Friday, December 26, 2014

Quotes of 2014

A collection of quotes said or written at some point during this calendar year.

In a review of the book: Fortune Tellers, James Grant offered the following on the limitations of forecasting and predictions:

Henry Singleton: Why Flexibility Beat Long-Range Planning

"Henry Singleton (1916-99), longtime chief executive officer of the technology conglomerate Teledyne Inc...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." - James Grant

Some thoughts from Warren Buffett on Berkshire Hathaway's (BRKa) intrinsic value and buybacks:

Intrinsic Value

"As I've long told you, Berkshire's intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That's why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. Purchases at that level benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount. We did not purchase shares during 2013, however, because the stock price did not descend to the 120% level. If it does, we will be aggressive.

Charlie Munger, Berkshire's vice chairman and my partner, and I believe both Berkshire's book value and intrinsic value will outperform the S&P in years when the market is down or moderately up. We expect to fall short, though, in years when the market is strong – as we did in 2013. We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%." - Warren Buffett

Sometimes, the ability to calculate extremely well can be an obvious advantage yet also a blind spot. Earlier this year, in a review of the book Brilliant Blunders, Freeman Dyson offered up Lord Kelvin as an example. Dyson describes "Kelvin's wrong calculation of the age of the earth" as resulting from "blindness to obvious facts." He attributes the misjudgment, at least in part, to Kelvin's exceptional math skills. In other words, too much focus on what can be calculated without due consideration for other, more important, less quantifiable factors can lead to avoidable misjudgments/incorrect conclusions. This can be as relevant to investment decision-making as it is to the development of scientific theory.*

On the downside of calculating too much:

Intrinsic Value

"Kelvin lacked our modern knowledge of the structure and dynamics of the earth, but he could see with his own eyes the eruptions of volcanoes bringing hot liquid from deep underground to the surface. His skill as a calculator seems to have blinded him to messy processes such as volcanic eruptions that could not be calculated." - Freeman Dyson

Here's Buffett on some of the fundamental elements of investing:

Buffett on Farms, Real Estate, and Stocks

"You don't need to be an expert in order to achieve satisfactory investment returns. But if you aren't, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don't swing for the fences. When promised quick profits, respond with a quick 'no.'" - Warren Buffett

"Focus on the future productivity of the asset you are considering. If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn't necessary; you only need to understand the actions you undertake." - Warren Buffett

"If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game." - Warren Buffett

"Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays." - Warren Buffett

"...macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle's scathing comment: 'You don't know how easy this game is until you get into that broadcasting booth.')" - Warren Buffett

Below, Warren Buffett and Charlie Munger offer some views on retail businesses:

Buffett and Munger Talk Retail Businesses, Nebraska Furniture Mart, and Amazon

MUNGER: I think Warren and I can match anybody's failures in retail.

BUFFETT: Yeah, we have a really bad record, starting in 1966. We bought what we thought was a second-rate department store in Baltimore at a third-rate price, but we found out very quickly that we bought a fourth-rate department store at a third-rate price. And we failed at it, and we failed...

MUNGER: Quickly.

BUFFETT: Yeah, quickly. That's true. We failed other times in retailing. Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that's working. And so the world keeps moving. It's hard to establish a permanent moat that your competitor can't cross. And you've seen the giants of retail...a lot of giants have been toppled.

MUNGER: Most of the giants of yesteryear are done.

More specifically, here's how they view Amazon (AMZN):

MUNGER: Well, I think it's very disruptive compared to everybody else, I think it's a formidable model that is going to change America.

BUFFETT: I agree. It's one of the most powerful models that I've seen in a lifetime, and it's being run by a fellow that has had a very clear view of what he wants to do, and does it every day when he goes to work, and is not hampered by external factors like people telling him what he should earn quarterly or something of the sort. And ungodly smart, focused. He's really got a powerful business, and he's got satisfied customers. That's hugely important.

More in a follow-up.

Adam

Long position in BRKb established at much lower prices. No position in AMZN.

Quotes of 2013 Part I & II

* Here's how Charlie Munger explained it at the 2002 Wesco annual 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."

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, December 19, 2014

Should Buffett Buy Uber?

A recent Fortune article made the case for something that at first glance seems rather unlikely. In it, Dan Primack argues that Warren Buffett should consider buying Uber. With this in mind and for context, let's look at some things Buffett has written over the years. Back in 2007, Berkshire Hathaway's (BRKa) four largest equity investments were Coca-Cola (KO) Wells Fargo (WFC), American Express (AXP), P&G (PG).

Here's what he had to say about those investments:

"...note that American Express and Wells Fargo were both organized by Henry Wells and William Fargo, Amex in 1850 and Wells in 1852. P&G and Coke began business in 1837 and 1886 respectively. Start-ups are not our game." - From the 2007 Berkshire letter

Three of those stocks remain top four holdings. More recently (over the past five years or so) some of Buffett's bigger purchases -- everything from partial ownership via equities to outright acquisitions -- have included things like Burlington Northern Santa Fe, Lubrizol, IBM (IBM), Heinz, Exxon Mobil (XOM), and Duracell. The youngest of these businesses is 86 years old. So, to say the very least, Buffett generally likes businesses with a very long track record that are less likely to experience major change* -- especially the kind of change that fundamentally alters the core business economics -- going forward.

"In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek." - From the 1996 Berkshire letter

So Uber would be a rather significant break, I think it's fair to say, from Berkshire's traditional approach.  Startups -- even very successful ones -- that compete in a rapidly changing environment isn't usually a part of the Berkshire playbook. Yet you never know. If the price was right, maybe something that now seems rather improbable could suddenly make a whole lot of sense.

The fact is that there have been many great businesses launched -- and Uber just might prove to be one of them though, at this point, I have no idea -- during the period that Buffett has been managing Berkshire (roughly five decades).

Berkshire's success over that time -- a 693,518% total return through the end of last year -- has essentially come from none of them.**

Many more great businesses will no doubt be created in the coming decades.

It seems likely they also won't be contributing much to Berkshire's intrinsic value going forward.

If nothing else, Berkshire's approach shows that attractive investment results do not necessarily depend on some unusual acuity for finding the next big thing. Exciting growth prospects and dynamic change might, in fact, offer the possibility for big investment gains. The problem is they also sometimes offer the chance to lose a whole lot of money. Big wins and big losses usually reside in the same neighborhood. They can be tough to reliably tell apart beforehand without making large mistakes.

This is not only due to unpredictable future prospects and a wide range of possible outcomes; this is also because the price one usually has to pay upfront for the most promising businesses is rather high.

Insufficient margin of safety.

Of course, some might be able to reliably pick the big winners, but it's easy to underestimate how difficult this is to do without also incurring big losses.

That may offer a more exciting ride but it's the net result, in the context of risk, that matters.

Owning businesses that can maintain attractive economics for decades, bought at a reasonable price or, better yet, at a meaningful discount to a conservative estimate of value, isn't a bad way to balance risk and reward. Exciting growth prospects not required.

Almost any business -- even a very good one -- will eventually experience real difficulties and unexpected challenges. Buffett's approach is, in part, an attempt to reduce the likelihood that investment results will be ruined by what are almost inevitable future business challenges.

"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." - From the 2013 Berkshire Hathaway letter

So, even with such an approach, mistakes will still get made.

Just because a particular business has succeeded for a very long time guarantees absolutely nothing.

Adam

Long positions in all common stocks mentioned excluding XOM

* This is not meant to be an all-inclusive list of Berkshire's more recent investment activity but, instead, just some good examples of the larger moves that have been made. Burlington Northern's historical lineage dates back to the late 1840s. Heinz was founded in 1869. Exxon was formed in 1870. IBM was founded in 1911. Duracell began in 1916. Lubrizol was founded in 1928. The names may have changed over time but all of these go back quite a ways. Naturally, all of these businesses have dealt with change over time but the question is how likely those changes will damage business economics. IBM would seem to fit the least well when it comes down to whether its business is likely to experience major change going forward. The Heinz investment is made up of common stock, warrants, and preferred shares. Berkshire also made a large investment in Bank of America (BAC) preferred stock and warrants. It won't be clear for some time how much BofA common stock Berkshire will end up owning though at this point it appears that it will be substantial. Once again, the bank isn't exactly a startup.
** This total return over five decades or so means that $ 10,000 invested in Berkshire would have grown to just under $ 70 million.
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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.

Friday, December 12, 2014

Wide Moat Businesses at the Right Price

For equity investors, it's not enough that a business currently possesses real competitive advantages if those advantages can't be sustained and, better yet, even strengthened over time.

Warren Buffett explained it this way in the 2007 Berkshire Hathaway (BRKa) shareholder letter:

"A truly great business must have an enduring 'moat' that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business 'castle' that is earning high returns."

An enduring 'moat' can come from things like an ongoing cost advantage or a strong brand that creates pricing power. Buffett later adds:

"Our criterion of 'enduring' causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism's 'creative destruction' is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all."

That the 'moat' remains robust -- and, in fact, is made even stronger -- requires that management isn't too distracted by short-term goals in lieu of what Buffett calls 'widening the moat'. A management who chooses the former over the latter can do real and permanent damage.

From the 2005 letter:

"Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as 'widening the moat.'"

A business might currently have -- or appear to have -- a decent (or better) competitive advantages, but what those advantages will look like further down the road is questionable or difficult to understand. Well, big investment mistakes can get made when that's the case. If the moat that now exists will be meaningfully reduced, or worse, disappear altogether, then the estimate of intrinsic value has a great chance of being very wrong. When attractive core economics today become much less so later on, misjudgments regarding current valuation -- and how valuation will change over time -- are more likely. An unreliable moat means that, as time passes, future free cash flows become increasingly uncertain. The result possibly being poor investment results or even permanent capital loss.

Exciting growth rates may not prove to be worth much if the moat collapses sooner than expected.

So quality businesses are those with advantages that are obvious, sustainable, and can be strengthened by competent management over time. A management who knows how to enhance whatever advantages exist, smooth out the important imperfections, and ultimately make the business tougher to dislodge from what is already an enviable position, can create a lot of long-term value.

The very best businesses can comfortably withstand mediocre (or worse) business leadership from time to time even if some real, at the very least temporary but possibly permanent, economic damage is caused by their actions (and maybe inactions).

Yet, as always, shares of even the best business needs to bought at a large enough discount to value to protect the investor from what is necessarily an uncertain future.

How price compares to a conservative estimate of value is one way -- though this has its limits -- to manage the unknown and often unknowable future risks. Always buying at a comfortable discount -- and what will be comfortable is necessarily stock specific -- protects, up to a point, against what might go wrong. Most of the time it's just not possible for me to come up with a reliable estimate of per share valuation for a particular stock. Well, at least not within a narrow enough range. This could be due to my own limitations or the characteristics of the business itself.

Either way, the right course of action will always be to stay well clear of any investment alternative where per share value within a range isn't obvious. The good news is that the investor always has the option of moving onto something else that's more understandable. For most stocks, it is simple avoidance that will be the way to go. The possibility of permanent capital loss is best reduced by paying an appropriately discounted price, considering the specific risks, for well understood businesses where per share intrinsic value can be estimated with high levels of confidence.

Buying the highest quality businesses -- those that generally have the very widest moats -- feels safer and certainly can be. At least that's the case if the price is right. In the late 1990s -- as well as with the so-called Nifty Fifty of the early 1970s -- some very good businesses became riskier to buy simply because of the extremely high prices relative to per share intrinsic value. Many still produced good investment results over the very long run but, since none of us have the luxury of investing with a rear-view mirror, paying such high prices did not offer much protection against what might go wrong. Just because it worked out that time tells you nothing about what's in store in the coming decades.

That's why margin of safety is such a fundamental investing principle.

In a 2007 memo, Howard Marks wrote the following:

"...the history that took place is only one version of what it could have been."

So that means "the relevance of history to the future is much more limited than may appear to be the case."

Shares of a merely decent business -- one with a moat though it may not be particularly wide -- bought at a huge discount to intrinsic value can actually be safer than the best businesses selling at a substantial premium. Still, all else equal and with the long-term in mind, I'd generally rather buy the higher quality businesses at merely reasonable prices than the lesser businesses with seemingly much bigger discounts. It's a matter of balancing the risk of permanent loss with potential reward.

The more uncertain something is, the bigger the discount to value one should pay. The tough part is that it's impossible to quantify all the risks. Judgment calls have to be made without precise numbers to rely on.

In a recent memo, Howard Marks wrote that the estimation of risk "will by necessity be subjective, imprecise and more qualitative than quantitative (even if it's expressed in numbers)."

I mentioned above that price has its limits when it comes balancing risk and reward. At times, the worst case scenario is so unacceptable that avoiding an investment with otherwise lots of potential upside is the right course of action. In other words no price will be low enough.

Later in the same memo, Marks offered the example of not wanting to be a skydiver who's successful just 95% of the time. With this in mind I added the following in a prior post:

That's a useful way to think about it. The outcome 5% of the time is just unacceptable no matter how good things go the other 95% of the time. There will be times where there's just no way to know the range of possible outcomes (sometimes due to investor limitations, sometimes due to external factors). The risk versus reward may in fact be very favorable, but it's just not clear so decisive action cannot be taken.

Otherwise, the price paid often dictates the risks that are taken. If a high quality business is selling at 50x earnings -- or maybe even 100x earnings -- it is possibly far riskier than a decent business with some real challenges and little or no growth selling at 5x normalized earnings. The decent business may lack a compelling 'story' but, then again, the 'story' is often just a distraction from what really matters when it comes to investment risk and reward.

Again, this works only up to a point because many moat-less businesses are to be avoided altogether -- because of the worst case downside -- no matter how cheap they seem to be.

Notice that growth hasn't been mentioned at all. Growth can be an important ingredient but it is just not necessarily an important ingredient.

Adam

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

Related posts:
Howard Marks on Risk
Risk and Reward Revisited
Buffett on Risk and Reward
Nifty Fifty - Part II
Nifty Fifty
Buffett on Widening the Moat

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, December 5, 2014

Investors Overestimate Their Own Returns

So it turns out that market participants have a tendency to overestimate their own investment results.

I found this particular bias very surprising -- much more so than the many other common investing biases -- when I first came across it. I mean, how could it be that the overestimation of returns is a pervasive problem? Well, it apparently occurs quite a lot. Maybe others are less surprised by the tendency, but it's certainly far more prevalent than I would have expected.

Jason Zweig recently pointed out that "nearly 90% of investors exaggerated their returns and that many who thought they had beaten the market had been beaten by it."

This is based on some research that was done in the late 1990s.

More recent research offered a similar conclusion. It points out that investor experience does reduce "the simple mathematical error of estimating portfolio returns, but seems not to influence their behavioral mistakes pertaining to how good (in absolute sense or relative to other investors) they are."

So experience matters but in a rather limited way. In fact, it showed that investors overestimate their returns and not by a small amount. It turns out that investors actually overestimated their own returns by greater than 11 percent each year.*

Every study has its limits, of course, but this is at least an indication that many do far worse than they think.

What makes this behavior tough to alter? Well, a tendency to believe that overestimating investment results is a bias that others have is certainly a contributing factor.

Here's how one study explains what's known as bias blind spot:**

"...individuals see the existence and operation of cognitive and motivational biases much more in others than in themselves."

A separate study describes it this way:

"Bias turns out to be relatively easy to recognize in the behaviors of others, but often difficult to detect in one's own judgments."

It would seem like that what leads investors to overestimate their returns should be easy to avoid but, well, it's apparently just not.

Awareness alone will hardly combat the tendency but it's a start.

An objective measurement system for the complete portfolio against an appropriate benchmark with an emphasis on the long-term might be helpful but, as the study above points out, this isn't strictly a measurement problem. It's important that things are NOT compartmentalized into separate buckets. In other words, if money was lost on something speculative, for example, it counts. Whether highly speculative or not, it's a permanent capital loss. Some also might choose to recognize gains while ignoring certain losses. It all naturally counts.***

So why do investors tend to not judge their own performance objectively?

Well, some suggest that market participants -- especially those who are very active -- may act this way to make themselves feel better about their results and to justify all the effort. They choose to selectively remember the most lucrative moves they've made while ignoring those that were less so. Whatever the reasons, if better understood by participants it just might lead to changes in behavior and, ultimately, a more realistic assessment of results.

In this article, Professor Terrance Odean said that even when investors "are not better than average, they pretty much have to believe they are just in order to do what they are doing, to be active investors."

It's not that temporary losses in the short run -- and sometimes even over the intermediate run -- are necessarily a problem. In fact, temporary losses are pretty much inevitable even for those who are very good at investing in equities. It's that, in order to measure results in a meaningful way, the poor performers -- especially those that are likely to become either permanent losses or produce subpar results over the long run -- can't be ignored.

Yet that's what some choose to do in order to make themselves feel better about their overall results.

Here's how Professor Meir Statman explained it later in the same article.

"The people who like to trade, who want to trade or who feel better when they are trading, they will look at their numbers in a way that justifies" continuing to trade.

Statman also said:

"They're going to justify it and they will sound logical — at least to themselves..."

Feeling better and justifying doesn't change the fact that the results are subpar. Allowing oneself to be fooled in this way is a terrible way approach such a serious thing.

There are other ways of compartmentalizing, in order to feel better about results, even if it increasingly torches reality. For example, choosing to not include cash in the total return calculation. Well, all the investable cash counts whether it happens to be invested at any particular time or not. If a fund manager sits on some extra cash for whatever reason, whether it turns out to be wise or not, that directly impacts total return. It is counted -- and very much should be counted -- in the total return calculation. This is done whether being in more cash leads to a favorable outcome or not. The same thing applies for the rest of us if relative and absolute results are to be objectively measured.

"The first principle is that you must not fool yourself, and you are the easiest person to fool." - Richard Feynman

So setting up an objective way to measure sounds easy enough but much of the above research more than suggests it's not.

I'd add that it's also important to not measure results over shorter time horizons. How someone has performed over one or three years -- and especially less than that -- should be of little interest. The problem here is that it might be a very long time before the results reveal it wasn't worth all the trouble.

In any case, if after a reasonable period of time an investor is underperforming -- especially if, as the research above seems to indicate, by a substantial amount  -- it's probably time to move on to more of an index fund approach.

Time will be better spent elsewhere.

The bottom line is that investors tend to overrate themselves.

Best to work hard at trying to not be one of them.

Adam

[An earlier version of this post was a draft that was mistakenly posted.]

* This has been covered to an extent in prior posts.
** A quick reference to this was made in my most recent post.
*** It's also naturally important that relative risk, though far more difficult to quantify than returns, is considered carefully.
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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.
 
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