It's a mathematical fact. There's no getting around it. The fact that we don't look at it, too bad for us." - John Bogle

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.

"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."

Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
"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 fi t 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." - Jeremy Grantham

"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." - Jeremy Grantham

Happy New Year,

Adam

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