Friday, January 30, 2015

Zero-Sum Games

While sports is not a subject that's covered much on this blog, I'll use the upcoming Super Bowl -- with consideration for the amount of betting on the event that will occur in mind -- as a convenient excuse to revisit some of the differences between gambling, speculation, and investment.

Naturally, a variety of bets will be placed on that big game. Also, plenty of bets were made on game outcomes and individual player performance (through, for example, various forms of fantasy football) during the regular football season. On occasion, I'll hear someone suggest that owning stocks is just another form of gambling. Well, it certainly can be turned into gambling -- or a gambling-like activity -- but it need not be. It all comes down to behavior. Those who trade rather frequently are doing what, at least to me, is effectively gambling. There's nothing inherently wrong with that approach other than too often it tends to be not all that lucrative.

In fact, what happens to a stock over short amounts of time is essentially a coin flip. The price action of a stock is moved in the near-term by the voting machine. The price level in the long run is set, within a range, by the weighing machine. In the short run it's a popularity contest; in the long run it mostly comes down to what something is intrinsically worth.

Now let's say, for example, someone participated in fantasy football league and ended up winning 7-8 times their money that was put at risk.
(Over the course of the regular football season.)

That's a nice rate of return by any standard, right?

It would be tough to match that by owning common stocks -- other than , maybe, the most speculative variety -- even with some leverage involved (e.g. via margin or equity options).

Yet such an impressive return can't viewed in a vacuum.

First, the fact is it's likely that all or a good chunk of that money put at risk in the sports bet could be permanently lost. In contrast, that can be a much lower probability outcome with, for example, a quality common stock that's bought well (i.e. plain discount to a conservative estimate of value) and owned for a very long time.

A sports bet -- or any bet -- is generally a zero-sum outcome. The reward comes at the expense of at least one other person.*

A good investment is -- or should be  -- very different. Capital certainly can and does get permanently lost with equity investments but, with a sound overall approach, the probability of it happening can be much reduced (over the long haul relative to typical pure zero-sum bets).

The value of a dollar bill will not increase in purchasing power over time. Well, at least that's the case if history is any guide. The fact is, especially over the very long run, most currencies tend to decline in purchasing power rather substantially. For a business -- whether owned outright or via common stock -- this need not be the case. Good businesses, unlike dollar bills, can intrinsically increase in value especially over the longer haul. They do so because, through their competitive advantages, quality businesses can profitably produce something of value year after year at an attractive rate of return on capital.** A business that is financially sound with a strong at least sustainable (though ideally improving) competitive position has the potential to generate attractive returns for quite some time.

So a key difference is investment can provide an outcome that is not zero-sum:

"...stocks grow in value over time because they retain earnings and they expand basically the companies underneath you." - Warren Buffett on CNBC

Those retained earnings may or may not be put to good use but, at least with capable management in place, it's unlikely the cash that's generated is being thrown into a furnace (though sometimes dumb capital expenditures and acquisitions act as a functional equivalent to this behavior). The earnings from a business with durable advantages should directly benefit long-term owners (via dividends and buybacks) or be of indirect benefit as the retained earnings are put to work (on hopefully what are high return investments) with an eye toward the longer term.

If two people put $ 100 each into a bet with each other then the winner walks away with $ 200 and the other walks away with, well, nothing.

Zero sum.

One winner.

One loser.

Much like the big football game this weekend.

If the same two people put $ 100 each into an investment that doubles in value both end up with $ 200. Both win.

Of course, it's also possible, unlike the bet, that they could have both ended up with a loss.

Now, an investment generally require much longer time horizons than a bet. Think decades. So they mostly will just not produce lottery ticket like outcomes. For those stocks that do happen to produce quick and spectacular returns, the risk of permanent loss was likely very high.

A big part of the challenge is minimizing the possibility of capital being permanently lost while still generating an attractive return. Risk and reward need not be positively correlated. Temporary paper losses are acceptable; permanent losses are not. Mistakes will inevitably be made but, when you can minimize the big losers then the winning decisions usually take care of things.

So returns need to be viewed in the context of the possibility of permanent capital loss. Most forms of gambling fail miserably in this regard. Gambling might provide some entertainment but, otherwise, it has little in common with investment.

I'd rather do something that's not such a zero-sum game. If I invest in equities – the businesses are growing; for example, Wrigley's will make more gum. It's automatically working for me, even if I do nothing. But if I invest in currencies, it's not working for me. - Charlie Munger at the 2005 Wesco Annual Meeting

Speculation and gambling are similar in many ways yet they are not the same:

"...I would distinguish between speculative and gambling. Gambling involves, in my view, the creation of a risk where no risk need be created." - Warren Buffett at the FCIC

Buffett contrasts pure gambling -- the taking on of risk that need not be taken on -- with someone who plants a crop early in the year, now has locked in expenses, and needs to speculate on what commodity prices will be late in the year.

The possible price fluctuation represents a real risk that already exists and needs to be managed. That kind of speculation is necessary and very important.

Lions, leopards, and house cats have some similarities but the differences matter.

Gambling, speculation, and investment might also have some similarities but the differences matter.

Investing well requires, among other things, figuring out what something is conservatively worth then buying when the discount becomes meaningful. A margin of safety is what protects against the unexpected and mistakes.

Buying a dollar bill for 50 cents makes permanent capital loss rather a lot less likely. The same goes for buying all or part of a good business at a 50% discount to intrinsic value (again, conservatively estimated) especially since there's the potential for increases to value.

Along the way market prices may fluctuate quite a bit but that, in itself, doesn't necessarily make the asset risky.


Related posts:
On Speculation and Investment
Bogle on the Financial System
Graham on Investment: "Most Intelligent When It Is Most Businesslike"
John Bogle on Speculation & Capitalism's "Pathological Mutation"
Bogle: Back to the Basics - Speculation Dwarfing Investment
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I

* For simplicity, I'm ignoring frictional costs here though many forms of gambling have huge frictional costs. So it's actually a negative-sum game for the participants putting money at risk (though not for the croupier).
** High returns on capital beats growth for its own sake. Businesses with exciting growth prospects understandably get plenty of attention. The question is (or should be) whether that growth can be achieved in a way that is beneficial to owners. Durable high returns on capital -- whether growing quickly or not -- is what matters. Growth can certainly be a good thing; it's just not inevitably a good thing.
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, January 23, 2015

Forecasting Folly

"There are two kinds of forecasters: those who don't know, and those who don't know they don't know." - John Kenneth Galbraith

With this Galbraith quote in mind, consider what Professor Daniel Kahneman wrote in an article back in 2011.

In that article, Kahneman explains that he was responsible for evaluating candidates for officer training during his time in the military several decades ago. The methods he and others at the time used were apparently developed by the British Army during World War II. Part of his job was to, after careful observation of potential officers, offer what were thought to be useful predictions about how these candidates were likely to perform in the future. Seems straightforward enough: simply figure out who was clearly qualified and who was not via a sound methodology.

Since certain individuals appeared to have strong leadership skills while others plainly did not, Kahneman (and others) felt quite comfortable making definitive predictions.

Unfortunately, that confidence was unfounded:

"...despite our certainty about the potential of individual candidates, our forecasts were largely useless. The evidence was overwhelming."

In the same article Kahneman also added -- and this might at least partially help explain why prognosticators continue to confidently prognosticate despite the folly of it -- the following:

"The statistical evidence of our failure should have shaken our confidence in our judgments of particular candidates, but it did not. It should also have caused us to moderate our predictions, but it did not. We knew as a general fact that our predictions were little better than random guesses, but we continued to feel and act as if each particular prediction was valid. I was reminded of visual illusions, which remain compelling even when you know that what you see is false. I was so struck by the analogy that I coined a term for our experience: the illusion of validity.

I had discovered my first cognitive fallacy."

If it's difficult to predict how one individual is going to perform, then the inherent difficulty of predicting what will happen with the stock market or something as complex as the global economy shouldn't exactly be a surprise.

Forecasting is tough to do reliably well. This article by Barry Ritholtz puts its more bluntly:

Pro Forecasters Stink, You're Worse

That doesn't stop many from trying to predict what is mostly just not predictable. There is, and there will continue to be, no shortage of experts making forecasts about, among other things, the markets and the economy. Many of them are extremely smart, informed, well-intentioned, credible sounding, and a number even have some interesting things to say.

The problem is that those well-intentioned experts may not necessarily be producing something that's genuinely useful. There naturally will be exceptions but, especially as the forecasts become more macro-oriented, I think it increasingly makes sense to be skeptical. The world has always been an uncertain place and will continue to be that way. Being flexible and open-minded beats rigid certitude.

Expert forecasters will no doubt continue looking into their crystal ball and offer what at least sounds like compelling thoughts about the future.

The fact that they continue to do so with a high level of confidence just might be, at least in part, the "illusion of validity" at work.

Unfortunately, some of us will also likely pay way too much attention to it.

From a separate article written by Ritholtz late last year:

"Despite the abysmal track record of almost all forecasters, the news media still loves them. It has air time and pages to fill and seems little concerned about giving space to money-losing prognosticators.

As I first wrote a decade ago, to forecast is folly. Today, we have Google Search to help us prove it. Pundits may forget, but not the Internet."

At a minimum, it seems like not a bad idea at all to at least pause for a second or two and consider carefully whether someone's predictions deserves any more consideration than the outcome of a coin flip.


Related posts:
Henry Singleton: Why Flexibility Beats Long-Range Planning
Forecasters & Fortune Tellers
Charlie Munger: Snare and a Delusion
On Forecasting
James Grant on Economic Forecasting

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, January 16, 2015

High Returns on Capital vs High Returns on Incremental Capital

The importance of high returns on capital has been covered a number of times in prior posts over the years.*

Well, it's not just the overall return on capital that needs to be considered. Some good businesses can generate very attractive returns on capital but not nearly as much on incremental capital. Naturally, some not so good businesses, whether they are growing or not, don't earn an attractive return on capital on much of anything. In this context, here's what Warren Buffett said about Coca-Cola (KO), See's Candies, and Buffalo News at the 2003 Berkshire Hathaway (BRKameeting:**

"The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke has high returns on capital, but incremental capital doesn't earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money, but can't generate high returns on incremental capital -- for example, See's and Buffalo News. We look for them [areas to wisely reinvest capital], but they don't exist.

So, what we do is take money and move it around into other businesses. The newspaper business earned great returns but not on incremental capital. But the people in the industry only knew how to reinvest it [so they squandered a lot of capital]. But our structure allows us to take excess capital and invest it elsewhere, wherever it makes the most sense. It's an enormous advantage."

One thing I think gets too little emphasis capital allocation decisions -- and doesn't get challenged nearly enough -- is the probability that the capital needed to pursue incremental growth will produce lousy returns or losses.

Questions like: Is the capital that's being allocated in pursuit of growth likely to produce an attractive rate of return adjusting (qualitatively) for the risks and considering alternatives? Are the range of outcomes narrow or wide? Is the worst case acceptable?

In other words, maybe the company will get bigger -- even impressively so -- but the shareholders end up no richer or even worse off and management ends up with a huge headache. Well, that headache just might lead to a core business that's not getting the attention it needs.

A number of otherwise sound businesses just can't get high returns on incremental capital. So it makes little sense for them to invest for growth. Unfortunately, this reality doesn't necessarily prevent the capital from being allocated imprudently anyway.

Intelligent capital allocation is one of those hard to measure but extremely important contributors to how much per share intrinsic business value will change, for better or worse, over time. Maintaining a comfortable financial position -- one that supports the business even in very difficult economic environments -- and competitive position is all-important. These things interact. Financial strength and flexibility allows the focus to be on creating/enhancing durable competitive advantages over time.

A business with a moat has a long-term competitive advantage.

Buffett calls activities that increase those advantages "widening the moat" and is paramount for investors.

Capital that's allocated to build, or at least maintain, long-lasting competitive advantages should take priority over, well, pretty much everything else.

Buffett on Widening The Moat

Wide Moat Businesses at the Right Price

Investment decision-making should come down to what will produce the highest returns on capital, with all risks and alternatives carefully considered, over the long haul. That, first and foremost, includes incremental investments aimed at protecting and strengthening the existing franchise(s).

The fact is that growth is too often pursued for its own sake and ends up destroying investment returns. As an example, costly and less than successful international expansions comes to mind. Lots of effort and capital put to work that ends up producing subpar results and even losses. Before meaningful capital is put at risk some healthy skepticism isn't the worst thing. Opportunity costs matter. An ill-conceived expansion or acquisition can become an expensive and high risk distraction. On the other hand, growth (whether organic or through acquisition) can at times be both high return while also making the moat wider.***

It's just not inevitably the case.

Some businesses have substantial financial strength along with durable competitive advantages but not much ability to make high return incremental investments. In those cases buying back stock can make a lot of sense if the shares are selling at a plain discount to per share intrinsic value.

From the 1984 Berkshire Hathaway shareholder letter:

"By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders."

The pursuit of dumb growth at the expense of moat widening initiatives should be avoided. This seems like it should be obvious but, even with good intentions, growth initiatives too often end up producing lousy or negative returns at significant risk compared to simply buying back a cheap stock.

Charlie Munger added this at the 2003 Berkshire meeting:

"There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there's never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit.' We hate that kind of business."

There's too much emphasis on growth with the implied or explicit assumption that all growth must be a good thing. Well, growth is just not necessarily a good thing.

There's too little emphasis on returns on capital (incremental or otherwise) and "widening the moat." 

Considering their importance to investors these things still often don't seem to get the attention that's warranted.


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

* Charlie Munger explains it this way: "Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."
** From notes taken by Whitney Tilson.
*** Or, at the very least, does no damage to the existing 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, January 9, 2015

Charlie Munger on Focus Investing

Charlie Munger once said:

"Our standard prescription for the know-nothing investor with a long-term time horizon is a no-load index fund."

It's simple.

There's plenty of low cost alternatives available.

Historically, index funds have performed better than the vast majority of active market participants over the longer haul.

So it at least seems a very reasonable prescription for many.

Well, what about those who think they aren't in the "know-nothing" category?

More from Munger:

"You're back to basic Ben Graham, with a few modifications. You really have to know a lot about business. You have to know a lot about competitive advantage. You have to know a lot about the maintainability of competitive advantage. You have to have a mind that quantifies things in terms of value. And you have to be able to compare those values with other values available in the stock market. So you're talking about a pretty complex body of knowledge."

Here's where his thinking gets more than just a bit less than conventional. He also happens to think, for those who are rightly confident and comfortable picking individual stocks, it makes little sense to diversify a whole lot.

"Our investment style has been given a name - focus investing - which implies ten holdings, not one hundred or four hundred. The idea that it is hard to find good investments, so concentrate in a few, seems to me to be an obvious idea. But 98% of the investment world does not think this way." - From Poor Charlie's Almanack

In a 1998 speech, Munger said he has "more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment."

So just how far from the "orthodox view" does he think it can make sense to go in some cases?*

"In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices.

I go even further. I think it can be a rational choice, in some situations, for a family or a foundation to remain 90% concentrated in one equity. Indeed, I hope the Mungers follow roughly this course."

That is, to say the least, far from conventional thinking, but the point is that diversification can be overrated.

Munger also once said:**

What's funny is that most big investment organizations don't think like this. They hire lots of people, evaluate Merck vs. Pfizer and every stock in the S&P 500, and think they can beat the market. You can't do it. Very few people have adopted our approach.

Now, the amount of portfolio concentration described above probably will likely be too extreme for most investors. It not only requires, after paying at least a fair price, having enough justified confidence in a very limited number of equities, it requires confidence that they will remain fine businesses long-term (and, as a result, will increase in per share value at a satisfactory rate).

So a concentrated portfolio becomes a recipe for real trouble for those who overestimate their own investing abilities. As always, it comes down to an awareness of limitations.

I think correctly judging which end of the spectrum -- with owning index funds being at one end, and owning a very limited number stocks at the other end -- is closer to the right approach for someone is easier said than done. At least it is based upon how poorly so many market participants have historically performed compared to the market overall.

At some level it comes down to knowing what you know and don't know.

Am I actually good at picking stocks?

Or am I getting into something I'm likely to not do very well?

It seems pretty clear that many don't quite get the answer to these kind of questions right. Too many think they're good at picking individual stocks and end up learning the hard way that they're just not; they attempt to outdo the market averages and, well, just don't in the long run. Lots of energy expended doing something that produces a result that's less than, all risks considered, what could have been accomplished simply buying a low-cost index fund (and learning to ignore the noise).

The reality seems to be that there are lots of active stock pickers --  some professional, some not -- who would be plainly better off NOT owning individual stocks. For these investors, index funds would not only improve long-term returns, they'd offer the bonus of additional free time to do something else more fruitful. I mean, the reality is that individual stocks often require a whole lot of work whether or not results turn out to be satisfactory.

Some might choose to think of an index fund as a way to simply match the "market average". Well, the word average is a distraction in this case. It turns out that, while it might called a "market average", it has hardly been an average result once frictional costs and mistakes are taken into account.
(i.e. If the vast majority of active participants are underperforming, then that by definition means simply matching the average is an outperformance. The word average in this context seems unfortunate.)

Now, it's worth pointing that index funds will only work if they're left alone over the long haul as the market (or individual stocks) goes through the inevitable -- occasionally rather wild -- fluctuations.

So fund investor behavior is a big factor and too often it is a negative one.

Unfortunately, it's the well-intentioned temptation to jump in and out of investments that too often contributes to bad outcomes. In other words, those fluctuations should either serve or be ignored. It's also worth pointing out that future expectations for long-term returns should probably be much reduced compared to the historic norms. Those who don't temper their long-term return expectations for the market as a whole going forward just might end up being rather disappointed.

As far as I'm concerned, though forecasters and fortune tellers will no doubt keep trying to prove otherwise, it's nearly impossible to know what's likely to happen in the future. The world for investors always has been, and always will be, an uncertain place. This reality need not adversely impact investment performance but too often that's exactly what happens. There's just no point in trying to foresee the mostly unforeseeable. Yet that doesn't stop smart people from wasting way too much energy trying to do just that. Instead of focusing on what's in their control (price paid, estimates of value, emotions, etc.) they focus on those things they mostly control or reliably predict.

I'll take someone any day who just says "I don't know" what an individual stock or the market as a whole is likely to do (near-term and even much longer) over those who are willing to make prognostications. Better to just expect difficult market conditions from time to time and realize that those difficulties may look nothing like those of the past; maintain reasonable but conservative expectations then end up pleasantly surprised if things go a bit better.

Also, having a flexible approach doesn't hurt.

Effectively picking individual stocks doesn't just come down to whether an individual possesses the necessary background technical abilities, it just as often comes down to psychological factors. For starters, it's not a bad idea to consider overconfidence the greatest enemy of all for investors. More generally, investing well means having a realistic sense of limits, abilities, and characteristics. Those that possess an ability to be sensible and long-term oriented when the markets become emotionally-charged from time to time (and they surely will!) have a big advantage.

So index funds, individual stocks, or some combination can be a logical approach depending on circumstances, skill set, and temperament (among other things). There is also, of course, a number of very capable active fund managers. It's one thing to identify who has done well in the past but it's much tougher to identify who will do well, over the long run, going forward.

In any case, no matter what the necessarily-unique-for-each-investor approach might be, lots of trading activity will likely do more damage (via additional mistakes and frictional costs) than good to long-term results. In other words, it's buying what makes sense consistently, trading minimally, then allowing those investments to compound over many years. The emphasis being on what's produced over time. Price and value should dictate investor action; market price action should not. Again, how prices fluctuate near-term or even longer should either serve the investor or be ignored.

Unfortunately, stocks are hardly cheap these days. So, for those with a long enough time horizon, a rising market is the last thing they should want right now. A rising market would make what is not particularly cheap even less so. More risk; less potential reward.

Whatever approach happens to make sense a very long time horizon is essential. Investment requires that the capital won't be needed anytime soon. Think decades not years.***

I'd add that who offer opinions on and attempt to understand hundreds of different stocks (and other investments) aren't acting in a way that's likely to produce great overall results. At least not for most of us mere mortals. Some skepticism seems in order for those who confidently offer a view on practically every investment alternative.

To me, the expert who frequently says "I don't know" when asked a question deserves credit instead of criticism. Though in itself insufficient, it's at least one indication that they're aware of their limitations.

Investment results are heavily influenced by the avoidance of big mistakes (i.e. permanent loss of capital that's substantial relative to the portfolio being managed). It's not that mistakes won't be made. In fact, they're unavoidable even for those who are very capable. The key is that they're kept small in relation to the overall portfolio. The possibility of a big gain should take a back seat the risk of permanent losses. Sticking with what you really know goes a long way towards this.

It's worth noting that Berkshire Hathaway's (BRKa) current size (and other factors) doesn't allow it concentrate the way it once did.

Still, if you look at the Berkshire equity porfolio, most of the dollars are invested in just five stocks.

It's also worth mentioning that, other than Berkshire's portfolio, the other (much, much, much smaller) portfolio that Charlie Munger apparently has some influence over these days is, I think it's fair to say, rather concentrated.

It's very much consistent with what Munger said above.


Long position in BRKb established quite a while back at much less than recent market prices. No intent to buy or sell near current prices.

Related posts:
The Seventh Best Idea
Index Fund Investing Revisited
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
Investor Overconfidence Revisited
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

* Munger also once said"The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn't make you with a whip and a gun?"
** This Charlie Munger comment comes from notes taken by Whitney Tilson.
*** Returns measured over time frames like two to three years or less are essentially coin flips. I'd argue five years is the absolute minimum and more like ten to twenty years or longer should be the focus.
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, January 2, 2015

Quotes of 2014 - Part II

Some additional quotes from 2014 as a follow up to this recent post.

Quotes of 2014

In the quote below, Buffett explains why liquidity sometimes is converted into a curse when it should be a clear advantage:

Buffett on Farms, Real Estate, and Stocks - Part II

"Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate.

It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.

Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.

Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of 'Don't just sit there, do something.' For these investors, liquidity is transformed from the unqualified benefit it should be to a curse." - Warren Buffett

He then explains how both he and Charlie Munger like to think about stocks:

"When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.

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." - Warren Buffett

Here's Charlie Munger's take on some of the boardroom dynamics that can cause compensation to end up being less than optimal for shareholders:

Buffett & Munger on Compensation - Part II

"You start paying directors of corporations two or three hundred thousand dollars a year, it creates a daisy chain of reciprocity where they keep raising the CEO and he keeps recommending more pay for the directors..." - Charlie Munger

He also explained why lots of disclosure regarding executive compensation is not necessarily the best thing for shareholders:

"I think envy is one of the major problems of the human condition... And so I think this race to have high compensation because other people do, has been fomented by all this publicity about higher earnings. I think it's quite counterproductive for the nation. There's a natural reaction to all this disclosure because everybody wants to match the highest." - Charlie Munger

In a memo written by Howard Marks back in September of 2014, he offered some thoughts about the various forms of risk. It is, to say the least, rather comprehensive. In my view, the memo is well worth reading -- not at all surprising since it is written by Marks -- in its entirety.

Some thoughts from Marks on risk:

Howard Marks on Risk

"We hear it all the time: 'Riskier investments produce higher returns' and 'If you want to make more money, take more risk.'

Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn't be riskier." - Howard Marks

"...the riskiest thing is overpaying for an asset (regardless of its quality), and the best way to reduce risk is by paying a price that's irrationally low (ditto). A low price provides a 'margin of safety', and that's what risk-controlled investing is all about. Valuation risk should be easily combatted, since it's largely within the investor's control. All you have to do is refuse to buy if the price is too high given fundamentals.'Who wouldn't do that?' you might ask. Just think about the people who bought into the tech bubble." - Howard Marks

Here's how Buffett and Munger view macro factors in the context of investing:

Buffett: We Ignore the Macro Factors

"We look at opportunities, as they come along, we try to figure whether we can understand the long term economic prospects of the business. A lot of times the answer is no, then we forget it. We are not making any judgment about where the market is going or we are not looking at any macro factors.

My partner Charlie Munger and I have been working together now 55 years. We've talked about every business you can imagine and stocks. We have never had one decision that involved a macro factor. It just doesn't come up." - Warren Buffett

Buffett then added:

"We don't get into macro. It just doesn't make any difference. We do decide whether we think we know where that business will be in 10 years or 20 years, and we know what we'll pay in terms of valuation." - Warren Buffett

More from Buffett on why liquidity can become a curse when it really should not be:

The Curse of Liquidity

"...if you are buying a business to own...the idea of what the market does on any given day, it's just meaningless. What you really have to look at is where you expect the business to be 5 or 10 or 20 years from now." - Warren Buffett

That's how most will think about businesses that aren't traded daily but, because stocks are quoted so frequently, behavior is changed for the worse.

 " can look at stock prices minute by minute. And that should be an advantage but many people turn it into a disadvantage." - Warren Buffett

Happy New Year,


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